ESG investing may be in vogue, but beware — there’s plenty not to like about it
The environmental, social and governance (ESG) movement is only the latest thrust in a multi-front exercise to advance public policy objectives through undemocratic means. As with the Business Roundtable’s efforts to replace the primacy of shareholder value maximization with that of a broader duty to “stakeholders,” ESG initiatives seek to supplant the longstanding focus of companies and investors on profit and financial return with ill-defined notions of “sustainability” as a guide to private sector decision-making and asset allocation.
The philosophical underpinnings of ESG are not new. Socially responsible investing and its antecedents are investing approaches that acknowledge the financial consequences of self-imposed restrictions on investment decisions. Prohibitions on investing in “sin” industries leave otherwise profitable investment opportunities in, say, tobacco or firearm companies to others, but recognize that doing so foregoes economic returns in exchange for the realization of some other form of psychic value — a clear-eyed tradeoff of costs and benefits, if not a profit-maximizing one.
ESG, by comparison, has been characterized as an evolution of socially responsible investing beyond that of simply applying a negative filter to exclude companies engaged in certain activities from investment consideration. Standard &Poor’s describes ESG as “provid(ing) a broader framework for looking at social impact beyond simply excluding companies associated with negative outcomes. … [It] allows market participants to conduct positive and negative screens to invest in companies that they believe are engaging in sustainable practices such as environmental stewardship, consumer protection, human rights and racial and gender diversity. … This strategy emphasizes financial returns as a secondary consideration after the investors’ moral values.”
It is this last point that increasingly has drawn the attention of commentators, market participants and policymakers. While its proponents assert that ESG investing strategies can generate “alpha” — excess returns above that suggested by an investment’s or portfolio’s risk — academic research suggests this is not the case, and unless one is willing to cashier the efficient markets hypothesis entirely, it seems obvious that any ephemeral investing advantage derived from an ESG strategy soon would be arbitraged away through the normal operation of securities markets. In fact, one might more reasonably expect a diversified portfolio of high-scoring ESG companies to underperform a comparably diversified portfolio without ESG considerations applied, because of the costs associated with ESG investment selection, monitoring and reporting.
Even if ESG strategies are oversold as “doing well by doing good” and only perform comparably with or marginally worse than index funds, is there any harm in institutional investors using ESG factors to guide investing decisions? There are, in fact, several challenges with, and negative consequences from, the application of ESG principles to enterprise management and institutional asset allocation.
First, there are the practical difficulties in determining what constitutes a high-scoring ESG company. Despite the rise of ESG-driven investing being a relatively recent phenomenon, there are already multiple ESG rating services, and research suggests a wide dispersion of ESG assessments of a given company among such providers (in contrast to bond credit ratings, which are tightly clustered). One such study, by a team associated with MIT Sloan’s Sustainability Initiative, found a correlation of 0.61 among five prominent ESG rating agencies; for S&P and Moody’s credit ratings, the correlation is 0.99. This is perhaps unsurprising given the subjectivity of the criteria noted above, as compared to the assessment of a company’s free cash flow or fixed asset coverage. Given this subjectivity, and the current vogue for all things ESG, ESG mandates create space for rent-seeking behavior by service providers in the ESG ecosystem.
This subjectivity and lack of consistency in ESG ratings highlights another problem with ESG-driven investing — the internal tension among the E, S and G. How to weigh environmental outcomes in comparison to a company’s social responsibilities? And how, in turn, does governance rate among these? Moreover, “governance” as applied in the ESG context is itself a slippery concept. In the traditional sense, good governance — whether corporate or public-sector — turns on notions of transparency, oversight, fair dealing, accountability and, in the specific case of private enterprise governance, shareholder value maximization. As stakeholder capitalism gains purchase, and diversity, equity and inclusion (DEI) and similar mandates make their way into the boardroom, a durable consensus as to what constitutes “good governance” may be hard to find.
Beyond such practical limitations to the application of ESG principles — and far more consequential — is ESG’s intrinsic lack of accountability. This manifests in two distinct, but each manifestly harmful, ways.
First, the incorporation of non-economic factors in the consideration of investment decisions runs counter to longstanding statutory and jurisprudential notions of fiduciary duty. Section 404 of the Employment Retirement Income and Security Act of 1974 (ERISA) establishes the duties of plan fiduciaries to act in the sole interest of participants and beneficiaries to maximize the risk-adjusted return of plan assets. Incorporating non-pecuniary considerations in the investment selection process runs counter to this obligation and highlights one of the flaws in large institutional investors’ advocacy for the application of ESG criteria. Such “institutional investors” should more properly be termed investment “advisers” or “managers,” since they make investments on behalf of plan or fund beneficiaries, not for their own account.
Notwithstanding ERISA’s clear direction that such fiduciaries are to maximize risk-adjusted return in dispatching their duties, and in marked contrast with ESG-focused or socially responsible mutual funds purposefully selected by the ultimate beneficial owner for their ESG characteristics, incorporating non-economic criteria without soliciting end-investor consent to such an approach — and prioritizing this over maximizing risk-adjusted returns — is irresponsible.
As damaging as ESG is to responsible financial stewardship, it does similar violence to the notion of responsive and accountable democratic institutions setting a society’s public policy agenda. However worthy the goals incorporated in ESG criteria may be, they are better and more appropriately pursued through legislative and regulatory means, with the consent of the governed or their democratically elected representatives. Assumption of responsibility for public policy imperatives by the private sector breaks the link between representative government and electoral accountability, uses capital markets to allocate resources and impose financial consequences on the basis of non-economic factors, and concentrates control over the direction of public policy among a cadre of institutional investors and corporate managers neither equipped with democratic legitimacy nor necessarily expert in the issues over which they hold disproportionate sway.
Notwithstanding its high-minded intentions, ESG is subjective, logically inconsistent, and encourages rentier behavior. It is also undemocratic, elitist, fiduciarily unsound, value degrading, and lacks accountability. Other than that, what’s not to like?
Richard J. Shinder is the founder of Theatine Partners, a financial consultancy, and a frequent lecturer, speaker and panelist on business and financial topics. He has written extensively on economic, financial, geopolitical, cultural and corporate governance-related issues.
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