In recent years, a movement for improved environmental, social and governance (ESG) action in the private sector has emerged as a major public policy issue. Because this ESG movement touches on almost every policy area in which R Street works, I thought I should write to tell you how we think about it here at R Street, as it’s likely to be playing a larger role in our work. I should note up front that Devin Hartman—our director of energy and environmental policy—helped me a great deal with this letter and will be leading much of this work.

We understand a part of the movement to be political in nature and other parts to be a reflection of civil society influencing business behavior absent political motivations. We consider some efforts made under its banner to be deeply problematic; others could offer a path toward a better, freer market. In short, we’re neither unabashed cheerleaders for ESG nor ardent opponents. As in other areas of focus at R Street, we favor free markets and limited, effective government.

Government Divestment and Investment Are Political

While the ESG movement draws together many strands of thinking, including the findings of academic corporate management research and the movement for socially responsible investing (which began in the 1960s), much of its recent motivation stems from political goals related to issues like race, the environment and the structure of the economy. At least, in theory, the movement asks companies to consider the positive and negative externalities their businesses create and maximize the former while minimizing the latter.

The term ESG comes from an October 2005 report from the United Nations Environmental Program, and most groups promoting the movement are associated with the political left. The movement faces a credibility problem across the political spectrum, however, with the right questioning its motives and the left questioning its impact and ambition. The left-right divide has been most clear in the debate over state pension fund investments in fossil fuels, firearms and tobacco and other industries that concern the groups on the left.

Recently, many on the political left have been critical of a 2021 Texas law that attempts to forbid the state from investing pension funds with firms that divest from fossil fuel. Similarly, many on the political right are critical of efforts in the State of California to require the divestment from the same fossil fuel companies Texas wishes to help.

This isn’t a new type of controversy or one particularly related to ESG. Government’s own purchasing and investing power has long served political interests ranging from the purely parochial (like mandatory set-asides for in-state firms) to those of international import (such divestment from Russia following that country’s invasion of Ukraine). These concerns are not really economic at all; they are more a matter of interest-group politics and tradeoffs. And, certainly, there may be cases—like divestment from Russia or other countries that violate human rights—in which taking a political stand is warranted even if it has a negative economic impact.

Politics aside, however, both forced divestment and anti-ESG laws are almost never good fiscal policy. Although the debate continues, the academic literature suggests that divestment rarely if ever achieves its goals of changing corporate behavior, and anti-ESG laws probably won’t do any better. The Texas law, for example, may actually serve to hurt the very fossil fuel interests legislators thought they were helping. In particular, it penalizes firms without an ESG focus and blacklists ESG-oriented firms that remain invested in fossil fuels but aim to trim environmental risk exposure, which is consistent with fiduciary obligations.

Even worse, the ESG laws are going to be expensive. Because so many firms have enacted policies that Texas opposes, it limits the state’s ability to raise money from investors. In fact, anti-ESG laws can materially increase the cost of capital for states who enact them by hundreds of millions of dollars.

That’s why we ought to be advancing policies that enable governments and corporations to focus solely on fiduciary responsibilities. Conservatives and libertarians would do better to ensure the alignment of fiduciaries and pensioners, such as making sure environmental considerations reflect risk rather than the values of the fiduciary, without undermining a business’s ability to manage that risk. Not every anti-ESG law is automatically bad. But those that pass should be narrowly tailored to ensure that they do not hurt public finances. Mandatory divestment policies deserve even more scrutiny because there is a strong case that forced divestment from any sizable industry will reduce risk-adjusted returns in the long run by narrowing the range of assets available to managers.

As a policy organization, we will evaluate the merits of proposals financially and avoid the political fray. Some movements to require investment or divestment can be understood in wholly political terms and will have little effect on finances. When that’s the case, we probably won’t have anything to say. But many policy directions, even if intended to make a political statement alone, result from a misunderstanding of ESG causes and effects and can do material damage to public finances and the business environment.

Leaving the Private Sector Alone

While government action to manage its own funds is an inevitable part of politics, we view efforts to mandate the private sector doing or not doing certain things in response to an ESG agenda as problematic.

