The murky precepts of Environmental, Social, Governance (ESG) criteria wield growing influence in investing and in regulation. Those who want to understand the reshaping of our financial landscape, especially as a means to resist it, should be familiar with ESG’s terms, goals, vocabulary, and advocates. Below, I sketch out several dimensions.
ESG advocates want to reshape the world in profound ways — from how we travel and heat our homes to what businesses must prioritize and whom global supply chains should benefit. They want to move the world to a “low-carbon” economy built on renewable energy. They also favor dramatic redistribution of wealth and power from the “haves” to the “have nots.” Increasingly, they make business their ally (willingly or unwillingly) in carrying out their plans.
To address these concerns with nuance and thoughtfulness, rather than simply reacting, we must raise awareness of ESG criteria, how they are being used, and what kinds of problems they will create. ESG will likely be around for a long time, so it’s worth taking some time to understand it thoroughly.
Here are some areas we’ll explore:
ESG advocates regularly use jargon like greenwashing, license to operate, net zero, diversity, equity, inclusion, and sustainability. Some of these terms have simple, clear meanings like reducing or offsetting greenhouse gas emissions. Others are quite ambiguous: How should a company advance “equity” or “inclusion”? Some terms have legislative connotations specific to the movement’s goals, like “carbon allowance” or “Scope 2 Emissions.”
But one thing you can be sure of: These terms affect bond issuance, investment strategies, corporate governance, and regulation. Whether you understand the language or not, it is being deployed actively to change business and government priorities.
There are several good overviews of the historical origins and evolution of ESG. The ideas were not created from whole-cloth over the past decade. Many of the ideas can be found in the movements of Corporate Social Responsibility, Impact Investing, Responsible Investing, and Sustainability. Initially, the idea was that businesses could and should consider their impact on the environment and the community as part of their profit-seeking strategy. Eventually this gave way to the demands of particular groups who had their own priorities for what kinds of “social responsibilities” businesses had.
The United Nations got involved in 2005 when the idea of a new ESG framework for corporations found central importance in its Principles for Responsible Investing initiative. Since then, a constellation of UN-related organizations have run with the idea and popularized ESG tenets in nonprofits, universities, trade associations, investment groups, and regulatory bodies. The global financial crisis of 2008 created discontent that made people more interested in “new” approaches to capitalism. The World Economic Forum has been one of the main formulators of this “better capitalism,” exploiting the COVID pandemic of 2020 to advance the “Great Reset.”
ESG advocates expect corporations to comply with ESG criteria according to the advocates’ specific goals. Many goals revolve around climate change predictions, though some involve social metrics. 2030 is a key year that ESG advocates want corporations and governments to focus on, because they claim that is the “point of no return” on global warming. It’s a convenient length of time for their agenda: far enough away that it won’t be immediately discredited if climate models turn out to be wrong, but close enough (as opposed to 2050 or 2100) to create a high sense of urgency and require rapid change.
On the social and governance fronts, ESG advocates want racial, ethnic, and gender diversity (not political, religious, or philosophical diversity) in the workplace and in the boardroom. More than that, they want companies to “give back” to various stakeholder groups in the community. Good governance, in their view, even extends to publicly speaking in favor of a variety of (progressive) policies and contributing to advocacy for the right issues — or at least not taking the “wrong” side of issues.
A dizzying array of organizations advocate judging investments and organizations by environmental, social, and governance criteria. From Non-Government Organizations (NGOs) to carbon offset specialists to emissions-tracking software firms, ESG advocacy is better thought of as a movement of special interests than a conspiracy, but a few key international elites drive the movement and, more importantly, define many of the terms and standards.
So many organizations advocate ESG that we ought to start by considering entire categories. At the “top,” a category of organizations set the goals and priorities of ESG. Then, a category of organizations “operationalizes” these broad goals into specific timelines, standards, and guidelines. Another layer of organizations will then educate and advise firms on how to meet (or game) ESG goals, targets, and standards. If that weren’t enough, we have additional categories of organizations that provide assessment, market compliance services, sell carbon offsets, and lobby public officials. The network of interests squeezes out dissent and standardizes the ESG narrative which businesses and investors must navigate.
ESG advocates want to turn capitalists into environmentalists. ESG has gained a surprisingly strong foothold in business schools, among investors, and in the world of finance broadly. Advocates have accomplished this infiltration in part through a serious bait and switch. ESG advocates initially claim companies should use ESG criteria to mitigate risk and improve profitability, but later seek to use those criteria to control corporate investment and operations.
Another means they use to influence investment is “sustainable finance.” Funding specific activities to advance climate or social goals has become a large and growing part of the bond market, reaching down to the local, municipal level. More than $2 trillion dollars of sustainability bonds have been issued. ESG investment funds, sustainability bonds, green bonds, blue bonds, social bonds, and a variety of others nudge borrowers to include ill-defined ESG goals in their plans.
ESG has also made advances in the legislative and regulatory arenas. Europe has gone much further down the primrose path than the US has, but federal regulators like the Securities and Exchange Commission (SEC), the Federal Reserve, and states like California seem eager to catch up.
The SEC will likely impose extensive greenhouse gas emissions reporting by the end of this year. California already passed extensive disclosure requirements as well as bans on the sale of new combustion engine trucks and passenger vehicles. California and Europe have had cap and trade programs in place for years. Europe recently enacted a variety of extensive ESG disclosure requirements and emissions-reduction standards.
The legal status of “fiduciary responsibility” is at stake — meaning that companies may no longer have a legal obligation to do their best to generate shareholder returns. Europe has already moved towards a “stakeholder” model of capitalism by requiring companies to focus on non-monetary issues. The German Due Diligence in Supply Chains Act requires companies with more than 3000 employees (and later more than 1000 employees) to evaluate the living standards and conditions of workers across their supply chains to make sure no human rights are being violated and that their suppliers are pursuing appropriate climate goals.
ESG’s attempt to remake financial markets and capitalism itself has already created all kinds of problems and unintended consequences. Pursuing various environmental goals such as using more renewable energy or generating smaller carbon footprints drives higher costs for just about everything – electricity, cars, houses, food,and other goods because producers have to use more expensive inputs and processes, face increased compliance costs, rely on less-efficient power generation, and so forth. These high costs are a significant problem.
But there are others.
ESG rules will make markets less competitive and more concentrated, because smaller firms will have more difficulty complying and staying in business. More time, money, and energy will be spent lobbying public officials for favorable rules and treatment, rather than improving products or customer experiences. Extensive top-down requirements can create systemic risk by encouraging companies to embark on new, untested behaviors en masse — such as putting everything on the electric grid (heating, cooling, transportation, and so on).
But what many find most troubling is how much social control will be exerted by undemocratic and anti-market forces with little accountability.
As you can see, there is a great deal to unpack. Stay tuned for future columns exploring these various parts of the ESG landscape.