In case you missed it,right now, there is a war going on between institutional investors who engage in ESG-based investing on one side and Republican-controlled states and the Congress on the other. Legislatures, attorneys general, and treasurers in about half of the US states (almost all controlled by Republicans) have turned against asset management firms that choose to invest in firms that comply with ESG principles. At the state level fund managers are accused for dereliction of their fiduciary duty to generate the best returns possible for the pension plans they manage in the name of state employees. They are also accused for being motivated by political agendas in favor of climate and social justice related causes.
Congress also passed a Republican-sponsored bill that prevents the enactment of a Labor Department rule that would allow but not oblige pension plan managers to adopt ESG criteria in their investing. The basic argument behind the bill is the same concern that fund managers will be motivated by their political views on climate and social issues.
But let’s start with some definitions. ESG stands for environmental, social, and (corporate) governance responsibility. Environmental encompasses concerns about the climate, the ecosystem and clean air and water. Social refers to corporate practices that impact the firm’s communities and issues of diversity (race, sex, gender, religion, ethnicity), equity (pay, opportunities, rights and obligations) and inclusion. Governance means corporations have sound rules for the delegation of power and accountability as well as for fair and full disclosure of information that is relevant to the firm’s stakeholders.
Governance was the first of the three that appeared as part of responsible business management more than 30 years ago. As public awareness grew about matters of social justice and environmental sustainability, the S and the E found their way into the acronym. In recent years the S and E also got an extra impetus as individual corporate leaders and collective bodies, like the Business Roundtable, expanded the responsibility of the corporation beyond shareholder value maximization to also include the interests of other stakeholders, including the environment and the society. All, good stuff you would think. So does the market. Based on numbers published by the accounting firm PwC , it is estimated that a total of $18 trillion are invested globally in firms that follow ESG principles.
Now, let’s look into the concerns regarding ESG investing. First, do ESG-based investments leave money on the table? I will start with the G(overnance). Numerous studies have shown that firms with superior corporate governance standards trade at higher stock prices all else equal. Studies have also shown that the rigorous corporate governance standards adopted and enforced by the SEC (Securities and Exchange Commission) and US stock exchanges account for the popularity of US capital markets as hubs of securities trading and for the value premium enjoyed by shares of firms listed and traded on US exchanges.
Reason also suggest that adopting principles of social responsibility that open-up opportunities for hiring the best from the pool of workers irrespective of demographic characteristics and creating working conditions that respect everybody ought to boost morale, loyalty, and productivity – all good for a better valuation of the firm. Generating good will with the surrounding communities where a firm operates should also be a positive thing for the firm.
Finally investing in environmentally responsible operations has upfront costs but it can also generate savings and lower the cost of adjusting to future environmental laws. It can also signal to investors that the firm has a sophisticated and up to speed management team that can handle not only environmental challenges but also other aspects of business. Ultimately though theorizing must be subject to empirical verification. So, let’s look at the evidence.
We have a rich roster of studies that compare the returns produced by ESG-based investments to those produced by other firms. In general, studies originating from business organizations report superior return performance for ESG-based investments. Academic studies (presumably better designed) also offer no evidence of inferior performance for investments structured by ESG criteria. Therefore, it seems that there is no empirical basis for the concern that ESG-based investments harm the financial interests of their beneficiaries. Consequently, if such investments are at worst return-neutral and at best profitable then the argument that they harbor hidden political agendas becomes irrelevant. After all, whereas investment performance is observable and measurable, intentions behind investments are not.
Nonetheless, there is a public policy issue that raises a troubling question about the anti-ESG stance. Markets are supposed to enable us to express our choices with regard to a range of personal preferences and priorities. This way the market can impact the conduct and viability of firms with respect to quality of products as well as business practices and operations that bear on society and the environment. It is only when the market fails in its monitoring and disciplining mission that the state intervenes to restore it through laws and regulations. It seems to me then that the anti-ESG stance – almost all of it originating within conservatives, who are the primary advocates of free markets – signifies an unreasonable dissonance. To exclude ESG principles from the range of priorities the market has to sort out is an admission of lack of trust in the market by its very advocates. Stifling the market that way is also the kind of value-destroying regulation for which conservatives always accuse liberals. Even worse, it is a sort of censuring investors with respect to their right to express their priorities in relation to environmental and social issues.
If there is a really good reason to scrutinize ESG-based business practices it has to do with how reliably the ESG scores firms receive correspond to actual compliance with ESG principles. A recent joint study by Columbia University and the London School of Economics found that firms with higher ESG scores had no better compliance than firms with low ESG scores. To address the issue, the SEC is in the process of drafting rules that will require that firms disclose their ESG policies and initiatives. As with public auditing firms, we need credible agencies for the assignment of ESG scores.
Raising investor confidence in the reliability of ESG scores is much more important than interfering with ESG-based investing and restricting investor freedom.
Let's Reason 