As with any function that impacts the public domain, environmental, social and governance (ESG) investing has become political. Media commentators opine that ESG investing warps free market capitalism by stressing non-investment criteria and, therefore, weakens the dynamism of the economy. These criticisms and the counter arguments favoring ESG investing reached a climax over President Biden’s veto of Congress’ attempt to invalidate a U.S. Department of Labor (DOL) rule that allowed retirement plans to consider ESG criteria in selecting investments. These fights over the validity of ESG investing mischaracterize the ESG framework. ESG is an investment discipline that can lead to better understanding investments from a risk and reward standpoint. Therefore, rather than perverting capitalism, ESG is a valuable tool that may lead to better investments, thus supporting free
market principles.
A Wall Street Journal opinion piece by James Freeman highlights the primary criticisms of ESG investing. The article argues that:
For the uninitiated, the ‘G’ in ESG is highly misleading because this is not about sensible corporate governance focused on the long-term health of a business for the benefit of shareholders. The ‘E’ and the ‘S’ are about serving political agendas on climate and social issues promoted by ‘stakeholders’ who often have no stake in the enterprise.1
This piece and numerous others argue that profit-seeking companies that compete on a level playing field are the means to support a growing economy that responds to changing conditions.
The most direct political controversy regarding ESG investing involves rulemaking at the DOL. Under the former Trump administration, Eugene Scalia, the DOL’s Commissioner, amended the Employee Retirement and Income Security Act (ERISA) to limit retirement plan investments to select investments based “solely on financial conditions.” The understood goal of this amendment was to limit the application of ESG investments within retirement plans. In its introduction to its published rule, the Employee Benefits Security Administration wrote:
The Department further emphasized in FAB 2018-01 that fiduciaries ‘must not too readilytreat ESG factors as economically relevant to the particular investment choices at issue when making a decision,’ as ‘[i]t does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors.’ Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits and ‘[a] fiduciary’s evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons consistent with the plan’s articulated funding and investment objectives.’2
In January 2023, the DOL reversed the Trump administration amendment and allowed the consideration of ESG factors in retirement plans. In its introduction to the new rule, the department stated that:
[F]irst, a fiduciary’s determination with respect to an investment or investment course of action must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis, using appropriate investment horizons consistent with the plan’s investment objectives and taking into account the funding policy of the plan established pursuant to section 402(b)(1) of ERISA. Second, risk and return factors may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action. Whether any particular consideration is a risk-return factor depends on the individual facts and circumstances. Third, the weight given to any factor by a fiduciary should appropriately reflect an assessment of its impact on risk and return.3
The DOL expressed this principles-based approach because it didn’t want to have a chilling effect on retirement plans’ use of ESG in their offerings to participants. The commentary also specifically noted the potential impact of investing on climate change and the president’s intention to allow consideration of environmental factors on investment screening.
Congress then voted to block the implementation of the new DOL rule through its powers under the Congressional Review Act. Most of the Republicans in Congress, along with a handful of Democrats, clearly wanted to restrict the use of ESG criteria. Finally, President Biden then vetoed Congress’ action and restored his DOL’s rule in March 2023. This veto was the first of his presidency.
Each side in these political maneuvers obviously believes that their actions represented the interests of their political bases and that arguing the merits will improve their standing in their parties. Democrats may support the use of ESG in retirement plans to appear “greener” to their constituents. On the other hand, Republicans (and Democrats in Republican jurisdictions) are attacking ESG as contradictory to the principles of free market capitalism.
Screening Process
ESG investing uses a screening process that integrates ESG factors into traditional financial analysis. This process starts with identifying and assessing relevant ESG criteria. The environmental criteria may include a company’s impact on climate change, its use of natural resources, its waste management practices or its pollution levels. Social criteria might consider the company’s labor practices, its approach to health and safety, its interactions with communities and its relationships with stakeholders. Lastly, governance criteria typically look at the company’s board structure, its executive compensation policies, its shareholder rights and its transparency and reporting standards. These criteria are used to evaluate the long-term sustainability of an investment.
ESG screening is typically part of a broader investment discipline. Passive strategies could incorporate ESG criteria when the underlying strategy uses quantitative criteria to conform to an index of securities. ESG is also used to complement active strategies when managers use fundamental or tactical methods to attempt to outperform indexes or limit volatility.
ESG investing may also be accomplished through several methodologies. One common method is negative screening, which excludes companies or sectors with poor ESG scores according to different ESG criteria relative to their peers. On the other hand, positive screening involves selecting companies with superior ESG performance or those demonstrating improvements in their ESG metrics.
ESG data used in the screening process is typically obtained from a variety of sources, including company reports, third-party ESG research providers, non-governmental organizations and government databases. Unlike financial fundamentals available through subscriptions to services such as Bloomberg and FactSet, ESG data sources are much less mature and, therefore, complete. Another difference between ESG analysis and more traditional investment modalities involves the subjectivity of much of the data involved. For example, it’s difficult to quantify many governance criteria such as board independence vis-a-vis management. Therefore, ESG investment processes are evolving rapidly.
