In recent years, regulators and other proponents of greater corporate attention to environmental, social, and governance (ESG) factors have treated boards of directors as, in effect, supplying ESG, making the decisions that take ESG into account. Yet there are obvious disadvantages to this approach. Perhaps the most significant is that using regulations to encourage boards to make pro-ESG decisions – supply-side regulation – fails to create an effective incentive structure, considering that directors are appointed by shareholder vote. As long as shareholders measure return on their investment in financial terms, supply-side regulation lacks teeth.
In a forthcoming chapter, I present demand-side regulation as a new regulatory concept. If a regulator (in the broadest sense of the word) wants companies to incorporate ESG-oriented decisions into their governance structures, the regulatory strategy must include the shareholders and investors. When stockholders have to abide by norms mirroring those of the corporate board, at least in theory, the incentives and investment aims of corporate directors and shareholders should align.
Many U.S, and European laws and legal frameworks involving ESG already reflect demand-side regulation. Notwithstanding their differences, what those laws have in common is their target: It is no longer the board of directors, the German Vorstand, the French conseil d’administration, or a similar body managing the affairs of the public corporation or company, but rather the shareholders and investors. After decades of focusing on directors’ duties to the corporation, stockholders, and society at large, this development is a major change. At least in theory, regulating the shareholders promises to change the incentives of managers in making decisions. If shareholders’ interests are no longer primarily financial, directors may be more open to giving ESG greater weight.
My chapter offers two contributions to the literature: It charts the territory and provides a description and analysis of legal instruments and regulatory strategies rulemakers already deploy for ESG demand-side regulation. Furthermore, it develops an analytical grid and evaluates the promises and perils of the different ways to govern the shareholders.
A basic distinction can be drawn between direct and indirect demand-side regulation. Whereas the first addresses shareholders and investors directly through ESG disclosure rules and requirements to commit to ESG, the second targets retail investors as a group and seeks to move them toward preferring ESG. In the EU, indirect demand-side regulation comes in the form of rules on investment nudging retail investors into ESG products. Instead of reducing the number of eligible voting outcomes, it aims at letting only those into the corporate arena who subscribe to ESG in the first place. If both institutional and retail investors lean towards ESG and publicly disclose information about their preference, it becomes easier for boards of directors to discern their stockholders’ desires and to adapt corporate management accordingly. Moreover, it becomes easier for ESG-friendly shareholders to coordinate.
While direct demand-side regulation holds promise because it forces institutional investors to commit to ESG publicly and by contract to their individual beneficiaries, doubts remain. Considering the broad variety of sometimes diverging values and perspectives subsumed under the ESG rubric, steering shareholders and investors towards this regulatory goal does not in itself alleviate the coordination problems within that group. In many instances, ESG-friendly shareholders pursue conflicting aims. For example, workers in an old factory with labor-intensive production care about keeping their jobs more than they care about the value of any stock they may own because their income constitutes a much greater part of their wealth than their stockholdings do. , Proponents of stricter environmental standards most likely emphasize cleaner and more efficient factories, even if this comes at a cost in terms of jobs in this factory. Consequently, balancing and coordination problems remain.
The chapter comes to similar conclusions with respect to indirect demand-side regulation. As mentioned above, indirect demand-side regulation tries to change the composition of the shareholder base by including only those investors who already express beliefs and attitudes that accord with regulatory ESG goals. Surveying and analyzing investors’ preferences, according to recent EU regulation, is the responsibility of investment advisers. Asking for ESG preferences exploits the so-called social desirability bias, that is, the tendency of people to act in conformity with prevailing legal and social norms even when those norms conflict with their own views. Consequently, when asked whether she wants to protect the environment and prohibit child labor, a retail investor will most likely answer “yes,” even if she would be more lenient in private. As a result, surveying retail investors’ ESG preferences nudges them toward the outcome desired by the regulator. This may increase investments in ESG funds and promote ESG-friendly voting by pension funds, even those not marketed as ESG-oriented. Who is not in favor of the environment or against child labor, after all?
What remains open, however, is the extent to which this strategy really leads to ESG-friendly behavior. Many empirical studies show that even those opting for an ESG product often prefer financial gains once the investment is made. Consequently, the largest group of shareholders will still judge directors based on financial performance. Therefore, the effects of indirect demand-side regulation are rather limited, and it will probably not cure the incentive problem of supply-side regulation. The same is true regarding ESG proponents who may be willing to give up profit for non-monetary benefits. Having more shareholders expressing general ESG preferences does not help solve the conflicts within that group, as is shown by the example of the cleaner factory and the conflict between workers and environmentalists.
 See, e.g., the unrest of British workers of Tata regarding Tata’s plans to “green” blast furnaces, https://www.nytimes.com/2023/10/30/business/tata-port-talbot-steel-emissions.html (last accessed January 22, 2024).
This post comes to us from Thilo Kuntz, chair in private, commercial, and corporate law and managing director of the Institute for Corporate Law at Heinrich-Heine-University in Düsseldorf, Germany. It is based on his recent chapter, “ESG Demand-Side Regulation – Governing the Shareholders,” forthcoming in Corporate Purpose, CSR and ESG: A Trans-Atlantic Perspective (Jens-Hinrich Binder, Klaus J. Hopt, Thilo Kuntz, eds.), Oxford University Press, and available here.