Toward Clarity and Consensus on “E”SG

R Street President Eli Lehrer recently wrote about our overarching view of environmental, social and governance (ESG) initiatives. This piece delves deeper into the “E” of ESG, which lies at the heart of today’s political controversy. To skip to the punchline, government-forced “E”SG is often deeply problematic. The rise of mainstream corporate sustainability in the last decade resulted primarily from non-governmental actors. This decade, regulation plays a bigger role. Altogether, confusion and political culture battles are resulting in policies that undercut freedom and threaten economic and environmental performance.

Whether “E”SG is friend or foe to economic freedom depends on the application. ESG can be top-down or bottom-up; it can reflect voluntary market forces or government fiat. While compulsory ESG threatens economic freedom, voluntary efforts may reflect a libertarian turn in society.

Given the media’s preference for personal narratives, it may seem that “E”SG is driven by the side agendas of a few business and political elites. While there is no doubt that public and corporate leaders play a role, the broad catalysts for ESG are societal preferences that translate into political and market forces. In other words, corporate sustainability is best explained as a strategic response to the evolving preferences of firms’ suppliers, investors, lenders, customers, employees, reputational influencers and governments.

Market forces fueled the most prominent “E”SG management practice last decade: a boom in corporate clean energy procurement. The C-suites of heavy industry, often considered “ESG laggards,” were directing their energy teams to procure more carbon-free energy than what they would normally recommend for compliance, cost and conventional risk management purposes. This did not stem from a benevolent awakening of heavy industry, but a response to changes in their business milieu. It provided a snapshot of a massive global trend, in which corporate clean energy purchasing volumes rose 658 percent from 2016 to 2021. This embodied the normalization of ESG management practices; by the end of 2020, 81 percent of companies had formal ESG programs.

Meanwhile, ESG investment went from niche to mainstream over the last decade. Domestic ESG investment surged 96 percent between 2016 and 2020, cresting $17 trillion in total. In 2019, ESG hit a tipping point, highlighted by a spike in corporate sustainability with an emphasis on climate commitments. Crucially, this occurred during the Trump administration, providing a natural experiment that leaves little doubt that ESG investing can boom in the absence of federal government coercion.

As ESG popularity rose, the pace of policy response was not far behind. The Obama, Trump and Biden administrations whipsawed federal ESG policy, such as ESG fiduciary guidance at the Department of Labor. Blue states pursued mandatory ESG practices, with Maine codifying fossil fuel divestment. Red states advanced anti-ESG legislation to blacklist financial firms and funds they felt were boycotting fossil fuels. The ultra-partisan ESG divide has quickly yielded unstable federal regulation and two Americas at the state level, leaving businesses in the middle of the fray. Only through sober dissection of ESG concepts, not hyperbolic pro- or anti-ESG campaigns, will the policy community better understand ESG and identify productive policies.

Understanding ESG

Developing a policy position on ESG is difficult because it lacks a clear, consistent definition. Generally, ESG is an umbrella term referring to the incorporation of environmental and social factors in management and investment decisions. ESG has various objectives, but there are two prominent categories:

1. enhancing risk-adjusted returns
2. achieving environmental or social impact alongside financial returns

The first category is straightforward. Virtue signaling aside, some corporate environmental practices enhance company value and risk-adjusted returns. Several notable “E”SG links to improved corporate financial performance include:

