by Samuel Gregg
“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.
One of ESG’s many difficulties, however, is that its goals and methods are characterized by an incoherence sufficient to call into question not just specific features of ESG but the conceptual integrity of the entire ESG endeavor. Another ESG problem is its tendency to blur ethics and sound business practices with the promotion of particular political causes. This mindset has spilled over into the outlook of financial regulators, and consequently threatens to facilitate widespread dysfunctionality in these agencies’ operations. Lastly, the adoption of ESG risks corroding understanding of the nature and proper ends of commercial enterprises—a development that has broader and negative implications for society as a whole.
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.
These ongoing shifts in emphases have generated substantial disparities and disagreement within and between ESG ratings providers about, among other things, what counts as ESG and what doesn’t; how to measure ESG compliance; and how much weight should be assigned to a particular ESG goal (e.g., protect the environment) vis-à-vis other ESG objectives (e.g., promote diversity). In a May 2022 Review of Finance article surveying these methodological and measurement issues, Florian Berg, Julian F. Kölbel, and Roberto Rigobon found that ESG scores across six of the most prominent ESG ratings providers correlated on average only by 54 percent. You don’t need a degree in statistics to recognize that such a low number indicates significant disagreements about which measures and goals really matter. In an earlier 2021 article, Berg, Kornelia Fabisik, and Zacharias Sautner presented evidence of unexplained and undocumented retrospective alterations to the data on which ESG scores were based. Data alterations are not unusual. Not explaining the reasons for the alteration, however, is.
Some major ESG supporters have conceded that this lack of agreement and consistency concerning ESG’s content and measurement methods raises questions about ESG’s credibility. This is not simply because it creates difficulties for assessing ESG compliance across industries and economies. If the content of ESG is 1) unstable or effectively amounts to whatever you want it to be or whatever happens to be the cause célèbre at a given moment, and 2) there’s no universally agreed-upon measure of success, then whatever claim ESG has to coherence and universal applicability starts to look very thin indeed.
This has real consequences for some important topics that investors tend to care about—such as executive compensation. If ESG is to become part of the way that a firm assesses board, CEO, and senior management performance, then coherent and agreed-upon ESG criteria are necessary. Yet in their analysis of ESG-related executive compensation, Bebchuk and Tallarita found that ESG-based compensation disclosures generally offer “vague and underspecified goals, such as increasing sustainability, diversity, inclusion, or employee well-being, without any specific targets or additional information.”
Such imprecision suggests that ESG is unhelpful as a tool for assessing management compensation. Worse, it could potentially be used to diminish executive accountability for profit-performance. It is not a stretch to imagine how executives could appeal to their higher ESG responsibilities to justify lower returns to investors. Nor is it hard to see companies using these broad ESG commitments to curry favor with political leaders who prioritize specific causes. This would only exacerbate the already widespread problem of cronyism and help shift executive incentives further away from creating economic value and towards rent-seeking.
Internal Incoherence and Politicization
Even when a particular issue receives strong affirmation throughout the ESG world, other problems soon become apparent. Consider, for instance, ESG’s present focus on diversity, equity, and inclusiveness in things like the makeup of company boards and management. In ESG literature, diversity, equity, and inclusiveness are treated as self-evident, virtually unquestionable values. A moment’s reflection, however, soon illustrates the perils of this outlook.
Inclusion, for instance, suggests that there is something inherently problematic with exclusion. Certainly, there are unjust forms of exclusion. It is wrong to exclude someone from being considered for employment simply because she is, say, of Asian ethnicity. Yet it is not wrong to exclude an Asian woman from a board position if she lacks the formal qualifications or requisite experience; or has a track record of bad business judgments; or has been exposed in the past as dishonest.
In other words, there are just grounds on which we rightly exclude people, whatever their sex or skin color, from being given particular responsibilities. Prioritizing inclusivity is thus not as unquestionable as ESG marketing pitches often suggest. Treating it as such is likely to lead to seriously mistaken personnel decisions. At present, it is hard to find ESG schemes that acknowledge such common-sense limits to their conception of inclusion.
Or take ESG’s stress on diversity. ESG materials do not present diversity as a species of pluralism, understood as individuals, associations, and communities in a given society living out their freedoms in different ways while being bound together by some common commitments and obligations. Nor is it about promoting individuality. Instead, diversity reflects the idea that, as Peter Wood relates in Diversity: The Invention of a Concept, everyone is defined by membership in social groups and is largely the product of such groups’ collective experiences. That draws attention away from two things: first, our common human nature and the essential equality of all humans qua humans derived from that; and second, the idea that all of us are as much individuals as we are social beings and thus shouldn’t be boxed into particular unchanging and unchangeable categories, whether by custom or law.