This is a place where we’re already engaged. Most recently, we raised significant concerns about climate-related disclosures the Securities and Exchange Commission (SEC) is hoping to impose on the private sector. While there certainly are real and future material risks related to climate change that publicly traded companies should need to disclose, the SEC’s original direction seemed vague and problematic. For similar reasons, we opposed efforts by state insurance departments and other agencies to forbid investment in specific industries.

Above all, we believe that governments should give broad—but not unlimited—discretion to companies and managers in interpreting their fiduciary responsibilities and developing their business plans. In any complex economy, company managers will have widely varying interpretations and strategies with regard to nearly all of the topics that the ESG movement seeks to confront. It’s perfectly reasonable for companies to have different strategies for addressing climate change or recruiting a good workforce. As such, enterprises should also be able to act in accordance with stated values, intelligence and assumptions about the market. Efforts to ban companies from opening up locations on the basis of their owners’ private religious views are deeply problematic, as are efforts to punish businesses for opposing a political agenda. In these cases, government officials are substituting their own preferences for those of the people who run the companies. Indeed, allowing political leaders to determine what’s in “shareholder interest”—outside of egregious cases—is almost always a mistake.

That said, there are cases where the government should regulate private corporate conduct. For example, if a company carried out a “greenwashing” campaign that made false claims about the environmental benefits of its products, it should be open to prosecution and civil action under fraud and tort laws. A company that discriminates against people of a certain race in hiring, likewise, should face sanctions under civil rights laws. Everything we know suggests that existing laws that forbid fraud, protect civil rights and require fiduciaries to carry out their responsibility are mostly adequate to regulate corporate conduct in this sphere. If there is a need for new laws to address specific actions taken in the name of ESG (or against it) that violate a clear thrust of public policy, we believe they should be written narrowly to address the specific, undesirable act.

Where We See Hope

All this said, companies should be able to implement voluntary ESG policies; done correctly, such policies could advance economic freedom, particularly in the environmental context. The stated purpose of ESG—encouraging companies to recognize and address the social externalities that result from their operations—is a worthy one. Right now, we rely on governments to handle many economic externalities, and this creates the free-market case for enabling certain voluntary ESG efforts.

Fundamentally, countries need environmental laws because businesses can profit by carrying out activities with resources they own (e.g., a factory) that damages things they do not (e.g., the air people breathe.) As economics Nobel Laureate Ronald Coase has written, there are ways we could theoretically accomplish these ends without governments. In fact, as he observed, in a world with established property rights, clear measures of the externalities and no transaction costs, purely private negotiators could arrive at economically optimal outcomes. This situation, however, does not exist outside of very localized environmental problems, which is why we need governments to enforce environmental laws on a national scale. But Coase’s insight does indicate that if policies can cut transaction costs, encourage private negotiations and establish property rights, society will achieve better outcomes than what could be achieved with top-down regulations. This has inspired increased reliance on markets to solve any number of problems ranging from acid rain to childhood education.

Changes in technology and social preferences make Coasian thinking more relevant than ever. For example, environmental considerations increasingly alter the cost of capital, signifying that markets are internalizing externalities that we once thought only governments could resolve. The policy implications pivot the role of government from coercive efforts to force markets to internalize externalities to that of enabling voluntary transactions. As free marketeers, that’s what we see as being good.

As such, reforms to overcome barriers to entry and reduce transaction costs and information deficiencies for environmental performance create an opportunity to make capitalism (already the best system for environmental quality) a force for even greater environmental good. In fact, fixing government failure is now more important to the clean energy transition than policies addressing environmental externalities. For example, Senior Fellow Philip Rossetti explained in Congressional testimony how regulatory reforms hold more emissions potential than the Inflation Reduction Act, which mostly subsidizes what the private sector wants to build but often cannot. In these cases, certain ESG measures—voluntary ones—can be good for those who favor limited government.

We’re skeptical of many things done under the banner of ESG and believe that elected officials should acknowledge the political nature of significant parts of the current debate while being careful about any new laws or regulations mandating or forbidding ESG activities. The former are never a good idea, and the latter should be written very narrowly, largely to ensure that fiduciaries are doing their job. While the wrong ESG-related policies can do tremendous harm, we also believe that truly voluntary, private action spurred by parts of the ESG movement can help solve social problems, encourage creativity and shrink the state’s role in the economy.

Image credit: Deemerwha studio

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