National Review Online, June 19 2023

Increasing criticism of ESG (an often incoherent investment “discipline” under which actual or portfolio companies are scored in part by how they score against various environmental, social, and governance measures) and the pushback against it in certain (red) states are worrying those in the ESG ecosystem who have done so well politically and economically (or both) out of it. Newspapers such as the Financial Times complain about elected politicians meddling in topics such as ESG, even though ESG is nothing if not political. Billionaires such as Mike Bloomberg and Tom Steyer have issued warnings that those who oppose ESG just don’t understand capitalism, as has (more or less) Al Gore, climate change “prophet” and profiteer.

All this was (more or less) to be expected. It was more of a surprise to read an article supporting ESG against its conservative critics by Jacob Soll, a professor of philosophy, history, and accounting at the University of Southern California, who cited, among others, St. Francis of Assisi. Perhaps it’s just me, but if I were looking to offer some reassurance to those uncertain about ESG (which may not, of course, be Soll’s aim), citing an individual who rejoiced in poverty is not an obvious course to take.

But before bringing Il Poverello into his discussion, Soll writes:

Conservative critics [of ESG] say giving value to moral or even scientific imperatives goes against the profit principle at the heart of the free market; for them, it’s foolish at best, and at worst an effort to impose a “woke” agenda.

The core of this policy strikes at what goes on balance sheets and how we value things. Are environmental concerns, social well-being and good government assets or liabilities? Or do they simply not matter amid the pursuit of profit?

The furor over “woke capital” is, or ought to be, a sideshow. Woke capital is a symptom, not the disease. A much deeper free-market critique of ESG and its equally repulsive symbiont stakeholder capitalism (an idea that should never be excluded from any discussion of ESG) rests on two core principles: a belief in property rights, and a belief in democracy. Stakeholder capitalism, no less than ESG, dilutes the former and risks eroding the latter. A couple of years ago, I wrote about stakeholder capitalism and property rights here:

[Stakeholder capitalism] is the idea that a company should be run for the benefit of all its “stakeholders,” a conveniently hazy term that can be defined to include (among others) workers, customers, and “the community,” as well as the shareholders who, you know, own the business. It’s a form of expropriation based on the myth that a corporation that puts its shareholders first must necessarily put everyone else last. In reality, an enterprise that, to a greater or lesser extent, fails to consider the needs of various — to use that word — stakeholders in mind, customers, most obviously (but certainly not only) is unlikely to flourish, and nor, therefore, will its owners.

And when it comes to the risk to democracy, I gave some background here:

The wider vision underlying stakeholder capitalism is one in which different interest groups such as employers, employees, and consumers collaborate in pursuit of mutually (if sometimes mysteriously) agreed objectives under the supervision of the state. It would never be quite post-democratic, not quite, in any likely American form, but what it would be is a variety of corporatism.

Corporatism takes many, many forms. It can range from the relatively (relatively) benign — it runs through European Christian Democracy, and it can be detected in early-20th-century American Progressivism — to the infinitely more heavy-handed. It has been an important element in the theory, if not the practice, of some variants of fascism, most notably in Mussolini’s Italy, but not only there.

A company is the property of its owners, its shareholders. It’s thus a simple matter of logic as well as longstanding case law that the job of a company’s management is to run the business for the financial benefit of its shareholders (unless those shareholders vote otherwise). To the extent that ESG or stakeholder capitalism “permit” management to ignore that obligation, they are nothing more than an attempt to justify a breach of trust and the expropriation of property rights (similar arguments apply, in many cases, with regard to the behavior of investment managers). Some might call that moral, others might say that it is theft.

And then there’s the small matter of democracy. In democracies, decisions on issues such as environmental policy should be made by the legislature. ESG and stakeholder capitalism are devices to use corporate power and money to make and implement policy in such areas, but without going through the bother of asking the voters.

And so to St. Francis.

Soll:

Saint Francis of Assisi and the Scholastic thinkers believed that all profit had to be measured with the concept of the “just price” — exchanges had to be mutually beneficial and no one could take an unfair profit from others.

Even beyond the just price, the medieval, Catholic inventors of capitalism believed that profit had to be balanced by morality. They were influenced by the ideas of the Fathers of the Church, that profits should be given to the poor and that those who died rich had as much of a chance of going to heaven as a camel did of going through the eye of a needle.

To shift focus for a moment, there is an interesting argument to be had on the topic of when capitalism (or proto-capitalism) was invented. Some maintain that it took a few more centuries to emerge than the time suggested by Soll, others that it had been around for millennia.

Nima Sanandaji, writing in CapX in 2018:

Far from being a recent innovation, enterprises, banks, advanced commercial practices and free markets evolved some 4,000 years ago in the countries we today know as Iraq and Syria. A better understanding of the story of capitalism is needed; since it shows us how important markets have been for human progress as well as how universal the link between development and market policy is across different societies.

