ESG’s Bad (But Not Bad Enough) Year
National Review Online, January 6, 2023
Ninth Avenue, New York City, January 2020 © Andrew Stuttaford
The year 2022 was not the best of years for ESG (an investment discipline under which portfolio companies are measured against various environmental, social, and governance standards). To take one example, as of January 5, the price of BlackRock’s ESG Screened S&P 500 ETF had declined by around 22 percent over twelve months, underperforming the S&P 500, which fell by around 20 percent. Those are only one year’s results (and they would have been marginally improved by dividends), but it’s still not the greatest of looks for an investment approach often sold (typically with higher fees) as a way of doing well by doing good. Making matters more embarrassing still, stocks in those wicked fossil fuel companies (in which ESG investors tend to be underweight) did well. The S&P 500 Energy sector index rose by around 44 percent over the same period.
Last year might be less of an outlier than ESG’s cheerleaders would like investors to think. The Harvard Business Review is hardly a bastion of the financial illiterates (to paraphrase Michael Bloomberg) or “Republicans” (to quote the line generally taken in outlets such as the FT, a home of — generally — genteel climate fundamentalism). Nevertheless, it was at the Harvard Business Review that Sanjai Bhagat wrote this early last year:
ESG funds certainly perform poorly in financial terms. In a recent Journal of Finance paper, University of Chicago researchers analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings. Although the highest rated funds in terms of sustainability certainly attracted more capital than the lowest rated funds, none of the high sustainability funds outperformed any of the lowest rated funds.
That result might be expected, and it is possible that investors would be happy to sacrifice financial returns in exchange for better ESG performance. Unfortunately ESG funds don’t seem to deliver better ESG performance either.
Researchers at Columbia University and London School of Economics compared the ESG record of U.S. companies in 147 ESG fund portfolios and that of U.S. companies in 2,428 non-ESG portfolios. They found that the companies in the ESG portfolios had worse compliance record for both labor and environmental rules. They also found that companies added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations.
This is not an isolated finding. A recent European Corporate Governance Institute paper compared the ESG scores of companies invested in by 684 U.S. institutional investors that signed the United Nation’s Principles of Responsible Investment (PRI) and 6,481 institutional investors that did not sign the PRI during 2013–2017. They did not detect any improvement in the ESG scores of companies held by PRI signatory funds subsequent to their signing. Furthermore, the financial returns were lower and the risk higher for the PRI signatories.
Oh dear.
There are plenty of reasons why ESG should underperform, many of them set out by New York University finance professor Aswath Damodaran (I have discussed them here, here, and here). And even if underperformance does not concern those agitated by climate change/crisis/emergency, it ought to change the way that ESG funds, a lucrative trade, are sold. Time will tell whether it does.
As Rupert Darwall highlights in “2022: The Year ESG Fell to Earth,” his fine discussion of some of the cracks appearing in ESG’s edifice, the relationship between geopolitics and ESG is another problem that cannot be avoided. Reckless climate policymakers and European complacency (most notoriously in Germany) handed Putin an energy card he should never have been given. How much of a role ESG played prior to 2022 in further strengthening Putin’s hand can be debated (Darwall would probably put more of the blame on ESG than I would), but that it played one cannot.
In an article for Capital Matters in November, Casey Mulligan noted this:
The cost of capital has also increased for fossil-fuel producers because federal financial regulators increasingly encourage woke investing, euphemistically known as “Environmental, Social, and Governance” or ESG, which declines to invest in fossil-fuel companies regardless of their financial promise. And this will be made worse if proposed new SEC regulations that include requirements for even small companies to track and report the climate impact of their activities come into effect.
That increased cost of capital (together with Biden administration policies) has been an important factor in causing American oil companies to produce less oil than would normally have been expected in the higher oil-price environment of the last year or so.
Mulligan:
Handicapping our industry — formerly known for its elastic response to world oil prices — has also enabled OPEC to gain more control over the world oil market.
Darwall:
By restricting investment in production of oil and gas by Western producers, ESG increases the market power of non-Western producers, thereby enabling Putin’s weaponization of energy supplies. Net zero—the holy grail of ESG—has turned out to be Russia’s most potent ally.
The idea that renewables are the answer to this problem only shows that climate policy-makers understand as little about engineering as they do about economics as they do about geopolitics.
Adding injury to injury, a considerable amount of ESG money has gone into the electric-vehicle sector. No small part of this has, directly or indirectly, benefited China both economically and geopolitically. Whatever the name of its ruling party, China is, lest we forget, a fascist state currently engaged in genocide. Allegedly “ethical” investing operates in curious ways.
Darwall explains that Vanguard did its bit to contribute to ESG’s tricky year. The U.S. index fund giant pulled out of both the Net Zero Asset Managers (NZAM) initiative and the broader umbrella group, Gfanz (the Glasgow Financial Alliance for Net Zero). Darwall quotes this comment by Vanguard:
“We have decided to withdraw from NZAM so that we can provide the clarity our investors desire about the role of index funds and about how we think about material risks, including climate-related risks,” the world’s second-largest asset manager said.
I wrote a bit about Vanguard’s move here. Suffice to say that this ought to spur a rethink by other major financial institutions about earlier climate commitments — commitments closely connected to ESG — made with little real thought of their implications.
Meanwhile, EU regulators have been making life more difficult for those peddling ESG products. I’ll write more on that on another occasion, but here’s a trailer from Bloomberg:
After a turbulent few weeks during which some of the world’s biggest asset managers removed coveted ESG tags from huge chunks of their business, industry bosses have had enough.
Managers running the funds affected are now talking openly of the “chaos” they say has hit the investment management industry. The chief cause, they say, is a regulatory framework whose confusing rollout just blasted a $125 billion hole through the very top of the ESG market.
