Environmental, Social, and Governance Funds with Paul Brest and Colleen Honigsberg

Shareholders and investors alike are pressuring companies to improve their environmental, social, and governance performance. And an increasing number of funds are designated as ESG. But how do we measure—and verify—ESG? Who performs the audits and do the ratings matter? Join co-hosts Joe Bankman and Rich Ford for a discussion with Professors Paul Brest and Colleen Honigsberg, co-authors of the Measuring Corporate Virtue and Vice: Making ESG Metrics Trustworthy, a book chapter of the recently published Frontiers in Social Innovation.

This episode originally aired on SiriusXM on April 23, 2022.

Environmental, Social, and Governance Funds with Paul Brest and Colleen Honigsberg


Rich Ford: From Stanford University and SiriusXM. This is Stanford Legal, I’m Rich Ford.

Joe Bankman: And I’m Joe Bankman. Today, we’re talking in front of a live audience with former Stanford Law School Dean Paul Brest, and our colleague Colleen Honigsberg about the challenges in measuring ESG metrics and corporate virtue and vice.

Bankman: Why don’t we just start off by asking the question of our guests, to jump in and tell us what these ESG metrics are. And Colleen, maybe I’ll address that to you. Just give us a brief primer on what we’re talking about.

Honigsberg: Sure. So there has been a huge interest in investing, and trying to actually invest in companies that not only make money, but also do good for the world. And so stated briefly, ESG is an attempt to identify, and measure, and track those companies. And so it’s a way that we assign sort of rankings and measurement, and so that we can actually identify which companies are doing good. The E stands for environmental, the S for social and the G for governance. And then within each of those categories, there are a bunch of different things.

So for example, for environmental, we’re going to start with carbon because that’s of course where everybody’s going to start, but you can also think of things like clean water would fall into environmental. For S you see a lot of interest in a lot of focus on things of diversity, avoiding force labor, avoiding child labor, but also treating your employees well. And, paying a living wage, human capital management, all those kinds of things. And then within G it’s like, how well is the firm governed? And so, how much power the shareholders have, how able are they to, express their voice? And we have a bunch of different measurements within corporate law to better identify those. So ESG is sort of how do we identify good features in each of these categories, and then rank the firm and, identify the firm that are doing well on these sort of environmental, social governance factors, in addition to just the pure profitability.

Ford: So Colleen, I want to invest in a company that I think is doing good things in the world, as well as just making money, and I could look at these ESG metrics and I would have a good idea of how socially responsible, how environmentally responsible the company is, is that the basic idea here?

Honigsberg: So that’s the theory, yes. Now, I think is what Paul and I wrote about is, it’s really, really, really difficult to do this in practice. And so that’s exactly what Rich said, that’s the theory of how it works. In practice, we have, I think, a long way to go before we’re really there.

Bankman: Let me ask Paul, can you tell us about, I’m thinking these are really different subjects. I mean, corporate governance is something most people don’t think about as investors, but some might, at least the average person might not the environment we might think about as purchasers or consumers as investors. How do these work at, do we just add up a number? How does this ranking system work?

Paul Brest: So you need to begin by thinking about each metric and its validity by itself. So there’s some things that are really easy to measure, for example, a company’s own greenhouse gas emissions are really quite measurable, but even in the environmental area, there are ones that are more difficult ones involving kind of water usage, which depends not just on how much water the company uses, but how readily available water is. And then on, as Colleen mentioned on the social side, there are things ranging from diversity, to whether you have child labor or forced labor. And those are probably, the child labor and forced labor are readily measurable, but there are questions then about whether those are readily auditable by some objective source. You have to begin with each one. And then as you suggest, Joe, the difficulty of aggregating them is really quite significant. That if somebody, a consumer investor may care a great deal about greenhouse gas emissions, but that same person may care less about diversity. So when you begin putting them together, it’s not clear what metric you can use to integrate them.

