Socially responsible investing is turning into a covert war on fossil fuels

Once a practice rooted in religious beliefs, socially responsible investing, or ESG investing in today’s lexicon, is about to become a secular practice mandated by the government.  

The Biden administration’s push to require all publically-traded firms to report their greenhouse gas emissions as a component of new public disclosure requirements is a step toward making ESG investing mandatory. In this new twist, the government will decide which firms deserve access to investment capital. Mandatory reporting of greenhouse gas emissions will lead to government regulations that will curtail new capital investments in companies that produce or consume fossil fuels.       

With a United Nations endorsement, the socially responsible investment fashion of the late 20th century transitioned into the Environmental, Social and Governance movement or ESG. Once a voluntary movement that prioritized investment in companies that adopt policies and practices that promote the progressive left’s environment, labor and human rights causes, ESG investing is about to become a regulatory tool they will use to achieve specific objectives.     

Investor interest in voluntarily supporting companies that champion specific nonprofit-oriented practices created incentives for businesses to signal their ESG efforts in public disclosures. The movement spawned an industry to provide ESG ratings that purportedly assess a firm’s adherence with ESG-related climate change, labor and governance policies. Investment managers use these ratings to identify ESG-friendly companies. More recently, international pressures have been building to standardize and mandate ESG disclosure. Last year, the UN Climate Change Conference (COP26) established the International Sustainability Standards Board (ISSB) to create standards for companies to use when making periodic disclosures on ESG-related issues.   

The experience with voluntary ESG disclosures suggests that mandatory disclosures alone are unlikely to produce progress on progressives’ agenda. Because voluntary company ESG disclosures and ESG rating have not produced the left’s desired outcomes, further government measures will be required.    

The incongruence between ESG ratings and the progressive left’s agenda is readily apparent. For example, a recent Bloomberg report analyzing the ratings produced by MCSI Inc. found that they “don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: The potential impact of the world on the company and its shareholders.” Similarly, an analysis of MSCI’s large bank ESG ratings found that many large banks received ESG rating upgrades “in recognition of their environmental efforts” despite the fact that they were among the banks most active in funding the oil and gas industries.    

The dissonance between ESG ratings and ESG goals is not limited to one rating agency. According to the Dow Jones North American Sustainability Index, Philips Morris gets a high ESG rating despite the fact that it sells 700 billion cigarettes a year. The irony is that the crusade to disinvest ‘big tobacco’ was one of the first organized campaigns of the nascent ESG movement. Similarly, Alphabet, Amazon and Facebook receive favorable ESG ratings while few socially responsible investors would likely consider them good corporate citizens, given their alleged monopolistic practices and their history of labor disputes.   

The fuzzy link between ESG disclosures and agency ESG ratings is being used to justify the standardization of ESG disclosures. But the move to standardize and mandate ESG disclosures has another purpose. It is the first step toward creating metrics regulatory agencies can use to penalize public companies involved in politically disfavored industries — most immediately, those that extract, refine or use significant amounts of fossil fuels.  

In the United States, the Securities and Exchange Commission (SEC) has jurisdiction over rules regarding mandatory disclosures in securities prospectuses and reoccurring public company reports. Since 2010, SEC guidance regarding ESG-related disclosure is that ESG considerations should be discussed when they represent a material factor in the business description, risks, management outlook or legal proceedings facing a company. The SEC is currently revisiting this guidance and seems likely to require public companies and investment funds to report on their ESG-related accomplishments in a standardized format that includes disclosures on their greenhouse gas emissions calculated using GHG Protocols.   

The plan to mandate disclosure of public companies’ greenhouse gas emissions, while veiled as an initiative to improve public disclosure, serves another policy goal of the Biden administration — restricting fossil fuel-intensive industries’ access to investment capital. The recent Financial Stability Oversight Council report found that climate change poses a systemic risk to the financial sector. Such a declaration empowers financial regulators to use Dodd-Frank Act powers to identify and mitigate systemic threats to the financial system.   

Under authorities granted by the Dodd-Frank Act, new regulations can be imposed to discourage investment in firms with high greenhouse gas emissions using the justification that the regulations are needed to reduce financial system systemic risk. Requiring public companies to disclose their emissions is but the first step in a broader policy agenda.   

Regulations to discourage investments in high emissions firms could take many forms once public firms are required to report them using standardized methods. Regulators could impose higher bank regulatory capital requirements for investments that fund firms with high emissions. Alternatively, they could use supervisory stress tests with extreme climate-change transition shocks to force banks to categorize such firms as exceptionally large credit risks. They could impose limits on the total greenhouse gas emissions in investment portfolios and require credit rating agencies to downgrade securities linked with high emissions. As Assistant Secretary of the Treasury for Financial Institutions Graham Steele has written, there are countless ways the data could be used to restrict carbon-emitting firms from accessing investment capital. 

Today, the option of investing in companies with ESG-friendly policies is at risk of being transformed into a requirement that companies prioritize the progressive left’s ESG goals over shareholder returns. Not only are periodic ESG disclosures likely to become mandatory, but the standardized data they will be required to provide will allow regulators to penalize public companies involved in disfavored industries including those that invest in, or make heavy use of, fossil fuels.  

Paul H. Kupiec is a senior fellow at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.