Free Market Tenets
As an added dimension of investment analysis, ESG investing comports with traditional free market capitalist tenets as elucidated by Adam Smith and traditional economists such as Milton Friedman. In The Wealth of Nations, Adam Smith discusses several conditions necessary for free market capitalism.4 Central to his view is the idea of the “invisible hand,” a metaphorical concept expressing that individuals pursuing their own self-interest can contribute to the overall well-being of society. The key mechanism here is the free market, where buyers and sellers interact with minimal government interference. Smith also highlights the importance of competition, as it drives innovation and keeps prices at reasonable levels.
ESG investing recognizes that ESG factors can materially impact a company’s performance and thereby its profitability. Smith’s idea of the “invisible hand” suggests that individuals seeking their own gain can inadvertently benefit society. Similarly, companies that adopt good ESG practices often create a virtuous cycle of better performance, leading to increased investor demand for their shares, which can result in higher share prices. Regarding competition, if anything, ESG provides another dimension along which companies compete. For instance, companies in traditionally polluting enterprises such as the energy sector are working aggressively to lower their greenhouse gas emissions. These efforts will make them less susceptible to fines or costly capital expenditures as regulators tighten emissions standards to combat climate change.
Milton Friedman, in his famous 1970 essay, “The Social Responsibility of Business is to Increase Its Profits,” argued that the only social responsibility of a business is to use its resources to engage in activities designed to increase its profits as long as it engages in open and free competition, without deception or fraud.5 This principle is often interpreted to mean that businesses should focus solely on shareholder value maximization because if management did otherwise, it would be imposing a tax on shareholders. Friedman’s article argues that any manager that isn’t making as much money for the shareholders is violating its duties as an agent of the underlying owners of that business.
Interestingly, Friedman notes that businesses need to conform to the “basic rules of society” including the law and “those embodied in ethical custom.” The rules of society aren’t stagnant, and our ethical customs are constantly changing. Companies that work to improve their ESG scores could be maximizing enterprise value by increasing the time horizon over which that business is able to operate profitably.
Friedman also argues that it may make sense for a business that works in a particular community to give back to that community, thereby also working for its own long-term self-interest. Similarly, a company can invest significant resources in employee safety programs. Obviously, the primary beneficiary of these programs are workers who will be less likely to become injured on the job. However, the companies themselves benefit from downstream effects such as less missed time from injury, lower levels of absenteeism, lower legal liabilities and lower regulatory fines. Two Canadian researchers studied data from hundreds of businesses in the construction, transportation and manufacturing sectors. Their findings indicated that expenditures on occupational health and safety measures had a positive return on investment on each of these types of businesses.6 These positive returns on investment suggest how owners and shareholders could benefit from increased spending on safety protocols.
Investment Risks
From an investment standpoint, ESG factors can help mitigate investment risks in several ways. First, integrating ESG factors into investment decision making allows investors to better identify and manage environmental risks, such as the financial implications of climate change, resource scarcity or pollution-related regulations. Second, strong social practices can lead to a more resilient and productive workforce, reducing labor-related risks and potential reputational damage. Similarly, good governance can decrease the likelihood of regulatory fines, lawsuits and reputational harm associated with poor corporate behavior. Furthermore, companies that demonstrate strong ESG performance can potentially attract more capital, reducing their cost of capital and enhancing their financial stability. Finally, ESG-focused investing can help investors avoid companies that are exposed to risks associated with negative social or environmental impact, which could result in lower demand for their products or services.
PG&E (Pacific Gas and Electric Company), a California-based utility company, has faced various environmental issues over the years. Even before the devastating wildfires in 2017 and 2018 that led to its bankruptcy in 2019, the company was scrutinized for its environmental and safety practices. In the years leading up to the wildfires, PG&E had been fined for various safety lapses, including the gas pipeline explosion in San Bruno, Calif. in 2010, which resulted in eight deaths. This explosion was the result of negligence on PG&E’s part as the pipeline was improperly installed. While the company subsequently checked and fortified its gas distribution network, it didn’t address safety issues with its electrical transmission lines, leading to devastating wildfires. A full review of PG&E’s lax safety culture may have helped investors avoid the economic fallout from its bankruptcy.
In March of this year, Silicon Valley Bank, the 16th largest in the country, collapsed spectacularly due to a “run” on the bank. The flight of depositors was directly caused by poor risk management as the bank purchased huge amounts of long-dated bonds right before interest rates rose. These bonds lost value, wiping out Silicon Valley’s equity precipitating the bank run.