Ford: So we’ve got three problems, then. One is just, how do you measure certain things? And that could be perhaps manipulated. Then you’ve got the problem of auditing. Maybe you can measure it, but you don’t know whether or not the company’s giving you an accurate measurement. And then you have the problem of trying to aggregate all three of these kind of disparate areas into one metric. Is that right?

Brest: I think that’s, that’s exactly right. And you know, it’s interesting, there are a number of companies that provide ESG ratings and it’s striking that the correlation, in the ratings, that the different companies get is pretty, pretty low.

Honigsberg: I’m going to jump in also, I think it depends to some degree which item you’re measuring, in that you can imagine, for some of them it’s very easy exactly, as Paul was saying, or not very easy, but carbon, we have, direct emissions that are way of measuring. For some, they’re a little bit more opaque, like does this company, are they good to the community? And you know, it’s a little bit hazier and harder to identify sort of, yes, no. So in some cases, depending on the particular factor, it can be more difficult.

Bankman: Colleen, let’s focus on maybe measurement first, and then I’d like to talk to you and Paul about the auditing, but can you give us an example of, kind of measurement issues that came up? I think we were talking about Google’s measurement methodology and maybe you could kind of walk us through some of that or pick up another example. So we get a sense of what’s going on when we look at a bottom line number.

Honigsberg: So I think what we had talked about before for Google, so we have, many companies have a goal. They want to be say net zero in turn of their carbon emissions. And so of course they’re producing some carbon. And so then we try to have offsets to get us down to net zero. So for example, Google, one of their offsets traditionally has been carbon saved by giving people good directions through Google maps, which I think we can all agree. Maybe there’s some sense to it actually, but it’s perhaps not intuitive. And so without a very comprehensive measurement system of exactly, this is what we would count as an offset. It becomes a little bit hazier. And I think an example of that, another one, there was recently like an NGO that came out and said, here are a whole list of us companies that are using force labor in China.

And when I looked up the ESG ratings for these companies, about 40% of them were rated triple a or double a by the lead a ESG rater. You would think a company that’s rated as a leader, triple a or double a would not be using forced labor, at least according to this NGO, it was, or all of them were. And so it’s really hard to identify some of the problems, even if we know, forced labor clearly is bad and, we need to get rid of it. But it’s hard to identify which companies are engaging in those practices. And I think this is where, as Paul mentioned, the auditing and the verification comes up.

Brest: Before we get to the auditing, I think it’s helpful to begin with just taking a single metric and seeing how robust it is. So take what I think is the best, the most measurable metric, which is greenhouse gas emissions. If you’re measuring your own emissions, which is in the parlance of this world called scope one emissions, that’s really easy. How well it’s audited is a different question, which you’ll come back to. As soon as you begin going to what are called scope three emissions, which are emissions that you in some way are responsible for either up or down your supply eye chain, they become far more difficult to even define what counts. So for example, there’s a Stanford task force, which I’m on trying to measure Stanford scope three emissions. Does that include faculty transportation? Does it include student transportation? Does it include faculty housing? Those are some decisions that have to be made before you can even measure it.

So we’d have to decide, for example, whether the emissions that are incorporated in flying all of our great guests here for those listening, this is student admit day. So in our auditorium here in room 290, our big lecture room, we have a bunch of terrific, prospective students here and we’ve asked them to fly out, but I suppose that’s entailed some greenhouse gas and is that credited against us or debited to us?

Ford: So Paul all and Colleen, given all of these complexities, I mean, Google can say we saved X number of carbon emissions because people didn’t drive around the block trying to find their location. I suppose Uber could say we saved carbon emissions because people didn’t drive. And instead they took an, an Uber. Is there all these ratings agencies, don’t they have some common standards or is it just up to the company to determine for themselves how to measure these various virtues?

Brest: So let me just say a word about the standards and then Colleen can talk about auditing. Again, there’s some standards which are not subjective, your own greenhouse gas emissions, whether or not you use child labor, whether or not you use force labor, or whether people in your supply chain, if you are an electronics manufacturer or garment industry, whether they use force labor, those are actual facts, right? Which can be determined, the tricky place even there, and, and this is an area that Colleen can speak to with expertise is the auditing function.

