Over the past year, the ground beneath the feet of those most responsible for driving ESG (environmental, social, and governance) initiatives in global corporations and financial institutions has shifted.
ESG is an investment strategy based on the theory that corporations that adhere to certain environmentally and socially conscious strategies are not simply admirable but also make for better investments. To be sure, plenty of skepticism surrounds the idea that capitalism—the engine of so much of the carbon emissions in the first place—can really be part of the climate solution. But until this year, it seemed like those voices would lose out.
For one, the advent of ESG as an investment product had already led to undeniable changes in corporate behavior and put previously nonexistent pressure on CEOs to take issues like carbon footprint, gender diversity, pay equity, and labor rights into account. Just a short list of outcomes would include Exxon being forced by the activist investors to accept two climate activists onto its board; the divestiture of billions of dollars by state and local pension funds from the coal and firearms industries; and the sudden willingness of CEOs, once allergic to taking a public stance on controversial issues, to speak on everything from net zero to eliminating child labor from global supply chains to U.S. voting rights. Second, although flaws and contradictions abound in the way ESG is defined, the amount of money being managed by ESG funds had exploded over the past decade.
But 2022 may have slowed some of that momentum. Driven by higher prices for fossil fuels, food, and other commodities—much of it caused by Russia’s brutal war on Ukraine—the “black hats” of the ESG debate, including oil and gas producers, coal miners, and the like, found their voice. Some investors, too, who previously assented to removing what they now called “stranded assets” from their portfolios, have had a rethink. After all, why remove oil or gas stocks from your retirement plan if the rest of the market is crashing?
In turn, financial advisers who apply anything other than financial factors when judging the value of companies’ shares have faced a backlash from Wall Street to Main Street. It’s the moment ESG’s enemies have been waiting for. And so a cabal of political opportunists, petrostates, and anti-government market puritans have launched the fight of their lives. This year may see who wins—or wins this round, at least.
Stakeholder vs. shareholder capitalism
Stakeholder capitalism, as some have called the larger backdrop to the ESG debate, began as a cottage industry of NGOs and think tanks attempting to apply the United Nations Principles for Responsible Investment (PRI) to the wreckage left by the poorly regulated markets that prevailed before the 2008-09 global financial crisis.
In the 13 years since, the idea that the world should embrace a more sustainable approach to market capitalism, commerce, and corporate governance has gained widespread acceptance and influence across most of the world. The cause has been taken up by politicians, economic theorists, and many corporate leaders, too. And in global financial markets and among financial professionals, this thinking evolved into ESG.
“At their current growth rate, ESG-mandated assets (defined here as professionally managed assets in which ESG issues are considered in selecting investments or publicly traded companies at which shareholder resolutions are filed on ESG issues) are on track to represent half of all professionally managed assets globally by 2024,” noted the global consultancy Deloitte in April 2022. Such reports have proliferated and have led to the creation of an entirely new industry of corporate sustainability lawyers, ESG risk analysts and investment strategists, and technology firms that collect and parse relevant data. Moreover, Deloitte and other Big 4 consultancies have hired thousands of “ESG consultants”—a job that didn’t exist a decade ago.
The growing slice of global assets under management (AUM) claimed by ESG has attracted more than hyperbole: It has also led to a surge in government regulation—the bane of any good Ayn Rand acolyte. The European Union, the U.S. Federal Reserve, and the Securities and Exchange Commission (SEC), along with hundreds of state, provincial, and local regulators, have started to compel corporations to disclose a wide range of data on their carbon footprint, labor and supply chain practices, gender and pay imbalances, and more. Such regulations have been welcomed by most ESG advocates as a step toward standardizing the way corporate performance on ESG factors is judged. It also tends to validate predictions that sustainability and other ESG practices have gone mainstream.
Ron O’Hanley, outgoing CEO of State Street—the world’s third-largest asset management firm—says the only way forward for finance and corporations is “to support the acceleration of the systemic transformations underway in climate change and the diversity of boards and workforces.” Like so many leading corporate and financial voices, O’Hanley embraces the idea that public companies should increasingly be held to account for their part in everything from climate change to income inequality to slave labor in the developing world.
Woke capitalism in the dock
But recent months threw a wrench into this narrative. Inflation pinched consumers and governments alike (though not, just yet, corporate profits). Supply chain dysfunction and the turbulent effort to decouple the West’s economies from supply chains in an increasingly authoritarian China are also factors. These dynamics, combined with the ever-looming chaos of an American presidential election cycle and the demented echo chamber of social media, have convinced the coalition of forces opposing ESG to strike now.
The campaign began in earnest in mid-2022, when a group of right-leaning U.S. states, led by West Virginia, declared they would not do business with global financial firms that embraced ESG tenets or refused, for instance, to include coal industry shares in their equity funds. This mostly produced a shrug from global financial firms—that is, until Texas, home to the sixth largest public pension system in the United States, joined in. Texas not only pulled its business from State Street, BlackRock, Vanguard, and a host of European banks that have downgraded fossil fuel companies, but also demanded that banks put an end to their unfair “discrimination” against gun and ammunition manufacturers.
Not to be left out, Florida’s governor and would-be 2024 GOP presidential candidate, Ron DeSantis, has denounced ESG as “woke capitalism” and has declared his state’s large public pension funds would cease doing business with firms attempting “to impose an ideological agenda on the American people through the perversion of financial investment priorities.” Declared DeSantis in celebration of a convincing reelection victory in November, “Florida is where woke goes to die.”*
If this sounds like a political stunt, it’s not. Unlike shipping undocumented aliens off to Martha’s Vineyard or to the vice president’s home in Washington, D.C., the threat by large states to blackball giant asset managers who do significant business with their governments carries a real financial bite.