While the post-mortem financial analysis is still being done, Silicon Valley left the position of chief risk officer manager vacant from April 2022 until January 2023. Therefore, nobody was in place to monitor systemic threats to the bank’s solvency when many of the poor investment decisions were made. Silicon Valley’s own Risk Committee Charter (February 2023) indicated that it was the board’s responsibility to appoint and oversee the risk committee. While Refinitiv (a leading ESG research service) gave Silicon Valley Bank an A+ for governance, a deeper dive into the underlying issues showed that less than half (only 43%) of the board of directors were “strictly independent.”7 This figure compares very unfavorably with the median for large banks, where over 70% are strictly independent. Additionally, only two of the 11 members on Silicon Valley’s board were under 60 years old. The age of the board members seems to be a mismatch with the bank’s entrepreneurial and technology savvy clients.
Understanding these types of cultural metrics is vital to understanding governance at any company, but sensitivity to these dynamics is especially important at financial institutions. Banks are fragile enterprises due to the relatively small amount of capital held relative to their liabilities. Having a diverse board with the independence and diversity to effectively manage a risky entity is vitally important, and strong due diligence of Silicon Valley’s governance would have benefited any investor.
ESG criteria also aids the broader investment community by increasing the quantity and quality of corporate disclosures. An example of a company whose increased transparency and ESG focus benefited investors directly is Royal Dutch Shell (Shell). Shell has faced significant pressure from investors to provide more detailed reporting on its climate impact and strategies. In response, Shell made a landmark move in 2020 when it set an ambition to become a net-zero emissions energy business by 2050, in step with society’s progress towards the goal of the Paris agreement. This included reducing the carbon intensity of the energy products they sell, evolving their product mix over time to meet customer demand and implementing carbon capture and storage and natural sinks to offset any remaining emissions. These efforts were coupled with an increased transparency in their annual sustainability reports, which provide specific details of their environmental impact and progress towards their stated goals. This transparency gave investors a clearer understanding of Shell’s strategic direction in response to climate change, allowing them to make more informed investment decisions. It also reassured them of Shell’s commitment to sustainable business practices, mitigating long-term investment risks related to climate change and maintaining its competitiveness in a future low-carbon economy.
While ESG investing adds value to the investment process, it’s impossible to quantify that value through comparative performance. Almost all active managers review corporate governance issues, and many analyze social and environmental metrics as pertinent to the business. Therefore, there’s no strict delineation between where this analysis is taking place and where it’s absent. Additionally, the investment processes used by the funds and separate account managers that brand themselves as ESG are different enough from each other that the performance benefits of ESG analysis couldn’t be distilled.
Another caveat to the advantages of ESG investing also needs to be addressed when ESG is used to benefit outside stakeholders rather than investors themselves.8 If third parties such as employees or individuals that live near a company’s operations are the beneficiaries of the ESG screens, then some of the criticisms leveled at ESG as an anti-capitalist endeavor may be valid. These managers may be greenwashing their investments to curry favor with regulators, politicians or others who may enable those managers to continue their rent seeking behavior. Regardless, this criticism isn’t valid when ESG is being used to better understand the risk and reward potential of specific investments.
Complex Debate
The debate around ESG investing is complex. While some critics argue that it distorts the free market system by emphasizing non-financial criteria, ESG investing enhances understanding of risk and return potential, thus providing a more comprehensive assessment of an investment’s value. Real-world applications of ESG demonstrate the investment benefits, especially those focusing on risk mitigation. ESG analysis also fosters greater disclosure and transparency through financial reporting, which provides significant benefits to investors. Regardless of the controversies, it’s clear that ESG investing isn’t antithetical to capitalism and helps the invisible hand benefit society at large.
Endnotes
1. James Freeman, “Has ESG Peaked? Now would be a great time to focus on market returns over politics,” Wall Street Journal (March 16, 2023).
2. Financial Factors in Selecting Plan Investments, Federal Register, 85 FR 72846, 29 CFR 2509, 29 CFR 2550 (Nov. 30, 2020).
3. Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, Federal Register, 87 FR 73822, 29 CFR 2550
(Jan. 30, 2023).
4. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (W. Strahan and T. Cadell, publishers: 1776).
5. Milton Friedman, “The Social Responsibility of Business is to Increase its Profits,” The New York Times (Sept. 13, 1970).
6. Cameron Mustard and Basak Yanar, “Estimating the Financial Benefits of Employers’ Occupational Health and Safety Expenditures,” Safety Science (November 2022).
7. Strict independence is characterized as not employed by the company; not served on the board for more than 10 years; not a reference shareholder with more than 5% of holdings; no cross-board membership; no recent, immediate family ties to the corporation; and not accepting any compensation other than compensation for board service.
8. Max Schanzenbach and Robert Sitkoff stress the importance of distinguishing environmental, social and governance (ESG) investing for third parties as “collateral benefits ESG” and “risk-return ESG” when ESG is used as part of the securities analysis to improve performance. See Max Schanzenbach and Robert Sitkoff, “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee,” Stanford Law Review (February 2020).