Ford: Well, let’s talk more about the auditing function then. I mean, if there’s some objective facts, are there objective auditors who we can rely on, or are we taking the company’s word for all of these things?

Honigsberg: So it’s a great question. We do have auditors, but they’re not what you would think of as financial auditor. So I think many of us have a picture of what a financial auditor used to be, what it looks like. No this isn’t quite the same as like the ESG auditors. For example, the guy who signed off on Amazon’s report last year, he’s also works as a nighttime DJ across the bay. And he works part-time at a vet’s office. So, not the kind of image that you would expect for like an auditor. And even within kind of the ESG space, you have different people who are auditing on the East Side, they have more science training. And then different people who might audit on the S side. So let’s take like auditing for force labor.

We want to identify force labor. Well, the first part comes with how do you identify your supply chain? So for most us multinational companies, they’re going to know who their direct suppliers are. So these would be called the tier one suppliers. So we can send an auditor there to look for forced labor. Well, if the company, that’s being audited knows that somebody’s coming to look for forced labor, you can expect that they’re going to change the circumstances when the auditor is going to come. So usually the auditor would come on some other pretense and say, they’re doing like a quality control check of the product or something like that. So they can go to the tier one supplier and look to see if they’re forced labor, but probably the tier one supplier who’s known to the us parent company, it’s less likely they have forced labor.

It’s more likely that you have what are known as the tier two or tier three suppliers who are then kind of down the chain, who are actually engaging forced labor. And it’s not clear the US company knows who those tier two and tier three suppliers are. So they have to go to the tier one supplier, find out who is supplying them, then go to the tier two, then go to the tier three and so on. And the tier keep in mind also, it’s not like it’s a supply chain that’s remaining the same every day, it’s changing around a lot.

I made some of the stories that you hear in this area from auditors who have gone abroad and tried to identify for forced labor practices that some of these, smaller tier three type suppliers they’ve been physically threatened, they’ve gone and identified forced labor, and child labor only have those put on a train and relocated to another place, and then another supplier pops up and it’s just doing the same thing. And it’s almost, as one woman described it to me who had been doing this for 20 years. She said, any company that tells you unequivocally, they don’t have force labor in their supply chain when they’re operating abroad, does. Because anybody who’s looked at it that closely will know that they just can’t rule it out because it’s too hard to rule out entirely.

So even if you know what you’re looking for, it can be really hard with our current technology to identify. So this is where I think, when I talk to the auditors in the space where they’re really hoping we can actually get technological developments that will allow us to better track products and better identify who those suppliers are and monitor them.

Bankman: You know, Colleen, it seems to me from the kind of law economics perspective that a lot of us have in law schools. And I’m one of them. This all seems almost kind of promising because what I’m hearing is that at the very least, we’re really increasing, maybe if we pursue this, the expense of hiring labor, that can’t be verified, and we’re making it tougher and tougher for companies. So if we keep pushing on this, hopefully we reduced child labor and forced labor. Even if we can’t rule it out entirely on a worldwide market. Is it okay to have that kind of big picture optimism for it? Or do you think this is so hopeless that no optimism is warranted?

Honigsberg: I think you can have that optimism, I would be curious what Paul says, I think the one concern is that the focus so far has really been on public companies. And there’s far less focus on private companies. And so even if we’re getting, we have a lot more visibility into what’s going on at publicly traded companies, and so the concern is that companies with bad practices are going to go private.

Bankman: You know, this seems like another familiar theme for those of us who do law and regulation, which is that if you regulate the most obvious, let’s just say culprits, to put the kind of worst frame on it, then you might get a victory there, but just drive people elsewhere. And one of the else wheres you’re talking about Colleen is from tier one to say, tier three or tier two to tier three and another elsewhere is from public to private.

Honigsberg: I think that’s right. I would be curious for Paul’s thoughts as well, too.

