The ESG Myth

May 28

Investors have been told that ESG will help them achieve higher returns — the truth is that ESG is designed to hurt business and investors alike.

The ESG paradox

Business has been attacked as greedy, but at its core the profit motive is how we flourish. It was business — and especially large scale industrial businesses — that lifted humanity out of eons of poverty, and extended lifespans from 30 to 80. And what fueled business was each investor’s, executive’s, and worker’s greed — their desire for a better life.

Today’s most popular investing trend, however, is based on the surprising premise that investors and businesses have been insufficiently greedy.

The trend is known as “ESG investing,” which stands for Environmental, Social, and Governance investing. ESG is a cousin of “socially responsible investing” (SRI) — the notion that moral considerations should trump financial considerations when making investment decisions. Usually this means refusing to invest in so-called “sin stocks,” like tobacco and firearms companies.

But unlike SRI, ESG supposedly allows investors to do well by doing good. According to ESG supporters, traditional measures of a company’s performance don’t capture everything relevant to the company’s long-term prospects. Investors need to look at — and companies need to pay heed to — the full range of impacts they have on the world. As ESG fund manager Georg Kell explains:

ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis, yet may have financial relevance. This might include how corporations respond to climate change, how good they are with water management, how effective their health and safety policies are in the protection against accidents, how they manage their supply chains, how they treat their workers and whether they have a corporate culture that builds trust and fosters innovation.[1]

By examining ESG criteria, supporters claim we can spot the companies positioned to succeed over the long run, which investor Jeff Masom says “will drive better performance” and “lead to better risk-adjusted outcomes.”[2]

But there is a paradox at the foundation of ESG investing. On the one hand, it holds that most businesses are greedy: absent careful monitoring, businesses will place profits ahead of their obligations to society. On the other hand, to say that integrating ESG considerations into our investments can improve financial outcomes means that these greedy businesses and investors have been leaving money on the table.

The resolution to this paradox is the insistence that companies are overly focused on their short-term profits. According to a report co-authored by economist Lawrence H. Summers, “corporations have shifted their traditional focus on long-term profit maximization to maximizing short-term stock-market valuations.”[3] ESG, Kell says, “ensures that the common good does not get lost in short-term profit making at any cost.”[4]

But the evidence for widespread short-termism is scant. When the U.S. Federal Reserve looked into markers of short-termism — underinvesting in capital expenditures and research and development by public companies — it found that:

public firms invest significantly more than private firms, and that this overall investment advantage stems largely from commitments to R&D investment. . . . That public firms invest more in R&D than private firms suggests that diversified public ownership somehow facilitates these risky, uncollateralized investments.[5]

Even on an commonsense level, the short-termism critique is hard to square with basic facts — like that the critique has been around for decades and yet U.S. companies continue to perform well, or that companies often have high valuations while losing money.[6]

The stock market is forward looking. Although quarterly earnings matter, share prices are ultimately shaped by people’s beliefs about the future earnings of a business. The reason we value a biotech company at billions of dollars today even though it’s losing money every quarter is because we expect it to make billions of dollars in the future. And by the same token, companies that are solvent can still find their share prices collapsing because investors believe their future prospects are dim.

Investors, in other words, are greedy. They buy shares in a company in order to profit. And the value of a share rests ultimately in the fact it entitles the investor to part of the company’s profits. A business that maximizes its long-term profits will maximize its present share price. A business that places something above its long-term profits — including short-term profits — will harm its present share price.

ESG isn’t necessary to make people focus on the long-term prospects of a business: the profit motive already encourages that. In fact, ESG investing has to ultimately lower investor returns. As AQR Capital Management co-founder Cliff Asness points out, no constrained investment approach like ESG can outdo an unconstrained investment approach.

Constraints can never help you ex ante and only sometimes ex post through luck. Why? Because if they help they aren’t constraints, they are what you want to do anyway. So, if you say your portfolio is better with a negative screen, you are saying that the old evil you who didn’t care about ESG issues also didn’t like more money.[7]

And it’s actually worse than that for investors. To the extent they succeed in driving down share prices for companies that flout ESG standards, they are making it more likely those companies — and the people who invest in them — will outperform in the future. Wall Street Journal columnist James Mackintosh observed in 2018:

the rebound in the sector environmentalists love to hate: Coal miners globally have returned almost 20% in the past 12 months in dollar terms, double the world market, according to Datastream indexes.[8]

ESG investing may punish “bad” companies — but only insofar as it punishes “good” investors. And punishing “bad” companies, not helping investors, turns out to be the point.