Over time, archaeologists have uncovered and translated a great deal of tablets left from ancient civilisations. Many of the tablets from Babylonia and Assyria, in contemporary Iraq and Syria, are receipts of economic ventures. They show that private profit-seeking merchants, rather sophisticated investment ventures and market price setting were common in these civilisations. Astronomical diaries written some 2,500 years ago show how market prices changed on a monthly, or even weekly, basis in Babylonia.

This shouldn’t come as a surprise. Given how prosperous the ancient Middle Eastern civilisations were and how important they were for human progress, it should come as no surprise that they were the birthplace of enterprise and market economy. Egypt on the other hand relied more on central planning, and predictably stagnated.

Some things never change:

Free markets, in different forms, also seem to have formed in the three other cradles of human civilisation – India, China and Mesoamerica. Since ancient times China has fluctuated between free market policies and statist control. The periods of free markets are those in which China has prospered.

It’s almost as if there’s a message there.

Sanandaji even suggests (Dominic Pino, avert your eyes) that Adam Smith plagiarized Xenophon (more on that here).

But back (sigh) to St. Francis and the scholastics. Soll is not, mercifully, recommending that we adopt a “just” price regime, but making the broader point (I’m oversimplifying) that there is a long tradition that profit is not its own justification, but should also be “moral.” Soll backs up his arguments with (to take a few examples), the views of 16th century Flemish painters, the “spiritual accounting” of 17th century Jesuits, the “moral accounts” of Benjamin Franklin, Jacques Necker (a not uncontroversial 18th century French finance minister), and Henry David Thoreau, another ascetic mystic with a distaste for business. “Trade,” wrote Thoreau, “curses everything it handles,” a somewhat discouraging point of view from someone with, we are supposed to believe, something useful to add to the way U.S. businesses are run.

But, summoning up this crew adds little of substance to a defense of ESG. There are few who would argue that profit is everything. To stakeholder capitalists and ESG’s promoters, Milton Friedman is the archetype of much that is wrong with contemporary capitalism, and yet in his now legendary article (The Social Responsibility of Business Is to Increase Its Profits) on shareholder primacy there is this passage (emphasis added):

In a free‐enterprise, private‐property system, a corporate executive is an employe of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of … society, both those embodied in law and those embodied in ethical custom.

“Embodied in ethical custom.” So far as its greatest advocate was concerned, shareholder primacy was not divorced from morality. Moreover, he evidently (and correctly) had no difficulty in finding those corporate executives who effectively anticipated ESG and stakeholderism, not just misguided, but morally wrong.

In making his case, Soll also cites the examples of Dutch water boards, which date back centuries:

The Dutch water boards, which governed water management, depended on precise accounting and a culture of auditing to make sure that public finance could manage the natural world. Public awareness of the value of water management was high, and leading thinkers and artists warned that thinking only of profits was hubris akin to madness or folly.

“Leading thinkers” and artists will think what they think, but it’s hard to imagine that many free marketeers today would disagree with the contribution made by the water boards (essentially a form of local government), or the importance of “environmental management” to the Netherlands.

After all, as Soll explains:

It… was a society whose wealth came from significant environmental management, as 40 percent of the Dutch Republic was below sea-level. Its rich farmlands were drawn from the sea through its polder engineering systems of levies, seawalls, dikes, sluices and managed lakes.

The Dutch need to manage their land’s relationship with the undeniable threat from the sea was a rational allocation of publicly funded resources. The same cannot be said of the current set of Western climate policies, which, all too often, seem to be driven by a combination of command-and-control nostalgia, and atavistic apocalyptic fears. The real lesson to be taken from the experience in the Netherlands is the extent to which the Dutch relied on adaptation (which later included extensive reclamation). They were able to pay for this with the fruits of their commercial success, both at home and abroad (some of it flowing, it must be said, from the slave trade).

Modern climate policies of the sort promoted within the ESG ecosystem, by contrast, do too little to help adaptation, and too much to install technologies that are not yet ready for prime-time (traditional Dutch windmills, by contrast, did what they were meant to do). What’s more, if climate policy continues along its current course, it will constrain the economic growth that creates the wealth that, if history is any guide, will enable humanity to make the investments needed to cope with whatever the climate may have in store for us and, quite possible, even avert some future difficulties to come.

Soll rightly notes that the Dutch were the first to set up a stock market. Not only that, as Martin Hutchinson points out in his fascinating book Forging Modernity, the most important Dutch province, Holland, had a de facto central bank from 1609, enabling a public debt market to grow up (according to Hutchinson, Holland’s borrowing rate fell by more than a half over the next forty years), another part of increasingly sophisticated financial markets (let’s not talk about tulips). Hutchinson explains that property rights were well-protected in the Netherlands, better than anywhere else in continental Europe. What’s more:

 [T]he country also had a well-established rule of law…[and] its bourgeois culture ensured that at least the middle classes could get legal redress if needed. With a solid government bond market and an early stock market had a good savings climate until 1672.

