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On Misplaced Faith in Regulation, the System Stewardship Groundswell, & Sesquimateriality

With “ESG investing” and shareholder activism occupying an increasingly prominent position in public discourse, we offer our thoughts on where investors’ and regulators’ roles in addressing systemic risks begin, end, and overlap. We also suggest you should help us get #sesquimateriality trending on social media.
Regulation v. System Stewardship: The Fading Promise of Governmental Intervention

We’re hardly alone in pointing out that today’s ESG activism has failed to stop companies from externalizing social and environmental costs when they can gain a financial advantage by doing so. Many other critics conclude that shareholder activism at companies is therefore a distraction at best and greenwashing at worst, and that shareholders should focus on government regulation as the only way to rein in cost-externalizing business decisions.    

While these criticisms often come from quarters that desire a more activist government role, a similar objection has emerged from a different direction. In the United States, and to some degree in other countries as well, a burgeoning right-of-center coalition complains that ESG activism by corporations and investors oversteps their proper sphere of influence. Led by conservative state officials, they maintain that corporate managers and investment professionals should use their power to maximize the returns of companies, not to engage in quasi-regulation. They argue, for example, that public pension funds shouldn’t ask individual companies to engage in any activity that doesn’t strictly relate to increasing their own profits, because doing so might reduce the money ultimately available for state workers who depend on pension funds for their retirement.

While these two sides are polarized on desired outcomes, they share a common, siloed view of how companies, regulators, and the economy operate, arguing as if each does not influence the other. In fact, there are multiple feedback loops among them. It is an observable fact that if shareholders do not use their governance rights to rein in the individual companies they own, those companies will, in pursuit of profits, find opportunities to externalize costs, lobby against regulation that reduces their profits, and use jurisdictional arbitrage to defeat rules that are passed. But while preserving profits at individual companies, these corporate activities often result in lower overall long-term economic performance that drags down overall portfolio performance. The micromotives of corporations thereby defeat the macroeconomic goals of their diversified investors, who rely on a strong economy, which in turn requires sensible rules to protect common resources.

To be effective, shareholder activism must focus on the conflict of interest that exists between individual companies and their diversified shareholders. Starting from that understanding, investors can practice system stewardship with a view toward complementing regulatory strategies. First, investors should exercise their corporate governance rights to stop corporate influence on the regulatory process where that influence interferes with economy-maximizing solutions. Second, investors should implement guardrails across their portfolios, limiting companies’ ability to use business practices that are profitable from an individual company perspective, but costly from the perspective of long-term, diversified shareholders.

To put a finer point on it, corporate capture accounts for much of the political paralysis that stymies meaningful regulation of systemic threats. Diversified investors and their fiduciaries can and should wield their stewardship power to address these threats in order to protect their ongoing portfolio value and prosperity.
Climate-related Risks & Diversified Shareholders' Interests
In March, the U.S. Securities and Exchange Commission (SEC) proposed a new rule that would require companies to disclose some of their greenhouse gas emissions in a standardized way, and to explain to investors how climate change could affect companies’ financial performance. The proposed rule focuses on “climate-related risks that are reasonably likely to have a material impact on [a company’s] business, results of operations, or financial condition.” Of course, this formulation excludes the risk companies impose on the broader economy and diversified portfolios when they externalize their environmental costs.