The ESG Credo

ESG isn’t only used to guide investment decisions. It is also used to pressure companies to act the way ESG activists think they should.

Sometimes that pressure is obvious and direct: for example, one group of shareholder activists, Follow This, exists solely in order to pressure fossil fuel giant Royal Dutch Shell to stop producing fossil fuels.[9] But often the influence is more indirect.

ESG activists often push companies to expand their reporting on ESG issues: producing increasingly detailed sustainability reports, climate reports, and social responsibility reports. In a world where investors are already overwhelmed with reports and disclosures, few are expected to read these reports.

Instead, companies like FTSE Russell, MSCI, and Sustainalytics use these disclosures and other information to create ESG scores. And since these scores are used to drive investment decisions by a growing number of investors — including the world’s largest institutional investors and asset managers — they exert an increasingly strong influence on companies.

So what are these standards? That’s not an easy question to answer. There are over 150 ESG ratings agencies employing different ratings standards and reaching markedly different results.[10] For example, Mackintosh observes that Tesla is “ranked by MSCI at the top of the industry, and by FTSE as the worst carmaker globally on ESG issues. Sustainalytics puts it in the middle.”[11]

What we generally find when we examine ESG standards is a laundry list of things that are obviously tied to a company’s performance (energy usage, employee turnover, non-discrimination, injury rate) and things that have little to no apparent relation to performance (greenhouse gas emissions, gender diversity, energy mix, CEO pay ratio, collective bargaining).[12]

This eclectic mix of factors helps explain why some studies have found that companies that have implemented ESG-friendly policies outperform companies that haven’t. Hester M. Pierce, commissioner of the United States Securities and Exchange Commission, explains this point:

First, given the breadth of topics that the term “ESG” purports to address, it is difficult to say that, for any company, it is the ESG factors in particular that have resulted in higher returns. Second, because ESG can mean so many things, a company may implement a number of policies that wind up counted as “ESG” measures that are simply the same good practices that companies have embraced for centuries.

In other words, ESG standards often include a lot of good business practices. This would seem to suggest that ESG standards are merely superfluous, calling attention to things any profit-driven organization would want to do. But Pierce points out it’s worse than that.

The problem is that, because discrete, time-tested measures have good results, once they are dubbed “ESG,” their success becomes an argument for implementing all kinds of unrelated, untested measures that conveniently share the ESG label.[13]

ESG advocates jump from the fact that some of the concerns they raise can impact the long-term performance of a company to the conclusion that anything labeled as ESG is in the interests of a company and shareholders.

That doesn’t follow. It’s obvious, after all, why a company would want to lower its energy usage, but why would it want to change its energy mix from affordable fossil fuels to less affordable wind and solar? It’s obvious why a company would be concerned about high employee turnover, but why should it care that its CEO pay ratio goes up if that’s what’s required to attract the most talented leader?

Clearly, a significant portion of ESG standards are driven by ideological, not business considerations. The goal of ESG is not to protect investors but to control corporations. Instead of leaving corporations free to create profitable products and services that enrich investors, ESG activists want companies to place a particular set of values above investor returns.

Which values?

The ESG ideology

The goal of ESG investing, supporters say, is to measure and promote sustainability. “ESG investing is sometimes referred to as sustainable investing,” observes the investment website Investopedia.[14]

“Sustainability” is a concept that comes from the environmentalist movement. Environmentalists critiqued capitalist economies on the grounds that, though they delivered progress and prosperity in the short-run, this was “unsustainable.” To many environmentalists, writes economist J.E. de Steiguer:

the free-market economic system is at least part of the problem, if not the principal cause of environmental degradation. The free market is seen as a system whose inescapable end is to exploit the planet. In order to have investment capital, the entrepreneur is forced to generate a profit, and profits come from business growth, which in turn necessitates resource exploitation and, ultimately, resource exhaustion. Thus, with a market economy, a vicious cycle is set in motion.[15]

If capitalism is unsustainable what, then, is sustainable? Reining in capitalism or overthrowing it entirely — moving from a society centered on profits and progress to one that, in Naomi Klein’s words, questions “the fundamental imperative at the heart of our economic model: grow or die.”[16]

