ESG — short for environmental, social, and governance, a framework through which businesses consider corporate social responsibility – has gotten a bit of a bad rap recently. This is particularly the zeitgeist in right wing circles. Last year, Florida Governor Ron DeSantis denounced ESG as ‘woke’ indoctrination. In January, New Hampshire Republicans tried to pass a bill that would make investing state funds in line with ESG criteria a felony. At a dinner at Yale I attended last month discussing corporate social responsibility, one girl sitting near me stated that the concept of ESG made her feel ‘physically unwell’.
In this article, I posit that these criticisms, while not completely misplaced, fail to recognise the benefits that ESG policies can bring. ESG policies, for the most part, help to make companies act more responsibly at limited cost. This is not a bad thing.
But first, why is it that ESG arouses such vitriol? A common theme among its critics is that ESG wrongly deprioritises returns. Invoking (incorrectly interpreted) Friedmanite ideas, many anti-ESG crusaders suggest that the purpose of a business is solely to maximise profits. The purpose of an investor is to maximise their returns. Everything else is superfluous.
This argument has some merit to it. Most institutions considering whether or not to adopt an ESG policy have some level of fiduciary duty to their shareholders or clients. If a pension fund makes bad investments, for instance, ordinary people – workers saving up so that they can reap money for retirement – will suffer. By not solely focusing on profit, it appears intuitive that ESG standards would decrease said returns. It seems to follow, then, that we should throw out ESG standards due to their adverse effects on profitability.
However, this argument is based on a misconception. Companies with ESG standards do not generally perform worse. In fact, the opposite may be true. A late-2023 study by Kroll, a risk and financial advisor, found that investments in companies with better ESG ratings dramatically outperform others with lower ratings – 12.9% to 8.6%. It is difficult to infer direct causation from this study because there may be omitted variables that are responsible for this difference; companies with higher ESG ratings are likely better run companies irrespective of their ESG policy. Nevertheless, this provides evidence that ESG standards are not always return-killers.
This makes sense, as there are several pecuniary reasons a company may want to employ an ESG framework. An ESG strategy allows a company to anticipate regulation before it happens. For example, a company which proactively chooses to reduce emissions via an ESG strategy will fare better if a carbon tax is implemented. ESG strategies can also help a company avoid negative publicity. Consumers often prefer buying products which they believe have been produced responsibly and humanely, rather than in a Rana Plaza type sweatshop. In such cases, adherence to ESG standards could increase sales. Thirdly, a company with a robust ESG strategy will often be able to attract and retain talent better than other companies, because people want to work at companies which they believe are having a positive influence. All of these serve to improve returns and profitability. The upshot of all this is that ESG strategies and maximising the bottom line often go hand in hand. This is not always true. It is difficult, for example, to see how widespread emissions reductions will improve big oil’s bottom line in the short term. However, it is certainly not the case that strong returns and ESG standards are mutually incompatible.
Many instead argue that ESG standards are anti-capitalistand wrongly add friction to the market. By forcing companies to focus on emissions, diversity, and so on, ESG standards foist upon customers and investors a progressive agenda they do not want.
There is, however, also a problem with this line of thinking. An assumption of the capitalist system is that markets are right and self-correcting. If investors, shareholders, and so on would choose to invest in companies employing robust ESG standards, it is hardly our right from a “pro-capitalist” perspective to say that they are wrong. If the market wants ESG, or at least does not care enough to buy non-ESG products, then it follows ESG should also be right. Otherwise, the invisible hand would over time crowd them out.
Some, instead, suggest that companies should not employ an ESG strategy because they are not the right entity to decide right and wrong. The argument goes a little bit like this: any form of ESG or corporate social responsibility involves a vision of the good. When a company decides whether to reduce emissions, increase the representation of underrepresented minorities, and so on, they endorse this course of action as morally right. Tallied up in their totality, these decisions can collectively direct the course of a society.
However, perhaps companies should not be the agents making those decisions. Companies are in no way democratic. They are profit maximising entities created to return value to shareholders. Instead of companies, it should be governments via the medium of regulation which direct how a company acts. This is not solely a criticism of ESG as a broader criticism of corporate social responsibility, the principle that businesses should do what they believe to be right in lieu of single-mindedly maximising profits.
I think there are a number of flaws with this argument. Firstly, regulation is not a panacea. Regulation generally lags behind problems because it takes time for regulators to notice a problem, conceive of a solution, convince others of its importance, and finally get it passed. It took the 2007-8 financial crash for the Dodd-Frank act to be passed. By the time regulation reaches a company such as OpenAI, it may be too late. Given The U.S.’s polarised and often dysfunctional government, it is also unclear whether some necessary legislation can pass at all.
Likewise, regulation generally deals in generalities, rather than specifics. Regulation may, for instance, say that a company cannot discriminate based on race. However, it does not provide specific numbers for how diverse a company should be, which is often based on many company-specific variables. This means that companies will always have significant wiggle-room to individually decide whether to pursue what they believe to be right, outside of the formal bounds of regulation.
