Is your business enterprise able to sustainably operate amidst the big context issues of the threats of climate change and the need for greater inclusivity? This is, essentially, the question of the day. Since I grew up before the advent of EDI and ESG, the presence of both in investing, in local business, in international conglomerates, in post-secondary universities and colleges, in technology, and in non-profit management is so ubiquitous that its underpinnings escape notice. But this is only a question if one is not involved in the day-to-day of a particular enterprise. We ask this question when we don’t have a working knowledge of the enterprise. In other words, it is a question that investors ask. If we do work in an enterprise, or have a deep partnership with them already, the question of whether an enterprise is environmentally sustainable, or whether it equitably employs people that inclusively represent the population of its stakeholders is flatly evident.
At the risk of being redundant, “ESG” stands for Environmental Social Governance, and is a framework for measuring a business’s efforts to combat climate change, to be socially responsible, and to be governed, in part, by some of the principles of Equity, Diversity, and Inclusion (EDI).
However, if you are the type of person who does not want to invest in firms that pollute the planet, mistreat workers and stuff their boards with cronies, ESG and EDI will seem like effective safeguards for your money. ESG and EDI are attempting to make capitalism work better and deal with the grave threat posed by climate change and frequent human rights abuses. It is actually a risk management agenda at its core, under the name of due moral responsibility for the world and others. In the case of ESG, it has mushroomed in recent years. According to The Economist, the largest investment managers claim that more than a third of their assets, or $35trn in total, are monitored through one ESG lens or another. It is at the point of being a base assumption of operations.
One could imagine that significant moral impacts would result from ESG; you would be wrong. Sadly those three letters have morphed into shorthand for hype and controversy. Right-wing American politicians blame a “climate cartel” for soaring prices at the petrol pump. Whistleblowers accuse the industry of “greenwashing” by deceiving its clients. Firms from Goldman Sachs to Deutsche Bank face regulatory probes. ESG is often well-meaning, yet it is deeply flawed.
The Economist argues that “it risks setting conflicting goals for firms, fleecing savers, and distracting from the vital task of tackling climate change.” In other words, it needs to be ruthlessly streamlined to stay in its lane – to focus on emissions only instead of accepting the mantle of addressing the entirety of the two aforementioned concerns. Businesses should stick with not polluting the ecology of our world. In other words, the government should strictly monitor emissions rather than try to save the world.
The term ESG dates as far back as 2004. The idea is that investors should evaluate firms based not just on their commercial performance but also on their environmental and social record and their governance, typically using numerical scores. The forces that have pushed it mainstream, not the least of which is a demand to invest in a way that addresses their concerns about global warming and injustice. More companies are offering ESG analysis. With governments often gridlocked, many people feel businesses should solve society’s problems and serve all stakeholders, including suppliers and workers, not just shareholders. This conflation of factors creates a pressing need to push back against Milton Friedman’s “shareholder supremacy” concept that now reeks of a disgusting odor.
Further, there is the self-interest of an asset-management industry never known to look a gift horse in the mouth: selling sustainability products allows it to charge more, easing a long blight of falling fees.
From the perspective of shareholder supremacy, ESG suffers from three fundamental problems. First, because it lumps together a dizzying array of objectives, it provides no coherent guide for investors and firms to make the trade-offs that are inevitable in any society. Elon Musk of Tesla is a corporate-governance nightmare, but by popularizing electric cars he is helping tackle climate change. Shutting the doors to a coal mine firm is good for the climate but awful for its suppliers and workers. Is it really possible to build vast numbers of wind farms quickly without damaging local ecology? ESG is delusional if it suggests that these conflicts do not exist or can be easily resolved.
ESG’s second problem is that it is not being straight about incentives. It claims that good behavior is more lucrative for firms and investors. In fact, if you can stand the stigma, it is often very profitable for a business to externalize costs, such as pollution, onto society rather than bear them directly. As a result, the link between virtue and financial outperformance is suspect. Finally, ESG has a measurement problem: the various scoring systems have gaping inconsistencies and are easily gamed. While, say, credit ratings have a 99% correlation across rating agencies ESG ratings align barely half the time. Firms can improve their ESG score by selling assets to a different owner who keeps running them just as before.
ESG and EDI initiatives remind me of the various English tests we used as a representation of one’s English skills: I could get any student to pass the test, but it was really hard to give them the skills to get out of the airport. ESG, likewise, is the same kind of test. The test is geared to financial performance and not to business virtuosity.
Of course, this is all to say that the types of judgment that investors want to have, without having the hands-on experience of dealing with the enterprise may not be accessible in the structure of the financial asset-management industry. After all, that industry tries to absolve the guilt of sins while retaining profitability. The kind of assurance of judgment an investor seeks is to look for the quality of goodness. And we naturally distrust anyone who seeks to display their so-called ‘goodness’. It isn’t virtuous to display one’s goodness; only God is good if we believe Jesus.
And so, In displaying the effort toward equity, diversity, inclusion, AND Environmental Social Governance to secure investment, we have entered into a Faustian bargain, and surrendered our ability to judge in the process. We may not even be able to get out of the airport.