The concept of sustainability would be popularized and expanded beyond environmental issues starting in the late 1980s. In 1987, the United Nations Commission on Environment and Development issued a report known as the Brundtland report after Norwegian Prime Minister, Gro Harlem Brundtland, who chaired the commission.[17]

The Brundtland report sought to promote “sustainable development,” which it defined as:

development that meets the needs of the present without compromising the ability of future generations to meet their own needs. . . . Development involves a progressive transformation of economy and society. A development path that is sustainable in a physical sense could theoretically be pursued even in a rigid social and political setting. But physical sustainability cannot be secured unless development policies pay attention to such considerations as changes in access to resources and in the distribution of costs and benefits. Even the narrow notion of physical sustainability implies a concern for social equity between generations, a concern that must logically be extended to equity within each generation.[18]

This expansive definition of “sustainability” to encompass not only environmental issues but “equity” ultimately climaxed in a fusion environmentalist author Andrew Edwards called “the Three E’s” of sustainability: “ecology/environment, economy/employment and equity/equality.”

Though on the surface these concerns appear eclectic, they are all aspects of the same ideology: egalitarianism.

Egalitarianism upholds equality — not equality before the law, but equality of condition: equal income, equal wealth, equal representation in government, equal representation in the boardroom, equal social status etc., etc. It opposes hierarchies, rankings, or anything that leads to one individual being treated differently than another individual.

Environmentalism is simply an extension of egalitarianism from equality among human beings to equality among all of nature. Philosopher Stephen Hicks puts in this way:

[E]galitarian critics began to argue more forcefully, just as males’ putting their interests highest led them to subjugate women, and just as whites’ putting their interests highest led them to subjugate all other races, humans’ putting their interests highest had led to the subjugation of the other species and the environment as a whole.
The proposed solution then was the radical moral equality of all species. We must recognize not only that productivity and wealth are evil, but also that all species from bacteria to wood lice to aardvarks to humans are equal in moral value.[19]

For egalitarians, capitalism created hierarchies of wealth, status, and power. The key to sustainability, they concluded, was ending the exploitation of people and nature unleashed by capitalism and its obsession with economic progress.

This was the intellectual milieu that gave rise to ESG investing in the early 2000s. ESG didn’t originate on Wall Street or in Harvard Business School. It was another ideological project of the U.N. — this one spearheaded by the U.N. Global Compact, whose mission was to issue a “call to companies to align strategies and operations with universal principles on human rights, labour, environment and anti-corruption, and take actions that advance societal goals.”[20]

Working with more than 50 financial industry CEOs, U.N. General Secretary Kofi Annan set out in 2004 to cajole the industry to integrate environmental, social, and governance considerations into financial markets. The end result was a report, “Who Cares Wins,” that helped spur the U.N.’s Principles of Responsible Investment (PRI), the fountainhead of the ESG movement.[21]

Why did the U.N. choose to focus on environmental, social, and governance issues? Why were those the categories deemed most vital to a business’s ability to succeed over the long run?

Not because the U.N. performed some scientific experiment or statistical analysis of companies with staying power. Those categories were chosen precisely because they named the three areas in which egalitarians saw business as violating their creed: they exploited nature (E), they exploited society (S), and their CEOs exploited owners and workers by getting boards of directors to pay them obscenely high pay packages (G).

In short, the goal of ESG was never to help investors prosper — it was to use finance to impose anti-capitalist ideas about corporate “social responsibility” onto business. The goal was never to help investors, but to use investors to inject the egalitarian ideology into the boardroom.

An egalitarian regulatory state

The problem with ESG is not that private individuals want to invest in companies they believe are moral (though they are wrong to treat a high ESG rating as evidence for a company’s morality). The problem is that major institutions with lots of financial power but little financial skin in the game are, in the name of ESG, strong-arming companies to act against the interests of shareholders.

Most of the pressure originates from ESG activist shareholders who buy shares in companies purely to get them to embrace their ideological agenda, whether it’s lowering executive compensation or, in activist investor Arjuna’s words, to get “Big Oil” to “shrink.”[22]

By themselves, these activists aren’t very powerful. But their influence is magnified because, instead of having to win over shareholders with skin in the game, they only have to win over a few big institutional investors, like the massive public pension fund CalPERS, and major asset managers, like mutual fund giants BlackRock and Vanguard. These organizations are often the biggest shareholders of public companies, though their power comes not from their own wealth but from the wealth of the investors they represent.