These problems surrounding ESG’s present focus on inclusion and diversity point to another difficulty. This is the hard-to-deny fact that many ESG concerns have taken on a political slant—one that aligns closely with what would be conventionally called progressive priorities—and are being used by governments and regulators to advance such goals in questionable ways. In 2021, the Biden Administration announced its intention of imposing new ESG disclosure requirements on publicly traded companies. Upon examining the requirements in question, the legal scholar Todd Zywicki found that “the disclosures advance left‐wing causes such as environmentalism and race, sex, and sexuality ‘diversity’ initiatives, not issues such as the rule of law, economic development, or affordable energy policy.”
ESG is also being used to shape how regulators expect corporations to address the political pressures to which they are inevitably subject. In his book The Dictatorship of Woke Capital, Stephen Soukup observes that under Securities and Exchanges Commission (SEC) rules, publicly-traded companies are allowed to exclude certain shareholder proposals if they receive permission to do so from the SEC. In 2019, Soukup writes, Apple asked the SEC to prohibit shareholders from voting on two propositions. One involved the promotion of intellectual diversity. The second focused on enhancing racial diversity. The SEC agreed that the intellectual diversity proposal would not appear on the shareholder ballot but allowed the racial diversity proposition to go ahead.
In short, racial differences were deemed more important by SEC officials than disparities in ideas. That is entirely consistent with ESG’s progressive slant—not to mention the SEC’s stated commitment to promoting diversity and inclusion within its own ranks, which, judging from the SEC Employee Affinity groups listed in the SEC’s Diversity and Inclusion Strategic plan, is overwhelming about ethnicity and sex rather than, say, religious or political affiliation.
The broader danger is that ESG will become a vehicle by which regulatory agencies like the SEC engage in mission creep. As the legal scholars Paul G. Mahoney and Julia D. Mahoney note, the promotion of ESG risks diverting the SEC from its official mandate: “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” Note that phrases like “protect the environment” or “promote diversity on Wall St firms’ boards” do not appear here. But this hasn’t prevented the SEC from looking at implementing new rules to require more extensive disclosure, for instance, of risks associated with climate change.
Regardless of whether the pressures to adopt such disclosures are coming from D.C. politicians, activists pushing particular causes, or within the SEC, any adoption of ESG disclosures by the SEC, Mahoney and Mahoney point out, cannot help but take an agency designed to be “a technocratic, expert body insulated from day-to-day political pressures” into the realm of deciding policy. In a constitutional republic like America, they note, such matters are properly decided through the legislative process—not by government employees.
In this sense, the SEC’s embrace of ESG fits into a broader pattern of regulatory agencies expanding their brief without direct authorization to do so. This cannot help but undermine the credibility that America’s primary financial regulator needs if it is to fulfill its actual designated mandate in an age of deep distrust of institutions. Moreover, by moving further away from maintaining a framework of rules and using ESG to try and shape company board membership on politically-contentious grounds, the SEC risks facilitating problems like the appointment of professionally-unqualified or inexperienced individuals to such positions. And that is in no one’s interest.
Getting Business Back to Business
Taken as a whole, the problems detailed above should be enough to cause policymakers, regulators, businesses, and investors to pause before advancing the ESG agenda any further. Unfortunately, as Andrew Stuttaford observes, the reaction of many ESG advocates to criticism of ESG and its associated agenda is to try and shut down any discussion by conveying “the impression that ESG is not really a proper subject for legitimate political debate.” There have also been instances of people inside large corporations who directly or by implication questioned ESG being forced out, as happened to HSBC Asset Management’s global head of responsible investing in the first half of 2022.
Looking beyond the immediate, however, I fear that doubts about the wisdom of embracing ESG will not grow or be allowed to be given expression within major businesses until a deeper and older problem is addressed.
In many respects, ESG reflects a long-standing desire to alter what an Aristotelian might call the “telos” of business. When then-presidential candidate Joseph P. Biden stated in July 2020 that “It’s way past time we put an end to the era of shareholder capitalism,” he was reflecting a long-standing lack of ease (something by no means confined to progressives) with the idea that the primary goal of business is the pursuit of profit and maximizing shareholder value. To the extent that ESG seeks to change this core feature of commercial enterprises, it risks seriously distracting private businesses from making their distinct contribution to society’s general well-being. From this standpoint, the negative externalities potentially generated by ESG stretch beyond business itself.
Understanding this point requires recognizing that all forms of associations have a specific telos which defines their raison d’être. The military’s defining goal, for example, is to protect a nation’s national security primarily through military means. The military is not responsible, however, for raising and educating children. That is the job of families. Nor is raising and educating children a prime duty of a hospital. Hospitals exist to protect and promote the good of health.
As organizations pursue their core functions, there are important side effects, many of which are positive in themselves. When a business teaches its employees the importance of teamwork or how to take prudent risks to achieve particular goals, it is shaping its employees’ character in beneficial ways. But a business seeks to inculcate such habits because they improve the company’s ability to fulfill its specific goals. It is not promoting character development for its own sake.
