in Bretton Woods, New Hampshire, 30 October 2023
Ladies and gentlemen, fellow panelists, thank you for being here. I’m thrilled to be not just attending but speaking at this event, for this legendary, time-honored organization. It’s all the more auspicious for me as an economist at AIER, which is hosting this event. So thank you for coming.
I’ll be discussing trends in the embrace of environmental, social, and governance frameworks in the corporate world both over the last five or ten years, and particularly over the last two years.
Much like the founding myths of ancient civilizations, the roots of ESG can be challenging to trace. I’ll begin with a few potential starting points. There is of course the 1960s influence of civil rights and consumer advocacy. Stakeholder theory was advanced, among others, by R. Edward Freeman in his 1984 book, “Strategic Management: A Stakeholder Approach.” The intellectual antecedent is shareholder theory, as popularized by Milton Friedman in his 1970 New York Times Magazine essay, titled “The Social Responsibility of Business is to Increase its Profits.”
The shareholder argument holds that businesses should focus on their core economic function of generating profits and that the pursuit of social or environmental goals should be the responsibility of individuals and not firms. Stakeholder theory emphasizes the interests of various stakeholders in society at large and has gained prominence over several decades.
Klaus Schwab’s 1971 founding of the World Economic Forum, then more blithely called the European Management Forum, is another. In 2004, the World Bank released a report titled “Who Cares Wins: Connecting Financial Markets to a Changing World,” which sought to provide guidelines for businesses to integrate ESG practices into their daily operations. Additionally, the United Nations Principles for Responsible Investing, published in April 2006, has played a significant role in the internationalization of ESG standards. The sheer number of sources of the ideas makes a comprehensive attribution beyond the scope of this talk.
Despite its unsystematic genesis, the consolidated ESG has irrefutably gathered momentum over the past five to ten years. But why? And why in the last eighteen or so months has there been a growing rush to shirk it?
One explanation is that ESG has picked up a head of steam on the basis of growing political freighting and ideological fervor. With the swearing-in of the 45th President in January 2017, the partisan divide both widened and deepened, and not only in the United States. Social causes and environmentalism have been central to that conflict.
Another is that the existential risks of climate change have become so clear as to be lucid. In other words, during some narrow period of time in the last decade, thousands of corporate executives and board members suddenly became aware that human existence was being inexorably drawn toward an apocalypse (of sorts), and accordingly snapped into action. Thus the development of corporate policies, growth in staffing, shifts in focus, and sizable investments undertaken over the past five to ten years are a sign of corporate America’s acknowledgment that the end is near.
A third is that economic pressures have come to bear on holdouts. This view holds that firms that have avoided putting ESG measures in place have found themselves marginalized, punished by customers, and excoriated by the market more broadly.
But this is my point of departure, inspired in part by the work of economists from Hayek to Kuznets to Rothbard and beyond. The previously cited explanations for the explosive embrace of ESG – shifts in ideology, a newfound appreciation of existential risk, and/or market forces – did not occur in some hermetically sealed container or static model. Just as in the investigation of business cycles, what we seek to explain is clustering. In the examination of boom-bust cycles, we seek to explain how it is that thousands or tens of thousands of businesses fail all at once. In other words, why in some short period of time companies of all sizes, across numerous industries and sectors, with homogenous entrepreneurial and managerial talents, and of a vast range of ages, fail within a few months or a year or two of one another? Similarly, here I seek to explain how it is that in a few years ESG investment rose from the tens of billions to over $2 trillion, and how in less than two years a sudden pushback and a move toward disinvestment has gathered palpable momentum.
But first a brief discussion of ESG. ESG’s foundations are ideologically sterling but economically bankrupt and empirically disingenuous. I’ll share a few examples.
For a time, Exxon was the top holding in many ESG funds and ETFs. How could it be that the company with the largest carbon footprint in the history of the world, and the poster child for all things corporate, evil, and ruinous as concerns the environmentalist and conservationist, could be the number one pick for scores of environmentally focused asset managers? Well, being a $400B company, even Exxon’s token virtue-signaling investments in green energy research were vaster than the market value of many entire companies. So it became a top investment of the greens.