TSC and B Lab U.S. and Canada submitted a comment letter on the proposed rule explaining why climate disclosure needs to focus on economy-wide impacts of company behavior, not just on how climate change affects company performance. Our letter focused on two axes of investor-centered climate concern:
  • Alpha v. beta: Investors’ climate-related financial risk can be divided between two value perspectives: (1) company-specific risks that potentially affect the relative performance of individual companies (“alpha”) and (2) systematic risks that potentially affect the performance of the markets as a whole, chiefly by threatening the performance of the global economy (“beta”).
  • Security selection v. stewardship: Investors have two primary methods by which to mitigate investment risk. Security selection directly impacts on portfolio performance by determining what securities are in a portfolio; the extent to which security selection can be a tool to influence beta is less clear. Stewardship—voting and engaging with companies already in an investor’s portfolio in order to change their behavior—can be a wielded as tool with an intent to drive either alpha or beta. 
As proposed, the rule is designed to assist investors in driving alpha, either through security selection or stewardship. Our letter argues for a disclosure framework that would also support a beta stewardship approach whereby investors engage with companies and vote their shares to push companies to end practices that, even if profitable for the company, threaten the economy and thus overall market returns. We believe that without an effective beta-stewardship approach, the drive for individual company financial performance will continue to drive climate risk. An alpha-centered investment thesis is simply not viable in the face of the climate threat.
Growing Body of Resources for System Stewards
In June, our friends and colleagues at The Investment Integration Project (TIIP) released a new report, Approaching the Tipping Point: Recommendations for building the marketplace for system-level investing, to help answer some of investors’ biggest questions around the implementation of system-level investing. It found that many investors want to do something to manage systemic social and environmental challenges and are familiar with system-level investing as a concept, but many struggle to implement strategies in practice. The report said:
Organizations like TIIP, The Predistribution Initiative, The Shareholder Commons, the CFA Institute, and investors, industry associations, and academics alike have provided early thought leadership about system-level investing, developed theoretical frameworks, and produced a library of related resources. As such, the financial industry does not have to spend time “reinventing the wheel” during this first phase of industry transformation. Rather, it can instead focus on identifying, curating, and adapting and improving on work that has already been done to ensure that the resources developed as part of this plan reflect best practices and industry consensus.
We couldn’t agree more, and are heartened to see a growing swell of support and tools for investors who understand that the greatest store of diversified portfolio value is the health of systems that underpin a thriving economy.
From Financial Materiality to Sesquimateriality: Comments on IFRS Disclosure
The International Sustainability Standards Board (ISSB) sought public comment on its:
  • Exposure Draft IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information (General Requirements Exposure Draft), which sets out the overall requirements for an entity to disclose sustainability-related financial information ; and
  • Exposure Draft IFRS S2 Climate-related Disclosures (Climate Exposure Draft), which builds upon the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) and incorporates industry-based disclosure requirements derived from SASB Standards.
TSC and B Lab Global submitted a response to both, supporting the comprehensive sustainability disclosure requirements while urging the ISSB to eliminate the enterprise-value limitation from the standards:
Because an entity’s sustainability-related information can be highly useful to its investors without necessarily being material to the entity’s own enterprise value, limiting the ISSB standards to enterprise value-oriented data will create an incomplete and quickly obsolete set of standards for general use financial reporting, as more investors demand the information necessary to protect the value of their diversified portfolios. Such protection requires investor-led stewardship to address the divergence in interests between individual entities that can externalize social, economic, and environmental costs, and diversified investors, who inevitably internalize those same costs.
Podcast: On System Stewardship, Sesquimateriality, & Rebutting Mike Pence
Our CEO Rick had the pleasure of joining Jérôme Tagger of Preventable Surprises and Alison Taylor of Ethical Systems on their “Breaking the Fever” podcast. Rick discussed the need for investors to shift to a perspective that considers entire portfolios, not just single companies within those portfolios. He also talked about “sesquimateriality,” a concept described in his piece at The Harvard Governance Forum arguing that the ISSB ought to widen its aperture to prevent its own obsolescence. (Is the world ready for #sesquimateriality? Care to try to get it trending on social media?) And finally, Rick offered his rebuttal to former U.S. Vice President Mike Pence’s comments on political bias among ESG advocates. Listen here.
Podcast: On System Stewardship, Corporate Capture, & the Comfortable Mirage of Divestment
Our CSO Sara enjoyed talking with Christine Macdonald of Tulipshare on their new podcast, “The Activist Investor.” Sara talked about how investors need to move toward a guardrail approach to protect diversified portfolio value from system-level risks. Sara also discussed what makes her optimistic and pessimistic about the world’s ability/willingness to address climate change, declining public health, and other systemic risks, along with her thoughts on divestment’s illusory promise to address ESG concerns. Listen here.
That's All for Now
We’re grateful to the Ford Foundation, the Omidyar Network, the Tipping Point Fund on Impact Investing, the Lankelly Chase Foundation, and the Heron Foundation for their investment in system stewardship through a range of organizations, including TSC.

Our work is made possible by generous supporters who understand the power of capital markets to affect our society and planet’s critical support systems, for better or for worse. To donate or to learn more, please contact Sophie or visit our website.
Team TSC
Rick, Sara, Sophie, and Eduardo
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