It would take a heart of stone not to laugh.
Darwall, however, rightly warns his readers that ESG has had its successes too, citing the, uh, departure of Stuart Kirk from HSBC “for voicing some hard truths about ESG.”
What’s more:
[In December], HSBC announced that it will stop financing new oil and gas fields, putting the West’s third-largest bank on Putin’s side in Russia’s energy war on the West.
HSBC, a bank which is uncomfortably close to the Chinese regime, is what it is.
Kirk, the bank’s global head for responsible investing (a job title emblematic of the opportunities for rent-seeking created by ESG) was pushed out (formally he resigned), for a speech in which he dismantled the logic of much of big finance’s climate orthodoxy. It was one of the highlights of a year in which the intellectual onslaught on ESG would, in a better world, at least have persuaded some of its proponents to switch their efforts to selling a different brand of snake oil.
But, for the most part, that’s not happening, and nor will it happen anytime soon.
For all the questions about ESG, ESG products (“sustainability” and ESG have large areas of overlap) are still attracting money.
The Financial Times (January 3):
Morningstar estimates sustainable funds attracted $22.5bn of net new money globally in the third quarter of 2022. That was less than the $33.9bn of inflows in the second quarter, but against a backdrop of significant market challenges, sustainable funds held up better than the broader market which experienced net outflows of $198bn over Q3.
Sadly, that’s no great surprise. ESG together with its equally repulsive symbiont, stakeholder capitalism, remains in keeping with the spirit of an increasingly collectivist era. And it doesn’t hurt that a part of the glue that keeps that collectivism in place is anxiety (to use a mild word) over the climate. Even more importantly, ESG and stakeholder capitalism continue to be pathways to a job, wealth, and power.
I’ve written (frequently) before about the way that ESG, “sustainability,” stakeholder capitalism, and other aspects of the ever-expanding climate-policy regime have created an ecosystem in which many businesses (consultants, professional advisers, financial types selling ESG products, and all the rest) have flourished. The owners of those businesses, and those who work for those businesses and, those who work in jobs created within other enterprises to enable them to adjust to this new regime — heads of sustainability here, heads of diversity there, and, yes, surviving heads of responsible investing too, as well as all those who report to them — represent a formidable lobby against any retreat from ESG. And the same is true of those sections of the administrative state (and those who work for it) being given the responsibility of policing how businesses live up to the commitments they have made in the name of ESG or the climate, a process that has also enabled a disturbing amount of regulatory mission creep.
And don’t look to CEOs or, indeed, to other senior executives, to risk the career damage that could come from pushing back against ESG. Not only are they under pressure from the large institutional shareholders who, to a greater or (see the comments on Vanguard above) lesser extent, have embraced ESG and stakeholder capitalism, but they are well incentivized to play ball. Diluting the importance of shareholder-friendly financial targets, makes it easier for them to get well paid, but, on top of that, the combination of ESG and stakeholder capitalism enables them to use their shareholders’ capital to buy them a seat at the corporatist table, seats that generate both power and yet more profit.
One heartening sign, however, has been the growing — and unfriendly — interest taken by politicians on the Right in ESG, something that Darwall also finds encouraging:
[ESG’s] existence as a political doctrine will continue until it is challenged and defeated politically. This is already happening in Red states such as Florida, Texas, West Virginia, and Utah. It also requires concerted leadership at a national level to get central bankers and financial regulators to quit playing covert climate policy and to shame banks such as HSBC into switching their support from Russia in the energy wars by dropping their anti–oil and gas financing policies.
Darwall’s point that ESG is a political doctrine matters. Many of ESG’s proponents have decried the interventions to which he is referring as political meddling which is, if nothing else, an impressive display of chutzpah. ESG is not only profoundly political, but it is also an attempt, particularly when reinforced by stakeholder capitalism, to bypass the democratic process. Intervention by elected politicians in this area is thus to be welcomed. The angry opposition to it reveals a lot about the agenda of those cheering ESG on. These political interventions have not always been perfectly constructed (the emphasis on the “woke” elements of ESG is understandable, but, in some respects, beside the point), but it would be a mistake to let the perfect be the enemy of the good.
The Right, however, should resist the temptation to try to impose an ESG of its own. Its best approach continues to be a defense of shareholder rights and the principle that political decisions should be left to the institutions provided for in our constitutional arrangements.
Despite ESG’s failures, whether actual or intellectual, and despite the beginning of serious political pushback, consigning it to the ash heap of investment history will be a hard struggle, not least (as indicated above) because of the interests behind it and the way that it has become entrenched in so much of business, finance, and the administrative state.
And not only there. To take an example, writing for Real Clear Investigations, Ben Weingarten reports that the University of Pennsylvania’s Wharton School will offer a new major called Environmental, Social, and Governance Factors for Business. In principle, that’s fair enough — ESG is a major financial and business phenomenon — but I somehow suspect that it will not be taught as objectively as it should be. Rather, what we are seeing (and Wharton is only one instance of a wider phenomenon) is institutional capture of the type envisaged by Gramsci and Dutschke, combined with the insight of Willie Sutton. The students signing up for that course will be going where they think the money is, and they may well be right.
Weingarten’s piece is well worth reading in full, but to conclude on a thoroughly bleak note, I’ll repeat some comments he quotes from Stephen Soukup, author of The Dictatorship of Woke Capital:
We’ve lost the institutional fight. The pro-ESG forces control the federal bureaucracy, the universities and B-Schools, and other institutions. . . . They can keep this clearly destructive, clearly disproven scheme going indefinitely, which will result in serious damage to capital markets and the economy more broadly.
There’s a long way to go.
Extracted from the Capital Letter published January 6, 2023