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 should involve a refusal to choose evil or to formally cooperate with other peoples’ evil.
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.
This just isn’t bad for businesses; it also damages society’s wider capacity to recognize that when business achieves its proper ends, the wider, albeit indirect benefits for others are enormous.
Courtesy of the American Institute for Economic Research (a longer version of the article is available on the website)
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