• Revenue growth. Consumer preference studies reveal significant and increasing willingness to pay for environmentally superior goods and services, such as clean electricity, materials, packaging and recyclability. Environmental advantage can generate customer acquisition and market expansion; consumer products with environmental claims grew 28 percent over the past five years compared to 20 percent for those without. Shifts in market sentiment have reshaped the business landscape to reward environmental credibility by creating value for customers and investors. This helps explain why the number of global retailers adopting science-based carbon emission targets went from five in 2018 to 66 in 2021.
• Cost and financial risk reduction. Some physical environmental effects like climate change present growing material risks to firms like property and casualty insurers, who are leading proponents of unleashing private climate risk finance. Business strategists find that some corporate environmental practices bolster risk resilience and returns to shareholders. Corporate environmental initiatives yield operational savings up to 60 percent and reduce water, energy and materials consumption.
• Regulatory, legal and reputational risk reduction. Environmental reputation risk has grown— rating agencies now factor it into default risk—as civil society pivots to pressure the business community over its environmental impact. Reputation increasingly affects the fate of business opportunities like new facilities in extractive and emitting industries. Superior environmental practices also reduce regulatory compliance, litigation and future environmental policy or “transition” risk.
• Enhanced labor productivity. Firms’ environmental reputations increasingly affect human capital attraction and retention. One survey found almost half of workers would accept a lower salary to work for an environmentally responsible employer, with most millennials willing to do so. Conversely, companies with environmental stigmas are prone to lose talent and face restricted talent pools.
• Optimized capital and investment. Allocations to environmental investing have massively increased, and with investments projected to reach $34 trillion by 2026. A firm’s environmental profile increasingly affects its cost of debt and equity capital. Mere access to conventional capital is a problem for the most environmentally degrading industries, such as coal.

Values-based ESG

Things get trickier with non-pecuniary objectives like impact ESG. The notion of values-based or purpose-driven investing precedes ESG nomenclature and has been used to advance progressive and conservative causes ranging from ending Apartheid to biblically responsible investing. A contemporary example is firms voluntarily curtailing operations in Russia after the invasion of Ukraine. Jennifer Schulp of the Cato Institute noted the imperative of understanding the difference between value-based ESG, which integrates financially material factors into evaluating a company’s economic prospects, and values-based ESG, which aims to alter corporate behavior and is comfortable sacrificing financial performance. For clarity, let’s distinguish these as pecuniary and values ESG.

To demonstrate the diversity of values-based practices, environmental funds employ a range of approaches. These include thematic investing, broad investing (portfolio weighted by environmental scores), active ownership and, yes, exclusionary screening. In other words, not all environmental funds are fossil-free.

Values-based ESG is bound to be controversial and difficult to execute because it broadens investment objectives and, perhaps, fiduciary duties. When investors have choice, their welfare may be maximized by investments that do not maximize risk-adjusted returns, if the financial cost is outweighed by the intrinsic value the investor places on environmental improvement. Rationales for this are similar to the economics of charitable giving, where motives include imperfect altruism, prestige and the “warm glow” of internal satisfaction.

Such preferences have become far more prevalent over the past decade, especially among Generation X and younger. A 2022 survey found that wealthier young investors are, on average, willing to lose 14 percent of their retirement savings for companies to reduce carbon emissions to net zero by 2050. Financial firms are taking note. Deutsche Bank recently discovered that 42 percent of its clients would pick a company with a AAA ESG rating in lieu of a CCC-rated company even if it dropped their expected returns from 8 percent to 4 percent.

This may come as a culture shock across generations. Generally, young investors want fund managers to advocate for environmental causes, whereas older ones typically want them focused solely on financial returns. Attitudes are highly diverse, which creates challenges to aligning investment strategies with individual preferences. This can create several problematic forms of principal (investor) and agent (fund manager) misalignment, as in the following scenarios:

• Fund managers pursue their own preferences rather than their clients, especially if it sacrifices returns without their clients’ consent.
• Fund managers inaccurately portray expected risk-adjusted returns of different investment options to clients.
• Fund managers employ investment strategies and shareholder proxy voting that reflect the average preferences of their client base, rather than accounting for the large variances within it.

Complicating this further is the fact that attributing environmental impact to a given ESG process or product is difficult to measure and verify. ESG metrics are a notorious mess. Ratings agencies use widely divergent techniques that lack concrete indicators and introduce market uncertainty; they often cannot agree on whether a company is “green.” Nevertheless, some investors integrate flawed ESG scores into investment strategies. This has fueled corporate sustainability’s credibility problem. Dismissive views of “E”SG’s environmental benefit have become commonplace. Despite the noise, it is important to note that the problem is information deficiency, and that market preferences for environmental improvement are robust and growing.

