Why Business Should Dispense with ESG

“Milton Friedman’s shareholder doctrine is dead.” Such was the headline of a 2020 Fortune magazine article critiquing Friedman’s famous New York Times opinion piece which, fifty years earlier, had argued that the social responsibility of business is to increase its profits.

The Fortune article was just one of many op-eds, academic papers, and books penned over the past 52 years disputing Friedman’s thesis. Their authors haven’t been shy about proposing alternative models. One approach that has achieved prominence is the stakeholder theory of business, which has swiftly embraced Environmental, Social, and Governance (popularly known by its acronym, ESG) criteria as a means to realize its objectives.

By stakeholder theory, I am not referring to the practice of businesses prudentially assessing their surrounding economic, political, and social environment to identify those constituencies (“stakeholders”) with whom any company must work if it is to realize profit. Commercial enterprises have been doing this for centuries. Nor am I thinking of the need for businesses to reflect upon what economists call externalities—i.e., the costs or benefits incurred by one or more third parties because of a company’s activities. This too is an area that business executives have long understood as something to which they must pay attention to continue operating.

Rather, I have in mind those theories which maintain that the purpose of business goes far beyond profit and maximizing shareholder value. Expansive or pluralistic stakeholder theory, according to Harvard Law School scholars Lucian Bebchuk and Roberto Tallarita, “posits that the welfare of each stakeholder group has independent value, and consideration for stakeholders might entail providing them with some benefits at the expense of shareholders.”

But how do we assess whether a business is promoting its various stakeholders’ well-being? This is where the contemporary emphasis on ESG comes into the picture. It is, alas, also where many subsequent problems for business and society more broadly begin.

Welcome to ESG

ESG is big business. Today numerous ESG-designated funds are operated by investment giants like BlackRock. Scarcely a month goes by without global management consulting firms like McKinsey & Company publishing articles urging companies to make ESG “real.” Major financial advisory services counsel clients on how to invest according to ESG guidelines, while ESG reporting and ratings providers assess companies’ ESG performance on behalf of institutional investors.

In its essence, ESG is a framework that purports to help investors and those claiming stakeholder status understand how well companies are contributing to the realization of goals over and above profit. On the basis of pre-determined environmental, social, and governance standards, ESG promoters claim that investors, stakeholders, and CEOs can discern whether companies are sufficiently dedicated to managing specific externalities like their environmental impact or to integrating particular commitments, such as diversity, into their structures and practices.

What, some might ask, is wrong with this? Who could object to encouraging companies to promote particular values and stakeholders’ interests as they pursue profit? For many people, the claim that you can contribute to any number of good causes while simultaneously making money is an attractive proposition.

The decisions of companies and people’s investment choices certainly have moral dimensions. At a minimum, such choices involve a refusal to choose evil or to formally cooperate with other peoples’ evil.

One of ESG’s many difficulties, however, is that its goals and methods are characterized by an incoherence sufficient to call into question not just specific features of ESG but the conceptual integrity of the entire ESG endeavor. Another ESG problem is its tendency to blur ethics and sound business practices with the promotion of particular political causes. This mindset has spilled over into the outlook of financial regulators, and consequently threatens to facilitate widespread dysfunctionality in these agencies’ operations. Lastly, the adoption of ESG risks corroding understanding of the nature and proper ends of commercial enterprises—a development that has broader and negative implications for society as a whole.

A Failure in Ends and Means

Let’s begin by asking a very basic question: does ESG operate in the way that it claims to? Recent academic analyses of this topic have raised major doubts about this. In their Review of Accounting paper “Do ESG Funds Make Stakeholder-Friendly Investments?” for example, Aneesh Raghunandan and Shivaram Rajgopal asked whether “ESG mutual funds actually invest in firms that have stakeholder-friendly track records?”

Based on a large sampling of Morningstar-identified American ESG mutual funds from 2010 to 2018, Raghunandan and Rajgopal determined “that these funds hold portfolio firms with worse track records for compliance with labor and environmental laws, relative to portfolio firms held by non-ESG funds managed by the same financial institutions in the same years.” As if that is not enough, Raghunandan and Rajgopal conclude that “ESG funds appear to underperform financially relative to other funds within the same asset manager and year, and to charge higher fees.” In short, not only have such funds failed to deliver on many of their ESG goals; they also cost more and provide less by way of financial return.

A similar picture of ineffectiveness emerges when we take a closer look at the composition of ESG funds. In his analysis of the makeup of ESG funds managed by some major investment houses, the Wall Street Journal’s Andy Kessler found that their composition differed only marginally from non-ESG-labeled funds. He discovered, for instance, that BlackRock’s ESG Aware MSCI USA EFT had “almost the same top holdings as its S&P 500 EFT.” Nevertheless, Kessler noted, the ESG-labelled fund cost 5 times more by way of fees. If this was the subtext to Elon Musk’s tweet proclaiming that ESG “is a scam,” he may have had a point.

Another complication involves the stability of the issues that preoccupy ESG investment vehicles. The areas covered by ESG are numerous and fluctuating. Once upon a time, the focus was on products like tobacco. Then climate change became popular, thereby making fossil-fuel industries a major target of ESG ire. More recently, ESG has embraced the universal prominence given to diversity, equity, and inclusiveness.