The social “pillar” of ESG encourages companies to prioritize fair and inclusive practices, to respect human rights, and to engage/craft corporate policy not just around shareholders, but stakeholders more broadly. But it seems odd, and some might say suspiciously convenient for a philosophy founded on moral, cultural, and epistemic relativism to suddenly assert very Western views of fairness and human rights. And if the definition of stakeholder is anyone who might be affected by a company’s sphere of influence, is not the entire world and every organic thing in it a stakeholder to Amazon, or Walmart, or Coca-Cola? The onus of those obligations somehow lands very squarely on the richest, and if you will the American-est, of companies.
Adherence to the governance principles would, among other things, see corporations invite collective bargaining into the cubicles and onto their shop floors even when their employees had not sought to unionize, and to pay taxes even when legally avoided.
There are few more direct, robust conduits of social good and welfare enhancement than private profit. The only way to earn a profit is to create value. Taking factor inputs and combining them into a good or service that consumers want, profitably, is unimpeachable evidence of value creation. Increasing profitability in a competitive marketplace requires constant innovation: to use resources more efficiently, and via increasingly productive processes. What this means is that embedded in shareholder theory are all the benefits sought by ESG promoters: conservation, equity, and other non-excludable outcomes of purposeful resource use.
The ESG wave has fostered the adoption of a new layer of corporate bureaucracy. Firms have been told that to properly execute ESG requirements, new audit, risk, compliance, and implementation (management) departments are needed.
I’m reminded of the early 1930s, when provisions were set forth for securities brokerages to have compliance departments with compliance officers, attorneys, standard operating procedures, and the like on hand, as well as requiring certain minimal amounts of capital to engage in certain lines of business. Now that was a kneejerk reaction to the stock market crash and intended at least initially for investor protection. The largest corporations today have the resources, time, and staffing – and the thought leadership – to make ESG standards lofty and complicated. In the same way that it’s hard to start a brokerage firm today, and a handful of big banks have been around since the 1930s, ESG may constitute a new barrier to entry for upstarts in certain industries. In a Buchanan and Tullock sense, ESG may represent stealth protectionism through the erection of self-righteous competitive obstacles. After all, who would dare argue that the costs of saving the Earth should be limited to firms in the Dow Jones Industrial Average?
Much could be said about the attempts to measure ESG compliance across a vast range of objectives and in the context of different firms. Clearly being environmentally conscious is a greater challenge for an automaker than an agricultural concern. So, the rules and the terms of measurement should be laid out clearly.
How delayed are the regulators of ESG marketing? Consider this: The first fund adhering to a socially responsible mandate was the Domini Social Index in 1990.
In August of 2020, assets in ESG ETFS surpassed $100B.
Would anyone like to guess when the SEC rolled out its complete disclosure rules for ESG funds? I should be clear, there have been regulatory measures in drips and drabs, but when the comprehensive rules were unfurled?
The Domini fund was released in 1990. ETF assets topped $100B in 2020.
May 25, 2022.
Indeed. In August 2019, the MIT Sloan School of Management opined that ESG ratings diverge substantially from rating agency to rating agency, leading to, I quote, “aggregate confusion.” And the ultraconservative bastion of right-wing thought, Harvard University, said in July 2021 that ESG measurement is a “muddy landscape,” adding that (and here again I quote): “We find that after a country or stock exchange implements mandatory ESG disclosure requirements, the affected firms increase their ESG disclosures and experience greater ESG rating disagreement.“
Thus firms are so concerned about insufficient ESG disclosure that they over-disclose. And time being a resource, firms are directing what should be aimed at their core businesses at the thought experiments of distant idealogues – all the worse, financed by shareholders. In that sense, I must hand it to the left: They despise commerce, but make businesses bear the financial and experimental burden of utopian schemes. Surely I’m not the only economist observing that virtually every proponent of ESG views government as an irreplaceable provisioner of public goods and corrective to market failures, yet are simultaneously eager to offload what are typically designated as state responsibilities onto private commercial entities? Whether they are conceding the incompetence of most public offices or trying to have it both ways, I don’t know.