Understanding ESG in this manner underscores several public policy priorities:

• Advance individual choice, such as letting investment beneficiaries have options and allowing consumers to have a choice of suppliers to exercise their preferences.
• Ensure principal-agent alignment, such as strengthening fiduciary standards and opposing mandatory values-based investing. Any new ESG policies must not jeopardize critical investor protections.
• Reduce information deficiencies and transactions costs, such as providing granular emissions information, granting regulatory permission for environmentally differentiated products, deterring deliberate “greenwashing” behavior and pressing improvements in “E”SG taxonomy that drive more reliable and useful ratings.
• Expand voluntary environmental programs and down-size coercive policy, such as conventional regulation, to the extent that markets internalize environmental externalities.
• Reduce government failures, such as arcane regulation inhibiting investment and energy projects that are the antithesis of environmental finance: “speed to market.”

Policy Developments

We usually think of public policy affecting the environment as being conducted by environmental institutions, such as the Environmental Protection Agency (EPA). But the mechanisms behind “E”SG are typically financial in nature. Unsurprisingly, environmental issue activity has increased at the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission and Federal Trade Commission (FTC). There is an unavoidable role for such institutions, as environmental factors play an increasing role in material investment decisions ranging from risk management to the accuracy of companies’ environmental claims. For example, the FTC is updating its “Green Guides” to address the validity of environmental marketing claims.

The most profound development is an SEC proposed rule on climate change disclosure requirements. We support a role for the SEC to clarify guidance, furnish investors with better information on climate risk and provide appropriate standardization of definitions for firms claiming to mitigate such risk. However, we are concerned with aspects that would create excessive compliance costs, interfere with markets, obfuscate material information to investors, exacerbate corporate liabilities and undermine private-sector led emissions mitigation efforts. It is important for firms to account for policy “transition” risk, but the SEC must avoid imposing its view of future policy and displacing that of the private sector.

Financial regulators need to stay in their lane to address legitimate information problems, lower transaction costs, clarify the rules of the road and reduce corporate liabilities while remedying deceptive practices. Congress will no doubt be active in an oversight capacity, but there is virtually no prospect for ESG legislation. However, legislation is blazing at the state level.

The bulk of state policy activity is bifurcated: many blue states aim to mandate ESG and red states aim to prevent voluntary fossil divestment. In 2021, Maine became the first state to require state pensions to divest from fossil fuel companies, while Texas became the first state to pass anti-ESG legislation forbidding state pension investing with firms that ostensibly divest from fossil fuels. This year, roughly two dozen states are considering anti-ESG legislation fueled by conservative rhetoric to “eliminate woke capital,” protect pensions and investments, and unleash the free market.

Indeed, advancing economic freedom while protecting fiduciary responsibilities are noble pursuits. Clearly, required divestment undermines economic freedom and inhibits the ability for fund managers to maximize risk-adjusted returns. Just as importantly, the predominant anti-ESG model of “anti-boycott” legislation contradicts economic freedom and fiduciary responsibility. As Schulp notes, state action that enshrines ESG or anti-ESG principles into investment decision-making is dangerous.

As previously mentioned, Texas passed the first anti-ESG law in 2021; further, in 2022, the state listed 10 financial firms and 348 investment funds that government entities were required to divest from. Contrary to its stated goal, Texas blacklisted firms and funds that remained invested in fossil fuels and bars some forms of pecuniary-only investment, which reduces risk-adjusted returns. Generally, such “anti-boycott” legislation uses a definition of boycott that is so vague that it empowers a government official with any bias against an entity to find ground to challenge the state-contracts eligibility of any company with a sufficient paper trail. It also undermines nearly every common standard of fiduciary responsibility.

The Texas law led to the exit of five of the largest underwriters in the state, forcing Texas cities to pay an extra $300-$500 million in borrowing costs in the first eight months of enactment. Extending the Texas law model would raise borrowing costs in Kentucky ($26-$70M), Florida ($97-$361M), Louisiana ($51-$131M), Oklahoma ($49M), West Virginia ($9-$29M) and Missouri ($32-$68M). Such legislation also harms investors. One such Indiana bill would reduce expected retirement returns by $6.7 billion over 10 years and lower estimated annual returns from 6.25 to 5.05 percent. Further, anti-ESG laws hold meager potential to affect the fate of fossil fuels. Pensions only constitute 12 percent of fossil divestment market share, with the majority stemming from educational institutions and faith-based organizations.