With functioning exchanges, decent property rights, a well-established rule of law, and that “bourgeois culture,” the 17th century Dutch had put key building blocks of a free-market economy in place, and they saw the rewards. ESG and stakeholder capitalism, by contrast, attack property rights, contribute to the dilution of legal certainty, and will discourage growth, investment and, even, the willingness of some companies to go public. The Dutch precedent may mean something other than Soll seems to suggest.

Soll also draws attention to policies such as heavy regulation on trade with USSR during the Cold War that, he argues, “show the U.S. government has not shied away from shaping commerce because of moral concerns and national interest.” That’s true, but the examples he cites were prompted more by security considerations than moral concerns. Needless to say, the leadership of some firms grumbled about the lost business opportunities that ensued, but Adam Smith would have understood what Washington was doing. As he wrote, “defence… is of much more importance than opulence.” It’s worth adding that the priority Smith put on national security would be tricky to square with ESG-driven restrictions (in some cases) on investments in armaments or in fossil-fuel production.

The first of Soll’s concluding paragraphs runs as follows:

In the end, ESG is just another name for moral considerations in capitalism. The left may think that’s an oxymoron and the right may see a woke conspiracy, but it’s a notion that has existed since the rise of capitalism in medieval Italy and which has been central to America since its founding.

As Soll states, the idea that capitalism should operate within a moral framework has a long history. Few would dispute that, but that doesn’t give ESG a clear pass. ESG is not “just another name for moral considerations in capitalism.” Rather it is a distinct system designed to encourage or enforce certain behavior within and by business. Maybe, in parts, it is analogous to a moral code, maybe. But even if that it is the case, just because it’s a moral code doesn’t mean that it’s the right moral code, or that others should have to comply with it.

Apart from obligations imposed by law or regulation, the only people who should decide on the applicability of ESG to their company are its shareholders. Their company, their rules. When those shareholders are funds made up of the savings of third parties, they should invest solely on pecuniary grounds (and vote their shares only in ways intended to maximize investor return), unless those third parties specifically agree otherwise, having been made aware that it may well mean sacrificing some return.

Yes, sacrifice some return: ESG has, famously, been marketed as a way for investors to do well by doing good. Soll refers to a book published in the 1980s, which “showed that ESG considerations [or, rather, earlier forms of “socially responsible” investing] bring higher returns over longer periods of time.” However, more recent evidence is at best mixed. (That’s being kind: Although, to be fair, there are other data that can be read in different ways.) But even assuming for the sake of argument that ESG can deliver sustainable outperformance, the way that markets work will, logically, mean that that will cease to be the case as the ESG advantage is “priced in.”

Meanwhile, Aswath Damodaran, a professor at New York University’s Stern School of Business, has described ESG as space for “useful idiots” and “feckless knaves.” Harsh, if accurate, words. It’s worth reading this, this, and this to see his reasoning, which dismantles much of the economic and, indeed, “moral” case for ESG: Investors may not do well, and (even by their standards) they may not do much “good” either.

Damodaran highlights the way that ESG has become an attractive feeding ground for rent seekers. Then again, many faiths, philosophies, or moral codes have been a source of rich pickings for the unscrupulous—think of the peddlers of Christian relics who did so well in the Middle Ages. Of itself, that does not necessarily discredit the underlying beliefs, but with ESG it comes very, very close.

Damodaran:

I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society.

Back to Soll:

[A]ttempts by conservative politicians to block ESG investments go against the basic principles of democracy and capitalism by which we have the right to spend and invest money according to personal choice, religious and moral freedom, and pursuit of the national interest through legislative consensus, all of which are fundamental to free societies and free markets.

On the contrary, the attempts by elected politicians in red states to insist that political decisions should be taken by those elected to do so, rather than by a murky, ever-shifting coalition of businesspeople, activists, investment managers, Wall Street opportunists, and who knows who else, is profoundly democratic. The problem is not that ESG is being subject to political criticism, but that it has still not had enough of it.

And yes, of course, if investors want to invest in ESG funds, or funds that reject “sin” stocks, or any other funds in which non-pecuniary factors play a role in the investment process, they should be able to do so, but investors who want nothing to with ESG or stakeholderism should also be able to invest according to their principles, too. However, the latter may find their choice increasingly constrained, albeit perhaps only indirectly, if the clout of the large institutional investors who have embraced ESG, reinforced by the subtler power of the proxy advisory “duopoly,” pushes more and more companies down a progressive pathway.

Extracted from the Capital Letter for the week beginning June 12, 2023