Hearing on “Protecting Investor Interests: Examining Environmental and Social Policy in Financial Regulation”

Summary

Past and ongoing regulatory efforts by the Securities and Exchange Commission have
entrenched a proxy advisory duopoly that has had the effect of increasing the politicization of
corporate business decisions and the allocation of capital assets, in particular in pursuit of
environmental, social, and governance objectives. This regulatory environment has led to a
substantial degree of automatic voting by managements in accordance with the recommendations
of the proxy advisers, which have few incentives to pursue the interests of shareholders and the
efficient allocation of capital, allowing them to indulge their own personal political preferences.

Under the chairmanship of Mr. Gary Gensler, companies essentially have lost the right to
respond to the recommendations made by the proxy advisers, to correct factual errors, and to
delineate analytic mistakes and inconsistencies between shareholder interests and the proxy
advice. In addition, an important SEC rule (Rule 14a-8) has been changed substantially;
previously, it allowed firms to seek a “no action” determination from the SEC staff allowing
management to exclude specific shareholder proposals from the annual proxy vote, in particular
ones irrelevant to the performance of the firm, certain not to enjoy more than marginal shareholder
support, and, crudely, a waste of time and resources. The application of Rule 14a-8 has been
changed to require firms to consider resolutions of “wider societal interest.”

One study published in 2020 found that pension funds with an ESG orientation lagged
those of non-ESG funds by two basis points per year over a ten-year period. One reason for this
systematic underperformance is obvious: An artificial constraint on the securities to be included
in a portfolio cannot increase expected returns. Analysis of the effects of ESG investing and
business management is complex, but it is unlikely to be small. Such a reduction in economic
returns means for the economy in the aggregate an inexorable reduction in the efficiency of capital
allocation and investment, a reduction in the economic value of the capital stock, a smaller
economy in real terms, less employment, and a reduction in labor productivity and wages.

These effects are difficult to estimate, particularly given that the shift toward business
management and investment behavior is constantly evolving, as is the case for policy formulation
in this area, so that no long term “equilibrium” impacts yet are observable. But a rough analysis
under wholly plausible assumptions suggests that expected investment returns might decline by
about 0.4 percent (40 basis points) over a 20-year period. Annual investment might fall by about
$16.4 billion, the capital stock over 20 years would decline from $59.4 trillion in 2021 to $52.6
trillion, yielding a decline in annual GDP of $850 billion, other factors held constant, and a decline
in the labor share of GDP — wages, salaries, and other compensation — of $510 billion annually,
or about 3.3 percent. Even an effect an order of magnitude smaller would not be trivial. However
crude these calculations, the adverse effects of a politicization of business management and capital
allocation can be serious under assumptions that, again, are wholly plausible, far more so than
commonly asserted.

Policymakers would be well advised to focus on regulatory and legal reforms aligning the
interests of the proxy advisory firms with those of their clients’ shareholders. The large asset
managers — Blackrock, State Street, and Vanguard — whatever the justified criticisms aimed at
them in this context, nonetheless have shareholders to whom they must answer directly, and thus
have far more powerful incentives to make recommendations that are efficient economically. This
reality is illustrated by the far weaker support for ESG resolutions by the large asset managers than
has been the case for the proxy advisers, or for the smaller institutional asset managers without the
resources to do their own independent analyses.

Policymakers should act also to constrain the efforts by regulatory agencies to pursue an
expansion of their ability to force ESG and other political objectives through regulatory policies
despite the absence of statutory authority to do so. A good example is the SEC proposed rule for
“The Enhancement and Standardization of Climate-Related Disclosures for Investors.” Among
other requirements, it would mandate that public companies estimate their greenhouse gas
emissions defined broadly, and analyze the “risks” that their emissions might pose to their current
and future investors. The problems that the proposed rule would create are serious, among which
would be an increase in the politicized allocation of capital and a reduction in aggregate economic
performance. The “information” to be disclosed would not be material, and the responses of public
companies would be driven by an imperative to avoid regulatory and litigation threats. No public
company has the ability to conduct the analysis demanded by the SEC — even the
Intergovernmental Panel on Climate Change has found it effectively impossible in a way consistent
with the evidence on climate phenomena — and a massive increase in litigation would be a
certainty regardless of how public companies were to respond to the regulatory requirements.

A similar set of problems are attendant upon the “high-level framework” “draft principles”
presented by the Board of Governors of the Federal Reserve System for the evaluation and
management of climate-related financial risks confronting Fed-supervised financial institutions
with over $100 billion in total consolidated assets. The evaluation of such risks would require
speculation about the evolution of political conditions and public policies. Moreover, the
overwhelming body of evidence suggests strongly that the “transition to a lower-carbon economy”
would prove hugely expensive, so that the almost-explicit Fed assumption that such a “transition”
is a virtual certainty is not to be taken seriously.

The proponents of policies designed to reduce GHG emissions almost never offer
projections of the climate impacts that their proposals will yield. Accordingly, it is important for
this committee to note, even in summary fashion, the future climate effects of public policies and
private actions reducing GHG emissions. A good example is the net-zero emissions policy of the
Biden administration: Applying the Environmental Protection Agency climate model, under
assumptions that exaggerate the future effects of reduced emissions of GHG, the net-zero policy
implemented immediately would yield a reduction in global temperatures of 0.173°C by 2100. The
ESG imperative for emissions commitments would have even smaller effects.

The efforts by ideological, bureaucratic, and economic interest groups to force businesses
and asset managers to redirect resources in ways favored politically represent, narrowly, the return
of Operation Choke Point, an illegal past attempt to politicize access to capital, one deeply
corrosive of our legal and constitutional institutions. More broadly, protection of those institutions
is consistent only with formal policymaking by the Congress through enactment of legislation.
This institutional protection would preserve the traditional roles of the private sector and of the
government, respectively, as part of the larger permanent objectives of maximizing the
productivity of resource use under free market competition, and of preserving the political
accountability of the policymaking process under the institutions of democratic decisionmaking as
constrained by the constitution.

Proponents of the market allocation of resources through the price mechanism — the only
system consistent with the preservation of freedom and the avoidance of a long-term shift toward
massive central economic planning — clearly recognize and support the right of individuals and
groups to use their own resources to pursue their preferred political outcomes. But the
politicization of business management decisions and the allocation of capital resources is a serious
problem for which government policies are responsible in substantial part. They are, in a word,
coercive. It is essential that Congress act to reverse and proscribe the regulatory actions both past
and prospective facilitating this growing trend of politicized resource allocation.

The 2003 SEC regulation that has created the ISS/GL proxy advisory duopoly must be
reformed. The same is true for the staff actions that have created a requirement that funds must
vote on all proxy issues, that funds could avoid liability by retaining proxy advisers, and that the
proxy advisers would bear liability only in extreme cases.

The right of companies to respond to the recommendations made by the proxy advisers, to
correct factual errors, to point out analytic mistakes and inconsistencies between shareholder
interests and the proxy advice, and other such relevant parameters must be reestablished. The
recent weakening of the right of firms to seek a “no action” determination under SEC Rule 14a-8
must be strengthened, in particular by removing the “wider societal interest” criterion for
disapproval of “no action” requests by firms with respect to proxy proposals irrelevant, politicized,
already rejected solidly by shareholders, and/or wasteful.

Congress should act to constrain the ability of regulatory agencies to expand their mandates
beyond those authorized by statute, and I hope that the Congressional Review Act will be applied
with increasing frequency. Above all, Congress must make it clear that only under new legislation
can regulatory efforts to force reductions in GHG emissions be justified.