When I buy an index fund from Vanguard, Vanguard gains the legal right to vote the shares I am paying for. The situation is even worse for pensioners. I can take my money out of Vanguard if I don’t like the way it’s voting on shareholder issues. Public employees like police officers and teachers don’t have a choice where their retirement funds are invested.

And it’s not simply that the leadership of these major financial players are able to vote with other people’s money. It’s that their incentives are often not aligned with those whose wealth they are entrusted with managing.

Take CalPERS. Its board of trustees is essentially made up of politicians. Their incomes don’t depend on making sound financial decisions for California public employees. Instead, they get rewarded with power and status for using the pension’s enormous wealth to promote politically correct opinions and causes — regardless of how this hurts public employees. For example, before defeating ESG champion Priya Mathur in elections for the the CalPERS board, Jason Perez observed:

All legal investments must be considered. Sometimes we make an investment decision to invest in socially unacceptable companies such as firearms and tobacco. We invest in these companies for the expected returns, [not] as a moral judgment. Divesting from the tobacco industry has cost our retirement fund dearly, $8 billion lost. Recently there was a motion made by a board member to divest from any company manufacturing or selling firearms or accessories. The motion included any firearm accessory, ammunition, magazines, etc. If the motion had been successful, CalPERS would have divested from not only the manufacturers, but also large retail stores such as Walmart, Big 5 Sporting Goods, Cabela’s, and Outdoorsman. Thankfully, the Board did not even have a member second the motion due, in large part, to the testimony of more reasonable people. This example clearly shows how CalPERS is being used as a Political Action Committee as opposed to a retirement fund.[23]

Major institutional investors and asset managers exercise enormous power over companies due to their ownership stakes. If they are acting from an anti-business, anti-capitalist ideology rather than fiduciary duty to investors, that is troublesome.

And increasingly they are. For example, shareholders had consistently voted down resolutions demanding fossil fuel companies report on their climate-related risks. But that changed once BlackRock started supporting such measures.

Finally, the influence of ESG activists is magnified even further by proxy advisors Institutional Shareholder Services (ISS) and Glass, Lewis & Co. (Glass), which together control approximately 97% of the market for proxy advisory services. These companies provide recommendations for how to vote on shareholder resolution. Their recommendations have been shown to be a major factor in whether resolutions get passed or not.[24]

But these advisors have no incentive to make recommendations that reflect the interests of shareholders. On the contrary, they too benefit from supporting politically correct opinions rather than those that will be profitable to shareholders.

What all of this means is that public corporations are increasingly subject to an unelected, unaccountable regulatory state — a regulatory state whose standards are shaped by the anti-capitalist, anti-business ideology of egalitarianism.

A New Direction

The egalitarian critique of capitalism and business was fatally flawed from the start. Capitalism is not unsustainable. The idea that it has created riches today at the expense of tomorrow is a lie.

As standards of living and population rose under capitalism, our access to natural resources dramatically increased. That’s because we don’t plunder a given stock of resources: we find progressively better ways to find, develop, and use the effectively unlimited supply of raw materials provided by nature.

We also progress in our ability to mitigate the side-effects of our activities, which is why our environment today is far better than our environment in pre-industrial times, and why the free, developed world has cleaner air and water than the unfree, undeveloped world.[25]

And just as capitalism leads us to treat nature in ways that are sustainable it leads us to treat other people in ways that are fair. Because all relationships under capitalism are voluntary, to gain benefits from others we have to offer them something in return. This leads to a flowering of win/win relationships.

No, the result is not equality of condition: some people will become richer and more successful than others. But everyone who seeks to make something of their life will end up richer and better off than they would be under any other arrangement.

Capitalism doesn’t hold back individuals in order to equalize the group — it allows every individual to rise as far as their ability and ambition will take them.[26]

Of course, individual businesses can take short-sighted or unfair actions. And investors should try to spot such companies. But focusing on “ESG” is not the way to do it.

ESG is a threat to shareholders and to businesses. It is a tool used by radical egalitarians to control business decisions by good, profitable companies.

Investors and companies should instead seek to develop improved standards for assessing a company’s positive and negative impacts on human flourishing — standards that aren’t tainted by the egalitarian anti-business, anti-capitalist agenda.

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