Soon after Florida’s announcement, Vanguard Group, the world’s second-largest asset manager after BlackRock, announced it would renounce its membership to the Net Zero Asset Managers group, which had pledged, among other things, to “support investing aligned with net zero emissions by 2050 or sooner.” Vanguard denies the two events are connected. But The Wall Street Journal’s editorial page—no fan of Net Zero thinking—celebrated the move as a major victory in the war against Woke.
Behind the political rhetoric and jockeying to inherit the mantle of Donald Trump ahead of the upcoming presidential election, though, there is a deeper, more intellectual pincer move afoot.
Much of the success that ESG investments have had in recent years—and the numbers don’t lie in that regard—is based on financial analysis and academic studies that indicate that companies which rank high on various ESG metrics outperform those which do not, or at the very least are more resilient to inevitable setbacks and economic down-cycles. This claim has largely held up during the most recent economic downturns and financial disruptions, including the Great Recession and the more recent pandemic.
The bet by ESG opponents is that now is the time to kick that particular leg out from under the chair. Following Russia’s invasion of Ukraine, for instance, S&P Capital IQ, a market index, found that investors who were heavily exposed to ESG funds lost more on balance than those who remained in traditional “values neutral” funds. This can be partly explained by the spike in share prices that oil and gas companies experienced when the war began and energy prices soared—a spike that ESG funds largely missed by removing or limiting the weight of energy firms in their portfolios. In effect, ESG opponents argue, being underweight oil and gas may or may not be good for the planet, but it’s going to be bad for your pocketbook.
Vivek Ramaswamy, who made his fortune in biotechnology and recently founded an anti-ESG asset management firm, Strive, is a leading voice against commingling environment, social, or other filters with good old-fashioned profit. “Companies should focus on exclusively making great products and services for customers and doing so for profit while leaving politics to the politicians,” said the author of The New York Times bestseller “Woke, Inc.: Inside Corporate America’s Social Justice Scam.”
Defending the defensible
One fascinating offshoot of the current debate is the status of defense companies. Once deemed anathema by many ESG-based funds, the war in Ukraine has cast a new, kinder light on the makers of the weaponry currently being used to defend Ukraine from Moscow’s onslaught. The debate is particularly acute for faith-based ESG funds—a surprisingly large and active pool of money that includes everything from cross-denominational vehicles like the FIS Biblically Responsible Risk Managed ETF (listed on the NYSE as PRAY) down to the Buddhist Churches of America Endowment Fund. The largest of these funds, GuideStone, has $14.2 billion AUM and does not invest in defense industry names. Then again, most would also eschew pharmaceutical giants Sandoz and Searle based on their manufacturing of abortion pills. ESG, it seems, is in the eye of the beholder.
In the end, the malleable nature of what constitutes ESG is perhaps its biggest vulnerability. Last summer, for instance, the EU revised its definition of what qualifies to be held in an ESG/Green investment fund to include nuclear power (due to nuclear power’s minimal carbon footprint and French lobbying) and natural gas import terminals (by virtue of their “transitional” value in the quest for eventual Net Zero, and their ability to help allay the sudden shortfall in Russian supply). Could defense now be added, too? Probably not. But it didn’t seem like nuclear would be added before last year, either.
These inconsistencies also point to a crucial difference between ESG, which weighs an array of factors beyond climate footprint and labor rights, and socially responsible investing (SRI), where a more subjective ethical filter is applied. Defense of democracy and preventing civilian slaughter might matter more to some funds than the fact that weapons kill people. So might a factor like diversity. As Bloomberg, in an analysis of the defense/ESG debate, reported: “U.S. military contractors have one of the highest percentages of chief executive officers who are women among S&P 500 companies, with both General Dynamics Corp. and Northrop Grumman Corp. led by women. There’s just one female CEO among the much larger group of S&P 500 banking stocks, by contrast.”
So far, there has been no rush to add shares of Lockheed Martin, makers of the US HIMARS artillery rockets that Ukraine has used to such great effect, to the ranks of ESG-qualified funds. The EU has not revised its definitions, and by and large defense firms—like gunmakers and tobacco companies—remain tagged as ESG noncompliant.
The larger question remains unanswered, however: Can a construct like ESG harness the power of markets and corporations to help solve the many disparate goals and problems it targets? Companies clearly feel like their brands have been put under a spotlight by the ESG ratings now published regularly by Wall Street ratings firms and amplified by media, activist investors, NGOs, and watchdog groups. They also fear new fines being levied by regulators at all levels. Some may even think Net Zero is actually the right goal to pursue, even if it shaves a basis point or two off of shareholder value.
But the debate will also serve to highlight the basic problem ESG is facing as it defends its integrity against partisan attacks, a problem laid out on these pages last spring: Is ESG its own worst enemy? There is no one definition of what ESG comprises, nor is there enough data over enough time to substantiate its claims of economic or social benefit. The attacks directed at ESG in 2023 will continue into 2024 and, very likely, form part of the Republican Party’s assault on the Biden administration and progressives generally. The “woke” label may be a stretch when applied to an investment strategy, but it does resonate amid the Left’s own culture-war puritanism. ESG is probably too big and too successful to date to die in its infancy. But just like an unformed, awkward teenager, it has entered the riskiest years of its short life.
*Comedian and political commentator Bill Maher had his own response to DeSantis. “Isn’t Florida where everyone goes to die?”