Progressives should not expect to fare any better with forced fossil divestment, which harms public pension performance, with earlier ESG mandates lowering returns by tens of basis points. Plus, the literature shows such tactics are rarely effective at inducing managers to change firm behavior.  

Progressives and conservatives need to course correct on ESG. ESG confusion on the left and right is a “threat to our thriving and free capital markets.” Distinguishing the appropriateness of pecuniary- versus values-based ESG is an important start. It may explain why experts see far less difference between the Trump and Biden administration Department of Labor ESG rules than the political rhetoric suggests. Encouragingly, Wyoming has redirected away from anti-ESG legislation, while states like Montana, Mississippi and North Dakota are beginning to avoid ESG prohibition bills and refocus on pecuniary pension objectives instead.

The business community should do itself a favor by clarifying discrete environmental investing and management practices, communicating their specific implications on financial performance and environmental impact, and rethinking nomenclature accordingly. Conservatives associate ESG with the concept’s origin in the United Nations Environment Program and, by extension, the objective to coordinate global capital allocation and regulation. It might be wise to pursue a new taxonomy for corporate sustainability distinct from ESG to minimize ongoing suspicion and usher in a liberty-compatible rebrand.

For now, all camps need to work toward consensus to better understand ESG and its implications for limited government to address legitimate market failures. Ideally, we will reach the point of societal realization that fixing principal-agent fiduciary misalignment, information deficiencies and government failure holds more potential for the environment than traditional environmental interventions. How poetic it would be if the “E”SG controversy ultimately led to consensus on the compatibility of liberty and the environment.

Consensus Building

The ESG controversy must be put into perspective. Abrupt shifts in social institutions typically first result in confusion and disruption, followed by adjustment periods and evolve to a new social compact. ESG is clearly in the earlier stages. Some herald it as a sign that free markets are working. Others call it a guise for mercantilism.

The development of explanatory frameworks is critical to advance understanding of corporate “E”SG. The rise of domestic mainstream corporate sustainability is primarily attributable to shifts in civil society and bottom-up market forces, namely the preferences of corporate constituents. However, government policy has played a growing role since 2021. Massive unknowns on the nature and magnitude of “E”SG mechanisms remain, and one evolving framework our team contributed to is the four influences of corporate sustainability. In the meantime, policymakers need to act with caution in the absence of complete information.

The most obvious thing is to not shoot ourselves in the foot. Policymakers should heed sage perspectives, like that recently offered by the National Taxpayers Union, to prevent imposition of government values on taxpayers and the private sector. The predominant forms of pro- and anti-ESG state laws violate this. Given the conflation of pecuniary- and values-based “E”SG, it would be wise to revisit the fiduciary standards of public pensions to ensure principal-agent alignment.

Enabling pathways for consumers, employees, investors and other market actors to exercise their preferences advances liberty. An informed market rewards corporate leadership that incorporates environmental factors to enhance company value and punishes those who stray from shareholder obligations. Better information also enhances the relationship between civil society and the business community, where firms’ environmental reputation would accurately reflect their environmental impact. For example, domestic industry often holds a global environmental advantage, where credible transparency would enhance the economic comparative advantage of the United States.

ESG must be assessed on its merits, not weaponized as a proxy for the culture war. The concept manifests in such a vast variety of objectives and behaviors that a principled political movement cannot entirely support or oppose it. Conservatives should keep an open mind on applications of “E”SG with liberty implications and adamantly oppose applications that undermine freedom. Progressives should see “E”SG’s legitimacy concerns as a fixable information problem. Both sides should appreciate the revealed preferences of the market’s power to improve environmental quality. A sound consensus would have us recommit to advancing economic freedom for the sake of our planet and pocketbooks.