I haven’t touched upon greenwashing, corporatism among massive asset management firms, and numerous other arguments about and against ESG, but it doesn’t matter that I can’t: Until about a year-and-a-half ago, all of this and far more was not enough to cause a mass refutation of the ESG push. For this reason, I now return to why ESG suddenly exploded into the corporate consciousness as a moral imperative and has both recently and abruptly fallen out of favor.
The outbreak of inflation in 2021 and its rise to 40-year highs in 2022, followed by the most aggressive rate hiking campaign since the 1970s, has violently overturned the prevailing landscape of the past 23 years, where 13 years saw negative real rates. For shareholders, the 2022 S&P 500 earnings season was a violent jolt back into reality. The term “earnings quality” refers to the reliability of current corporate earnings in predicting future earnings accurately. Over the past year or so, the quality of earnings has been dismal. Earlier this year, nearly one in three constituents of the Russell 3000 index was unprofitable. Even before the Bud Light disaster, a handful of large-cap firms that had earlier voiced full-throated support for ESG – Apple, Disney, Newscorp, eBay, Boeing, Alphabet, Dell, General Motors, and others – were slashing unnecessary expenses. Dividend payments, typically considered sacrosanct during all but the most severe financial straits, have been cut substantially this year.
Firms are now contending with the highest interest rates they’ve faced since 2007, and in some cases back to 2001. A substantial amount of corporate debt assumed at lower interest rates is now more costly to service.
Corporate issuers are currently spending more than $675,000 per year on climate-related disclosures alone, and institutional investors are spending nearly $1.4 million on average to collect, analyze, and report climate data, according to a survey released by the SustainAbility Institute. Not included in these estimates are costs related to proxy responses to climate-related shareholder proposals, costs for activities including developing and reporting on low-carbon transition plans, and stakeholder engagement and government relations. Again, this is just for climate disclosures, not the numerous other environmental, social, and governance strictures private firms have been expected to shoulder.
And so as the title of an article I wrote earlier this year contends, my hypothesis is that while other reasons describe how the ESG movement spread after it started, the one that explains its sudden adoption and as-sudden rejection is that ESG is an artifact of zero interest rate policy, as were $250,000 Pokemon cards on the way up, and hedge funds harvesting losses from failed NFT exchanges on the way down.
Just last week Morningstar reported that assets flowing into ESG funds peaked in the first quarter of 2021, falling each quarter until the first quarter of 2022. At that point, the decreasing investments became withdrawals from those funds. The reasons attributed to billions of dollars leaving the ESG sector include concerns about greenwashing and political backlash. That the flight of funds coincides almost perfectly with the start of inflation and turned negative shortly after the Fed began its contractionary policy bias is either not noticed or considered.
Also about a week ago, the New York Times ran a headline entitled, “Big Oil Gets Bigger as ESG Funds Are Falling Out of Favor” commenting that ESG funds are continuing to see outflows.
My contention is that the ESG movement has been in the spirit, if not a strictly theoretical manifestation of malinvestment as predicted by Austrian Business Cycle Theory (ABCT). Many years of negligible interest rates have given rise to bubble-like firms, projects, and by extension, business concepts. The latter, which include but are not limited to ESG, seem feasible and arguably essential when the money spigots are open. When interest rates normalize and sobriety re-obtains, cost structures reassert themselves. It’s back to the business of business. In closing, I quote loosely from my article:
“The salad days of easy money, accompanied by the schmaltzy wishlists which monetary expansion permitted activists to force upon corporate executives are over. Money again costs money. In the face of rising interest rates, an uncertain path for inflation, budget-constrained consumers, and rapidly deteriorating corporate earnings, shareholders are for the first time in a long time taking a close look at how and where their money is being spent. Although it is unlikely to disappear completely, the ESG fad is probably past the crest of its popularity. Unlikely though it seemed a few years ago, with positive real interest rates and classic financial relations reappearing, it’s time again for firms to focus on the considerable challenges of simply making money.”
Thank you.
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