The upshot of all this is we should not think regulation can or should be the sole mechanism to ensure positive corporate behaviour. Besides, it is a false dichotomy to suggest we must choose between ESG standards and regulation. In reality, the two go hand in hand, providing different yet equally important restraints on corporate behaviour.
More generally, it is also not true businesses are unable to choose what is right and wrong. There are a number of things which, all else equal, are widely agreed to be good for the country. Take reducing emissions, for instance. While a sliver of the population believes that climate change is a hoax, there is a general consensus among scientists and the U.S. at large that climate change is real, and that reducing it would, all else equal, be advantageous.
While people disagree over the extent to which we should pursue emissions reductions due to its associated tradeoffs – namely its high costs – it is widely agreed that having less carbon dioxide going into the atmosphere is ceteris paribus a good thing. On the level of an individual company, this means that, if an executive believes that their balance sheet can take greenhouse gas reductions, doing so is good.
Anti-ESG advocates may contend that, while it is true that there is near-unanimous agreement on a few issues, there are many elements of common ESG standards that don’t fit this bill. Affirmative action is a good example. In the past few years, the US has been consumed by an effervescent debate over affirmative action, with each side saying the other is acting discriminatorily. In these cases, where there is genuine disagreement, should companies and executives still take a stand?
I believe the answer often is still yes. People face moral quandaries in their personal lives all the time. Should parents monitor their children’s social media activities? Should somebody tell a lie if it will make the other person feel better? There are no universally agreed upon answers to such questions, and yet people still should still do what they believe to be right. To do so is their duty.
While corporations are much larger, and often make decisions that impact more people, there is little reason to think they operate in a fundamentally different way. Perhaps they have even more of a duty because of the impact of their choices.
Besides, deciding to not make a choice – for instance, choosing to not have a diversity program – is still itself making a decision. The upshot of this is corporations cannot avoid making morally significant choices even if they try. It is a form of cowardice to suggest that corporations can shut their eyes and pretend they are oblivious to the issues that face them.
It is thus the case that, just as how it is preferable for ordinary people to do what they believe is right in difficult circumstances, it is desirable for businesses and executives to do what they believe to be right. Now, social obligations need to be weighed against ones fiduciary duty to relevant parties, and I do not suggest there is a universal formula for how to balance the two.
One may rightly be sceptical of the extent to which businesses actually will do what they think is correct. Companies often shroud bad behaviour under morally righteous language. Big Tobacco, for instance, kept on professing cigarettes were beneficial social lubricants to society without any adverse health benefits long after they knew that they were basically vaporous poison. This is why, for all its flaws, regulation is absolutely a necessary restraint on corporate bad behaviour.
However, this criticism does not rebut the underlying idea of corporate social responsibility that companies should do what they believe is right. Instead, it merely suggests companies often in reality may not be actually doing what they believe is right. If anything, bad actors need more corporate social responsibility, not less.
I thus believe that it is absolutely justified for companies to make decisions about which moral issues to take a stand on. However, in the title of this article, I say that I want to defend ESG only for the most part. Thus far, this article has heaped praise on ESG like a college student speaking to an associate at a Goldman Sachs networking event. So what’s the problem? The problem isn’t with the broader concept of corporate social responsibility. The problem is that ESG does not go far enough.
ESG revolves around several quantifiable standards. These include everything from carbon dioxide emissions to avoiding conflicts of interest, fair pay, and waste reduction. The advantage of these standards is that they give consistency and comparability across companies, meaning shareholders can make an informed decision about which companies to invest in and when to call for change.
However, the problem with having a precisely articulated set of standards is that a company can often be led to believe that its corporate social obligations are met once this narrow set of standards is met. This can lead to a form of whitewashing where the impact of the company outside of ESG prescriptions is disregarded.
Consider a private equity firm which buys a hospital system, raises prices across the board, cuts the quality of care, and generally makes life worse for the people relying on it for health care. All of its ESG criteria may be met. This action may not increase emissions, reduce diversity, and so on. but this does not imply that the investment made a positive impact on the world. This issue is particularly pernicious because companies are often the agents themselves creating ESG standards, thus meaning they may leave out inconvenient truths.
ESG standards are thus a double-edged sword, allowing some corporate social responsibility but often masking adverse effects that do not fall within its purview. This is not a mortal blow to ESG. Some corporate social responsibility is better than none at all, and its comparability does give a set of pressure points shareholders can use to ensure better behaviour from companies. However, it is a limitation worth thinking about.
There is also one further problem with ESG. As a concise, often poorly understood acronym, it makes a perfect enemy. Much like CRT (critical race theory), ESG is something to which all sorts of ills can be arbitrarily attributed, with or without validity. This shortcoming may prove to be more impactful than any of its others. ESG has dramatically changed the business landscape. The way executives think, act, and consider the role of a company is radically different to how it was 50 years ago. While ESG as it stands may not go far enough, hopefully the concept of corporate social responsibility will continue to grow and flourish over the coming decades.
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