ESG is on the ropes — is it worth saving?

Recent headlines have not been kind to the environmental, social and governance investing (ESG) movement. Last week, the Wall Street Journal reported that the Securities and Exchange Commission is investigating Goldman Sachs over its ESG investment funds. On May 31, German police raided the offices of fund manager Deutsche Bank’s DWS in connection with an investigation of alleged “greenwashing,” said to occur when fund managers make unrealistic or misleading claims about an investment strategy’s environmental bona fides. 

The week prior, Stuart Kirk, head of responsible investing at HSBC Asset Management, was suspended by his employer after giving a presentation in which he said that bankers and policymakers were overstating the impact of climate change in an attempt to “out-hyperbole the next guy.” Even BlackRock, the world’s largest asset manager and helmed by Chairman and CEO Larry Fink — who long has heralded his firm’s role in financing an inevitable “energy transition” — recently announced it is likely to vote against shareholder resolutions seeking to ban new oil and gas production.

In the wake of all this, some advocates say that despite it experiencing “growing pains,” ESG isn’t going anywhere. Gillian Tett, chair of the U.S. editorial board for the Financial Times, averred recently that notwithstanding ESG’s evolution, the “concept of responsible investing and business is not likely to disappear anytime soon.” She stated further: “Call this, if you like, the rise of stakeholder capitalism — or (as I prefer) a world where lateral vision is needed, rather than narrow tunnel vision.”

Stakeholder capitalism, you say? Actually, I don’t like.

The attention-grabbing headlines hardly scratch the surface of the myriad problems associated with applying ESG principles to corporate governance and investment management. Russia’s invasion of Ukraine has catalyzed a reset of governmental and private sector prioritization of energy security and exposed how far the rhetoric of a purportedly unavoidable energy transition has outpaced the world’s tangible readiness for it. The DWS investigation and the suspension of an HSBC executive for his verbal miscues each highlight different aspects of the grift underpinning the rapid growth of ESG-oriented funds.  

According to Morningstar, assets committed to ESG strategies grew by 53 percent, year over year, to $2.7 trillion in 2021. This mania for “sustainable investing” has helped arrest a longstanding trend in investor fund flows toward lower-cost exchange-traded funds (ETFs) and passively-managed vehicles; actively-managed ESG funds offer considerably more attractive economics for investment advisers and the ESG phenomenon has spawned an elaborate infrastructure of consultants, rating agencies and ancillary services all dependent upon ESG remaining in vogue.

Even Elon Musk has found his way into this recent ESG doom cycle. Standard & Poor’s exclusion of his automotive and clean energy company Tesla from its ESG index in late May drew a harsh rebuke from Musk: “ESG is a scam. It has been weaponized by phony social justice warriors.” Some observers believe that Tesla’s removal from S&P’s index was more likely precipitated by, and in retaliation for, Musk’s free speech-motivated bid to acquire Twitter and rightward political drift than any evidence of an objective decline in the firm’s ESG metrics — a view supported by Tesla’s continued inclusion in MSCI Inc.’s market-leading ESG rating service.

One need not necessarily believe the ESG movement to be a grift or a scam to see that, however well-intentioned its proponents may be, it is predicated upon questionable assumptions. For example, until recently, ESG enthusiasts had argued that ESG-driven investment strategies offer an opportunity for market outperformance (“doing well by doing good”) — a supposition now widely challenged, if not thoroughly debunked. 

In addition, as evidenced by the Tesla controversy, there is a lack of consistency across the various services offering ESG scores; a recent paper from researchers at the Massachusetts Institute of Technology and the University of Zurich examined data from six prominent ESG rating agencies and found correlations among them ranging from between 0.38 and 0.71; bond credit rating agencies, by contrast, have a 0.92 correlation. This suggests a level of subjectivity inherent in ESG rating criteria, which risks rendering them of little practical value. 

Only recently have companies, investors and governments come to acknowledge that the E, the S and the G can be at odds with one another. The invasion of Ukraine has focused attention on the criticality of energy security, which pits the E-informed objective of phasing out fossil fuels against an S-focused desire to meet the world’s energy needs without reliance upon militarily aggressive, revisionist autocracies.

Gillian Tett’s article centers on the idea that the challenges faced by the ESG movement are to be expected as part of the continued evolution of responsible investing and business practices.  While she prefers a different label, she believes stakeholder capitalism is “here to stay,” burying economist Milton Friedman’s doctrine that the primary duty of a commercial enterprise (and its fiduciary agents) is to maximize shareholder value, as contrasted with serving multiple stakeholder masters poorly.

What Tett doesn’t address in her call for investors and corporate executives to have “lateral vision” is that interposing private companies as the vehicle to address exigent public policy issues is a double fault. For investment advisors such as Blackrock, the application of ESG criteria absent explicit direction from fund beneficiaries arguably violates advisers’ fiduciary duty to maximize investment returns. Unless and until the responsibilities of a fiduciary are defined more broadly by legal jurisdictions and regulatory agencies of record, incorporating ESG considerations into the investing process should be viewed as fiduciarily suspect.

Moreover, placing public policy within the ambit of corporate and investment management supersedes democratic accountability. Pursuit of any given policy result properly belongs within the sphere of democratically-elected governments, which are held responsible by voters at the ballot box. The ESG movement shifts policymaking to institutional investment advisers, along with corporate boards and management teams, who — from an electoral perspective — are accountable to exactly no one. Reviving corporatism to advance public policy initiatives is hardly “progressive.”

Despite the protestations of its advocates, perhaps ESG’s problem isn’t simply managing through an uneven awkward stage, but rather its internally inconsistent, rent extracting, value destroying, and unaccountable, anti-democratic nature. For anyone seeking ethical investment alternatives, socially responsible investment vehicles existed long before the term “ESG” was coined and remain available to those prepared to incorporate non-pecuniary considerations into their investment decisions. 

Allowing beneficial investors the freedom to choose investment vehicles aligned with their values directly avoids the twin problems of fiduciary drift and usurpation of the democratic process, along with the countless negative externalities resulting from having ESG principles imposed by unanswerable institutional investors, reflective of private agendas, or placed upon the private sector by governments or regulators lacking the will to take legitimate action in service of preferred policy outcomes. 

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. Follow him on Twitter @RichardJShinder.