These ongoing shifts in emphases have generated substantial disparities and disagreement within and between ESG ratings providers about, among other things, what counts as ESG and what doesn’t; how to measure ESG compliance; and how much weight should be assigned to a particular ESG goal (e.g., protect the environment) vis-à-vis other ESG objectives (e.g., promote diversity). In a May 2022 Review of Finance article surveying these methodological and measurement issues, Florian Berg, Julian F. Kölbel, and Roberto Rigobon found that ESG scores across six of the most prominent ESG ratings providers correlated on average only by 54 percent. You don’t need a degree in statistics to recognize that such a low number indicates significant disagreements about which measures and goals really matter. In an earlier 2021 article, Berg, Kornelia Fabisik, and Zacharias Sautner presented evidence of unexplained and undocumented retrospective alterations to the data on which ESG scores were based. Data alterations are not unusual. Not explaining the reasons for the alteration, however, is.

Some major ESG supporters have conceded that this lack of agreement and consistency concerning ESG’s content and measurement methods raises questions about ESG’s credibility. This is not simply because it creates difficulties for assessing ESG compliance across industries and economies. If the content of ESG is 1) unstable or effectively amounts to whatever you want it to be or whatever happens to be the cause célèbre at a given moment, and 2) there’s no universally agreed-upon measure of success, then whatever claim ESG has to coherence and universal applicability starts to look very thin indeed.

This has real consequences for some important topics that investors tend to care about—such as executive compensation. If ESG is to become part of the way that a firm assesses board, CEO, and senior management performance, then coherent and agreed-upon ESG criteria are necessary. Yet in their analysis of ESG-related executive compensation, Bebchuk and Tallarita found that ESG-based compensation disclosures generally offer “vague and underspecified goals, such as increasing sustainability, diversity, inclusion, or employee well-being, without any specific targets or additional information.”

Such imprecision suggests that ESG is unhelpful as a tool for assessing management compensation. Worse, it could potentially be used to diminish executive accountability for profit-performance. It is not a stretch to imagine how executives could appeal to their higher ESG responsibilities to justify lower returns to investors. Nor is it hard to see companies using these broad ESG commitments to curry favor with political leaders who prioritize specific causes. This would only exacerbate the already widespread problem of cronyism and help shift executive incentives further away from creating economic value and towards rent-seeking.

Internal Incoherence and Politicization

Even when a particular issue receives strong affirmation throughout the ESG world, other problems soon become apparent. Consider, for instance, ESG’s present focus on diversity, equity, and inclusiveness in things like the makeup of company boards and management. In ESG literature, diversity, equity, and inclusiveness are treated as self-evident, virtually unquestionable values. A moment’s reflection, however, soon illustrates the perils of this outlook.

Inclusion, for instance, suggests that there is something inherently problematic with exclusion. Certainly, there are unjust forms of exclusion. It is wrong to exclude someone from being considered for employment simply because she is, say, of Asian ethnicity. Yet it is not wrong to exclude an Asian woman from a board position if she lacks the formal qualifications or requisite experience; or has a track record of bad business judgments; or has been exposed in the past as dishonest.

In other words, there are just grounds on which we rightly exclude people, whatever their sex or skin color, from being given particular responsibilities. Prioritizing inclusivity is thus not as unquestionable as ESG marketing pitches often suggest. Treating it as such is likely to lead to seriously mistaken personnel decisions. At present, it is hard to find ESG schemes that acknowledge such common-sense limits to their conception of inclusion.

Or take ESG’s stress on diversity. ESG materials do not present diversity as a species of pluralism, understood as individuals, associations, and communities in a given society living out their freedoms in different ways while being bound together by some common commitments and obligations. Nor is it about promoting individuality. Instead, diversity reflects the idea that, as Peter Wood relates in Diversity: The Invention of a Concept, everyone is defined by membership in social groups and is largely the product of such groups’ collective experiences. That draws attention away from two things: first, our common human nature and the essential equality of all humans qua humans derived from that; and second, the idea that all of us are as much individuals as we are social beings and thus shouldn’t be boxed into particular unchanging and unchangeable categories, whether by custom or law.

These problems surrounding ESG’s present focus on inclusion and diversity point to another difficulty. This is the hard-to-deny fact that many ESG concerns have taken on a political slant—one that aligns closely with what would be conventionally called progressive priorities—and are being used by governments and regulators to advance such goals in questionable ways. In 2021, the Biden Administration announced its intention of imposing new ESG disclosure requirements on publicly traded companies. Upon examining the requirements in question, the legal scholar Todd Zywicki found that “the disclosures advance left‐​wing causes such as environmentalism and race, sex, and sexuality ‘diversity’ initiatives, not issues such as the rule of law, economic development, or affordable energy policy.”

ESG is also being used to shape how regulators expect corporations to address the political pressures to which they are inevitably subject. In his book The Dictatorship of Woke Capital, Stephen Soukup observes that under Securities and Exchanges Commission (SEC) rules, publicly-traded companies are allowed to exclude certain shareholder proposals if they receive permission to do so from the SEC. In 2019, Soukup writes, Apple asked the SEC to prohibit shareholders from voting on two propositions. One involved the promotion of intellectual diversity. The second focused on enhancing racial diversity. The SEC agreed that the intellectual diversity proposal would not appear on the shareholder ballot but allowed the racial diversity proposition to go ahead.

In short, racial differences were deemed more important by SEC officials than disparities in ideas. That is entirely consistent with ESG’s progressive slant—not to mention the SEC’s stated commitment to promoting diversity and inclusion within its own ranks, which, judging from the SEC Employee Affinity groups listed in the SEC’s Diversity and Inclusion Strategic plan, is overwhelming about ethnicity and sex rather than, say, religious or political affiliation…..

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