ESG: smoke and mirrors or a way for markets to help save the world?

Companies embrace environmental, social and governance imperatives — but the debate is far from settled

While progress was made at the 26th Climate Change Congress of the Parties (COP26) in Glasgow, the collective action needed to keep global warming to 1.5°C below preindustrial levels is absent. But the failure of governments to make sufficient (and binding) commitments should not stop the private sector changing its production patterns to become more sustainable.

Indeed, companies are embracing environmental, social & governance (ESG) imperatives and incorporating them into their decision-making. Some have seen ESG performance as a once-in-a-generation opportunity to redefine capitalism, using the power of markets to tackle some of the most pressing issues of our time. It is indeed an opportunity for companies to incorporate longterm value creation and stakeholder engagement into their calculus for success and profitability.

Integrating ESG performance as a criterion for accessing capital portends a potential seismic systemic shift in how markets operate. In short, ESG promises to advance enlightened selfinterest, rescind short-termism and fix the planet; all while companies continue making profits.

However, the ESG debate is far from settled, and there has been mounting backlash from both regulators and activists. For instance, Tariq Fancy, who was involved in the initial propagation of the ESG idea while chief investment officer for sustainability at BlackRock, the biggest global asset manager, now criticises its operationalisation. In late August Fancy wrote a series of articles titled “Diaries of a ‘Sustainable Investor”, criticising ESG as a dangerous placebo harming the public interest, and a way for companies to avoid regulation. By marketing ESG to solve systemic issues, companies can avoid regulations such as higher taxes and even carbon tax. Similarly, Robert Armstrong of the Financial Times has openly opposed ESG, calling it a dangerous distraction. Armstrong points out that an investment in a low-carbon exchange-traded fund does not have much potential for any ameliorative effect on climate change. Aswath

Damodaran posits that ESG is a mistake that will cost companies and investors money while making the world worse off. For Damodaran, ESG stands to enrich consultants and bankers while reducing shareholder power. To this end, corporate executives and fund managers and not individuals become experts of value systems.

The first big criticism of the ESG obsession is that ESG ratings of fund managers tend to differ in accordance with the secret sauce used to develop ratings. A Washington Post article comparing ESG fund ratings for companies (ExxonMobil, Tesla, and Berkshire Hathaway) illustrates this.

The ratings and scores are often difficult to understand due to a lack of clarity in the underpinning methodologies. Disclosures are unregulated, and the data informing ESG scores is difficult to understand going from one ESG fund to another. ESG funds decide for themselves how ESG criteria will factor in their makeup. This lack of standardisation and easily understandable metrics confuses investors as they do not know how the proverbial ESG sausage is made.

Fancy argues that ESG scores can be a type of corporate virtue-signalling without substance, while evaluating sustainability criteria across fund managers is a challenge for investors. Some rating systems grade a company’s stated commitment to ESG principles even where there is no evident action to bestow credibility on those intentions.

Adherence to ESG becomes tantamount to a marketing strategy to attract green capital without genuine execution. In other words, it is easier (and profitable) for companies to present themselves as supporting ESG for the potential capital that can be gained rather than for genuine commitment to ESG performance. Armstrong and Fancy also suggest a misalignment of time horizons. Fund managers are motivated by earnings from quarterly management fees while systemic ESG issues such as climate change, poverty, and wealth inequality require longer timelines.

Since all future profitability depends on an ecologically functioning planet, fund managers and shareholders will need to accept reduced short-term earnings for the sake of future profitability.

Armstrong and Fancy say the financial incentive for fund managers to sell larger quantities of ESG products, regardless of lack of tangible effect these products have, is selfdefeating. Fund managers charge higher management fees than non-ESG products, and profits are made from the volume of units in the fund sold. Similarly, Damodaran posits that experts that stand to benefit (accountants, measurement services, fund managers, and consultants) are on the ESG “gravy train” at the expense of taxpayers, stockholders and other stakeholders, the people who are meant to benefit.

Divestment the selling of shares that do not meet ESG criteria by investors and fund managers

is the primary mechanism through which ESG pressure operates in capital markets. In theory,

ESG investing decreases the cost of capital for “good” companies, moving companies towards sustainability. However, for every stock divested by ESG funds, non-ESG investors can pick them up at bargain prices. Essentially, this points to a collective action problem. Until the free-riders are crowded out, ESG risks being a red herring.

Contrary to Armstrong and Fancy’s assertion of a clear-cut binary wherein the choice is either government regulation or ESG as a distraction from required regulation, ESG should rather be seen as a signal to regulators of appetite for streamlined regulation pertaining to sustainability issues. The EU’s landmark financial sustainability regulation, for instance, requires companies and organisations to locate sustainability within the very core of their business models. These regulators can then reduce the likelihood of greenwashing by firms and funds, increase transparency and assist investors to better understand what they are investing in.

Milton Friedman said the social responsibility of companies is to increase shareholder value and create profit. Buttressing this are social norms (bonuses for boosting company earnings) and regulatory norms (fiduciary duty of investment firms acting on behalf of individuals to invest in profitable securities). In situations where pursuing ESG norms would reduce company profitability, companies are less likely to pursue them without external pressure (such as regulation, shareholder action, or capital constraints).

Companies will only pursue additional social responsibilities if they add to profitability and access to capital.

In the light of the ESG debate articulated above, it is essential to move away from a utopian idea of ESG as the saviour of the world to address and resolve systemic issues. This requires an understanding of ESG’s current limitations and the need for it to exist alongside more effective government regulation and credible punishment for mere greenwashing or empty virtuesignalling.

COP26 has again shown the shortcomings of deficient global political will. ESG, rightly understood and applied, can nonetheless shape private sector activity in a way that starts to shape political will towards net-zero by 2050 (and not 2070).