Brest: So I mean, an answer to your basic question, Joe, I think first of all, I think that incremental progress is worth making, right. I just think that it’s important that both those who provide the ratings and those who consume them, be realistic about what can be measured, and try to do it in increments. And I think your basic point that, is this putting pressure. Yes. But only if people don’t become so cynical about it, that it’s just regarded as something you put on a piece of paper and nobody pays any attention to.

Bankman: And that’s raising all whole set of questions about what disclosure does as well, because ultimately this is simply a disclosure provision. And we know from other areas of regulation that sometimes disclosure works and sometimes it doesn’t. And if people are cynical about it, we kind of know the answer there as well.

Ford: Well there’s so the next question I suppose, for Paul and Colleen is what can we do to improve the situation, to continue to push in a positive direction, given these challenges? And we’ll be back with that question with more from Paul Brest and Coleen Honigsberg about ESG metrics and measuring corporate virtue and vice next on Stanford Legal on SiriusXM.

Bankman: Welcome back to Stanford Legal on SiriusXM. I’m Joe Bankman along with Rich Ford. Today, we’re talking about corporate ESG with Paul Brest and Colleen Honigsberg. We were talking before we took a break about the problems of measurement and the problems of auditing. Colleen, there’s a new SEC rule on this, SEC Securities and Exchange Commission, that’s getting involved in this. Can you just give us an overview of what that’s about and how we might think about that?

Honigsberg: Sure. So the SEC has traditionally mandated disclosure of material information. And so if it’s going to be something that is relevant to the stock price, and relevant to how shareholders are going to vote on issues, we want to disclose it. And the ESG disclosures have occupied a really kind of interesting/controversial area, because there are a lot of investors, especially big institutional investors who say, look, carbon is material. We need to know how this company is going to operate. If we have, changes with climate change. For example, how is this going to affect it’s business model and how will it affect the value of certain assets? And we saw this most prominently, recently at Exxon, which there were a group of very small investors who actually launched a proxy fight and were able to get some of their people on the board, which was really, really unusual to try to get Exxon, to actually engage and do a little bit more clean energy.

So there are a lot of investors who really, really, really care about this. And both on the climate side, on the environmental side, but also on like the human capital side, and that they say employees should really be treated as assets, not as expenses. And you need to value them more. And we want to see that they’re happy, because then they’ll do better work and it’s more profitable and thus it’s financially a material. So there are a lot of people who have made this argument, but the SEC has sort of, especially during their Republican administrations has been really opposed to mandating new disclosures because, many people take the idea that we already disclose so much information. It’s really costly to be above our company, and they provide these hundred page disclosures that nobody’s reading. So there’s been a back and forth over this. And a lot of the traditional administrations, or prior administrations have said, look, if information on climate and carbon emissions were material, then investors would demand that companies disclose that information. Companies would adhere to their requests.

And the fact that companies are not disclosing it, means that it must not be material. The sense otherwise investors would be refusing to buy them. And this administration said, actually, no, we think it is material. We are going to require that companies disclose at least some information on their carbon emissions. So they are now going to disclose, or they propose to have companies disclose scope one and scope two, and often what they’re known as scope three emissions, which Paul was mentioning earlier. So the rule, this proposal is a long way from actually becoming a rule and a mandate, but it was a really giant first step. The EPA requires a lot of the same information, but to have companies actually provide it in their securities filings was huge in this area.

Bankman: Again, this resonates with kind of a central issue in legal regulation, which is, should you require companies to do something, or does the free market kind of operate in an idealized way on its own? And one view here is you didn’t have to require companies to disclose anything. If investors wanted it, they demand it. And companies that did disclose would be valued higher and the system would run on its own, and that’s one point of view and this administration had another point of view that it is material and it ought to be disclosed. So let me throw this to Paul or Colleen, what would disclosure mean on this? How hard is it going to be to get disclosure on something like carbon emission?