Such clarity about any human association’s core purposes matters because it helps prevent organizations from drifting into areas that distract them from realizing their primary objectives—or, worse, impede them from doing so. This brings us to a central problem with ESG. The primary responsibility of the business enterprise is not to save the planet or promote diversity (let alone fight wars, raise children, or maintain law and order). The central telos of business—especially so in the case of publicly-traded companies—is to generate a profit for its owners. This is the principle around which a commercial enterprise structures its organizational framework and operations. It is self-evidently true that when a business departs from this principle, it can no longer be called a commercial enterprise.
A business’s embrace of its commercial telos is not a warrant for it to imagine that the ends justify the means. Making money does not amount to a license for companies to engage in wanton destruction of the natural world, lie to their customers, engage in theft, or force their employees to work in dangerous conditions. Such things are wrong in themselves and rightly prohibited by law. That same commercial telos, however, does mean that business is under no obligation to engage in environmental activism or advance progressive—or, for that matter, conservative—political causes. ESG, however, encourages businesses to think that they are. Government interventions to impose ESG requirements upon companies would only reinforce such misconceptions.
More generally, the adoption of ESG corrodes the understanding that it is through pursuing their specific telos that businesses contribute to the well-being of the whole. Just as the military promotes the well-being of everyone in a political community by fulfilling its specific mission of promoting national security, so too do commercial enterprises contribute to the general welfare through their pursuit of profit.
To realize profit, for example, a business must employ a variety of people with different skills. It cannot do so without paying salaries or wages to employees. This income provides employees with economic resources and therefore opportunities to purchase life’s necessities, buy assets, save for their future, perhaps privately educate their children, etc. In short, by pursuing profit, businesses indirectly create possibilities for other people to pursue their own goals. The same pursuit of profit indirectly allows businesses to increase the sum total of wealth in a given community. Such economic growth is essential if goods like health care, education, and employment are to become more available in any given society for more people over time.
ESG, however, clouds our ability to recognize these realities. Indeed, the more ESG encourages businesses to give equal or even greater priority to the realization of other ends other than profit, or to confuse management of externalities with advancing specific political agendas, the more it weakens understanding of the proper telos of business among company boards, CEOs, employees, policymakers, and citizens. 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.
Goodbye to ESG?
In a market economy bounded by rule of law, constitutionally limited government, property rights, and respect for principles of natural justice, people should be as free to invest as they wish. That includes the liberty to invest in self-described ESG funds or companies that claim to be ESG compliant. Businesses are also free to create as many ESG investment vehicles as they want. What ESG proponents, however, can’t do is indicate that those who don’t embrace their approach to commerce are somehow less ethical or less worried about externalities than ESG enthusiasts. If anything, ESG advocates should be far more candid about ESG’s shortcomings.
Whether ESG goes the way of other once-fashionable and now-defunct business theories associated with long-forgotten acronyms remains to be seen. A recent McKinsey article about ESG argued that, despite recent criticisms of ESG (some of which they regarded as fair), businesses’ adherence to ESG “is likely to become essential to maintaining their social license.” I don’t know how else to interpret this than as a claim that businesses need to appease legislators and activist groups vis ESG if they want to stay in business, regardless of how deficient ESG might be.
Indeed, the fact that a business concept is incoherent, struggles to demonstrate its effectiveness, or serves to rationalize poor performance by senior executives is no guarantee that it will disappear. That is especially true if there are groups with a vested interest—Chief Diversity Officers, ideologically-driven human resources managers, management consultants adept at playing on business leaders’ insecurities, CEOs anxious to marginalize investors who question management performance, etc.— in maintaining such ideas in place.
In the end, it will not be yet another theory of the firm that will cause businesses that have embraced ESG to rethink their position. For one thing, even the most die-hard politically progressive investor will have limited patience for business losses or fees that they deem excessive. Eventually, no amount of CEO appeals to what they claim are their wider obligations to society is likely to pacify angry shareholders. At some point, market signals are likely to crowd out virtue-signaling. There are even investment funds emerging that intentionally avoid any association with ESG or similar agendas, and instead explicitly prioritize shareholder value.
Something else, however, is more fundamental. And that is the emergence of a measured self-confidence among business leaders in the essential rightness of focusing their organizations on the pursuit of profit. Unless commercial enterprises embrace that foundational principle and its underlying logic without embarrassment or undue qualification, they will struggle to resist those who want to replace this telos with a different inspiration and rationale. At stake is much more than the basic legitimacy of commerce. Also threatened are the very real economic and non-economic benefits that business delivers to society when commercial enterprises concentrate primarily on doing what they are designed to do: i.e., business.