Without question, today’s leading corporate buzzwords are contained in this well-known acronym: ESG—Environmental, Social, and Governance. Most notably, these three words are not simple dictionary entries that permit discussion of thorny questions on how best to regulate the environment; deal with social issues relating to the workplace on such hot-button topics as income inequality, gender equity, and unionization; and structure corporate governance to incorporate the first two issues. If that were the modest intention of the ESG movement, no one could explain the huge emotional, intellectual, and political crusade that the three letters embody.
The current strength of the ESG movement lies in how tightly it dovetails with progressive views on substantive issues. There is no question within this movement that global warming is the main environmental challenge—demanding a quick retreat from fossil fuels in favor of a rapid expansion of wind and solar energy to provide for home heating and automobile fuel.
The social issues are not intended to extol the virtues of a market economy, but instead highlight the necessity of following policies of diversity and inclusion in order to remove perceived racism and sexism from the workplace and the larger society, and to ensure workers have a voice in the workplace, coupled with a rich array of positive rights—vacation pay, health care, minimum wages—that progressives believe markets cannot supply.
And governance does not amount to an endorsement of the position announced most famously by Milton Friedman more than fifty years ago: that “the social responsibility of business is to increase its profits”—subject to its duty to comply with extrinsic forms of government regulation, including on environmental issues, such as dealing with pollution. Instead, in line with the famous announcement by the 2019 Business Round Table (BRT), corporations must look beyond shareholders to take into account a larger class of stakeholders—commonly defined to include employees, suppliers, customers, and the community at large—and should adjust their business plans to give due weight to all of these interests. For the modern BRT, the purpose is to promote “an economy that serves all Americans” by investing in both their workers and their communities. This movement has swept the investment community, so that by the year 2025, ESG assets could, according to Bloomberg, reach $53 trillion—roughly a third of assets currently under corporate management and up from the estimated $38 trillion by the end of 2021.
But just how well does this model work? One metric for conducting this analysis is to look at shareholder performance under the two rival approaches. At this point, it is not easy to evaluate counterfactual scenarios. Just take the simple statement that ESG asks that firms invest in their workers and communities: that unexceptional view is also endorsed by any firm following Friedman’s shareholder primacy model. The corporation that wants to maximize profits without such investment has to a steep hill to climb. It is simply a caricature to assume that a firm maximizes profits by minimizing the wages and benefits that it pays to its workers. Keep them too low and the best workers will leave, forcing the firm to engage in an extensive recruitment campaign, likely to fail once disgruntled employees tarnish the firm’s reputation. As in most scenarios, here the usual marginal conditions will take over, such that corporations in this position will put the additional dollar on the table in wages, benefits, and good relationships if it will yield more than a dollar in profit. Similarly, a rational firm will make other workplace adjustments to preserve the good will of their workforce and is often the best insurance for continued loyalty in both bad and good times.
Community investment is a trickier matter, necessarily commanding less attention than workplace issues. But it, too, can never be wholly ignored: the ability of firms to obtain the cooperation of public and private bodies alike depends on their ability to be good citizens, which includes supporting local charities and youth teams, hosting community events, and supporting local relief efforts. Once again, however, community relations are a delicate two-way street—these communities must meet the firm part way for the cooperation to continue.
So, what then differentiates the ESG model from the standard business approach on this critical metric? Much of the gap is contained in the words “diversity and inclusion and gender equity,” which are difficult to evaluate. Some fraction of these efforts is critical to the maintenance of workplace performance and morale, because the composition of the workforce by race, sex, and nationality has changed vastly since Friedman penned his article in 1970. His profit-maximizing firm will, nonetheless, be sensitive to all these contemporary issues. But the reason that this variable is so ineffable is that many of these diversity and inclusion programs are not outreach efforts to select the strongest workforce based on objective criteria. Instead, their new focus is on diversity and inclusion foremost and for its own sake, even if it necessarily results in a weaker workforce than would otherwise be the case. Indeed, the intensity of the movement evinces tradeoffs in these performance-versus-equity priorities: ESG firms do not perform as well in the market as those firms that hew closely to the Friedman position of shareholder primacy.
In principle, a market should be able to sort itself out, so that firms that are explicit can attract investment from individuals and investment funds that are prepared to accept lower returns for greater equity. The danger here, however, is that the ESG movement is not content with firm variation but seeks to impose a uniform set of dictates on firm behavior writ large, at which point the shift from shareholder to stakeholder primacy is likely to lead to larger dislocations if allowed to freely run its course.
The key objection to this position is not that these groups have no stake in a firm’s welfare. It is, instead, that the very notion of a fiduciary duty makes it clear that no officer or director of a public corporation can serve two masters whose interests diverge. Indeed, one reason why large public corporations typically have a single class of common stock is that this simple corporate structure eliminates a large set of potential conflicts of interest that would otherwise arise if different shareholders had different kinds of holding, so that management could not know how to decide when its preferred shareholders (with a dividend priority) want safe investments, while its common shareholders want riskier ones.
And the conflicts of interest only grow as more and more groups are admitted under a big stakeholder tent. Should the firm support unionization to help some workers, if it means reducing firm profits, cutting out some nonunion workers, raising prices to customers, and reducing purchasers from various suppliers? No one has figured out a metric to resolve these knotty choices, which is why the single focus of the Friedman approach gains traction. Each of these groups can be represented by their own fiduciaries, who have an undivided loyalty, so that the bargaining structure has a strong likelihood of generating gains all around—a situation that can never happen if hapless directors and officers must be all things to all people at all times.
The Business Round Table also does not account for the fact that its brand of corporate ESG will change both how shareholders choose corporate boards and in turn how those boards choose corporate officers. The stakeholder logic invites more aggressive forms of intervention. The most extreme version of this position was proposed some years ago by Senator Elizabeth Warren, whose misnamed Accountable Capitalism Act would have required that all very large corporations obtain a United States Charter, which would issue only if 40 percent of their boards were selected by their employees. That proposal would make it impossible for a firm to negotiate at arm’s length with its workers, who in turn would gain a virtual veto position with respect to any major corporate transactions, like mergers and spinoffs. Put aside its confiscatory nature, and ask two questions: which employees and why only employees?
Such extreme positions garner little support, but that is decidedly not the case with the recent Nasdaq rule that mandates corporations have diversity by race or sex or explain why they cannot achieve that goal. Because it operates as a major pathway to equity markets, Nasdaq has real monopoly power because of its ability to delist. And that power is backed by the Securities and Exchange Commission. It therefore does function something like a common carrier with a duty to take all comers, which does not happen if its board mandate remains in effect. If firms were better off by meeting these requirements, they would do so voluntarily. And if they cannot, why should they have to explain themselves to a remote board that knows significantly less about the firm’s business than the firm itself? In this instance, then, diversity is at war with inclusion, for decentralized decision making, as defended by Friedrich Hayek, is the best protection against collective error—a position that is all too easily forgotten in today’s age where moral certitude is in no short supply.