Brest: So I have not read any part of the 500 page proposal from the SEC, but once again, carbon emissions are the easy case in ESG, especially your direct emissions. By the way, you describe the role of regulation, but in between not doing anything and disclosure is sort of in between not doing anything and actually regulating how great the carbon emissions can be. The role of disclosure is to make it readily available in some standardized format to consumers or investors and others.

Ford: So given these, this SEC proposal, and I will throw this to Paul and Colleen as well. Should we be more optimistic? Is this likely to help correct some of the problems that we’ve looked at before with respect to the concepts, with respect to auditing and verification, or are you pessimistic even given this new SEC regulation? I’d be assuming it goes into effect.

Honigsberg: First, I think assuming that it goes into effect is pretty key here. We will wait and see about that one. And I think that also what Paul said too, is that the type of information being disclosed at this point is information that’s relatively easier within the ESG space to identify. It’s more of like direct carbon emissions or carbon emissions from a building that say, rather than you own, you can think of a direct emissions as say, I own a building the emissions from that building. Whereas like indirect, on the first step, may be, say I lease a building and the emissions that come from that building that I lease.

So those type of emissions are much easier to identify and to audit. And in many cases are already being reported to the EPA. So I think we’re, relatively comfortable with that on the ESG space. Where you start getting into a lot of the other ESG areas is, do I see the SEC moving on something like, human capital? I think if they did, in some of the other areas, it would be, more notable than perhaps in carbon. Because carbon is when the ESG movement started, it really started with carbon. And these other ones it’s kind of snowballed and it’s picking it more and more social values, but we’ve had carbon the longest, and I think that one’s the one that’s easiest to identify measure in audit.

Brest: Let me add that I think required disclosure, assuming that it can be done well, and well audited solves one of the problems that the rating agencies create. Let me just say the rating agencies, aren’t the auditors. They take information and then they provide to consumers or investors or others kind of aggregate ESG ratings. As I mentioned before, there’s, there’s actually not very strong correlation among the ratings of the half dozen or so major rating agencies. And one problem is that the way they do the ratings is proprietary, they don’t make it public. So that if you wanted to understand what goes into those aggregate ratings, you couldn’t find out. I think one advantage of disclosure, if it’s successful, is that it will enable more investors, and perhaps other rating agencies to use that data and be more transparent about how it’s provided.

Bankman: Thank you. And of course, disclosure and uniform standards also require whole set of auditors. And I know Colleen you’ve you spent part of your life in that world, and you spent part of your life analyzing that world, and coming up with the right rules and requirements for auditors is itself a kind of a heavy lift.

Honigsberg: It is. And I mean, coming up so first you have to have, auditing standards, you have to have people trained in those standards. I think though, the connection really between kind of financial reporting and the ESG reporting, is actually, it’s super interesting. And at least to me, it’s almost like a political economy story because a lot of the people who request ESG information, it’s that they’re trying to get information that’s actually material to the company, or they think is material. And for many of these things, if they say, okay, climate is material, because it affects the value of your oil reserves. Well, this is something that you can imagine really should have been captured by a financial accounting standards in the first place. And I think you can make that argument for a lot of the ESG issues actually. Is that if they really are financial material, they should have already been included in our generally accepted accounting principles.

And that’s different than the auditing side, it’s more of the accounting principles. But this is also one of to note is like the SEC itself is pushing ESG type disclosures. But they wouldn’t have, they wouldn’t be in that position. If the financial accounting standard centers had just incorporated some of this ESG information, in a way that European accounting standards have been much more inclined to do. And so the fact that our US accounting standards have been really slow to, kind of adapt ESG issues, and incorporate them into areas of our existing financial statements where that information had actually been material, has meant then that you need that the SEC has felt it actually needs to step in and start mandating some of these rules.

Bankman: We’ve been talking with Colleen Honigsberg and Paul Brest about corporate ESG. And I feel Rich, we’ve really just touched the substance. We haven’t even talked about G which stands for governance, but we hope Paul and Colleen you’ll come back again and tell us what’s happened with the auditors, with the public perception, with the SEC rule. For now we’ll thank you, and thank our listeners for listening to Stanford Legal on SiriusXM.