Environmental, social and governance investing has been under fire recently, and politicians, environmentalists and business leaders are flocking to its defense. The inconvenient truth for those defenders, however, is that the ESG framework introduced within the rubrics of corporate social responsibility or sustainability is, at best, an ill-specified platform of objectives imposed on business entities.
Assertions lauding the potential blessings of sustainable investing and transparent disclosure of ESG activities run a broad gamut. One is that investing in entities that promote a small carbon footprint, equity and healthier community is the fiduciary duty of funds toward their clients.
A second is that ESG is as essential as cash flows in driving a company's true market value. A third asserts that banning consideration of ESG factors would lead to poor investment outcomes.
Finally, some argue that businesses should be required to address the total costs of their activities, including noxious gas emissions, depletion of natural resources, lack of diversity, etc.
The first three assertions are either false or self-evident (and irrelevant). The fourth has merit but is fraught with difficulties in implementation.
The first assertion suggests firms should undertake ESG activities even when they harm their shareholders. This is a novel construction of fiduciary duty. Is it consistent with the efficient allocation of social resources and economic growth?
I argue it is not: If ESG activities benefit shareholders, rational management whose interests align with those of its investors will undertake them. If not, investors seeking financial returns will withdraw their investments from firms undertaking return-reducing ESG activities, leading to the eventual collapse of such entities. Only if all investors derive utility from ESG would firms survive while conducting such activities, but this would be at the expense of less efficient resource allocation and slower growth. While investors' welfare may be enhanced in this latter case, financial metrics will reveal an economic slowdown under the traditional measures of GDP and its growth.
The second assertion fails for the same reason: considering ESG factors in addition to expected cash flows will lead to losses sustained by shareholders who primarily derive their utility from the latter. While not stated explicitly, the assertion could be that ESG activities might benefit shareholders in the long run but not in short-term cash flows.
But managers emphasizing the short term at the expense of the long term is a general problem that applies to all firm activities, not just ESG. The cure is creating proper incentives that gear managers toward the long term rather than demanding that firms engage in ESG activities even when shareholders' short- or long-term returns are compromised.
The third argument suffers from the same fate as the first two. ESG factors will be considered if investment outcomes and the firm's market value are boosted. If not, they would be ignored. There is no reason to either encourage or ban ESG investments.
The fourth is the only surviving argument, but fraught with conceptual and implementation difficulties. Indeed, ESG activities directed toward benefiting a firm's shareholders at the expense of other entities or constituencies would distort allocative efficiency and hence should not be undertaken.
A firm should consider such externalities in its production or investment decisions to bring about efficient resource allocation in the economy. The cost a firm imposes on others should be internalized, possibly through the regulator imposing a tax. A symmetric subsidy can be employed when the firm confers beneficial externalities on others. The major obstacle to implementing such schemes is the unavailability of truthful information about the potential costs or benefits of different levels of abating the externalities' impact.
About half a century ago, I served as associate director of research at what was known as the "Trueblood Committee," charged with the articulation of accounting objectives. I suggested a mechanism whereby firms are induced to transmit truthful information about potential costs and benefits of abating harmful externalities (including ESG) at different levels to a policymaker and incorporate such effects as cost or revenue in their financial statements rather than simply disclosing them.
The committee at that time did not recommend such treatment, and the Securities and Exchange Commission and the Financial Accounting Standards Board recently chose to demand confusing and often unverifiable and potentially untruthful ESG investment disclosures. The fourth assertion fails to address the mechanism through which businesses are supposed to address the cost of their activities and, just as importantly, abstracts from the thorny issue of potentially untruthfully informing a policymaker about the potential costs and benefits of abatement.
To illustrate the thorny issue of false reporting of ESG externalities, consider "Firm A" engaging in an activity harming the operations and decreasing the revenue of "Firm B." A policymaker can ensure an optimal (from society's standpoint) level of harm is inflicted and no more.
To this end, the policymaker would require truthful information about the potential costs of abating different levels of damage by A and the potential benefits to B at each of these levels. These potential costs and benefits are forecast by the two firms and cannot be verified. Hence, a mechanism like the one I proposed that induces the truth is essential. Moreover, this mechanism does not require public disclosures that can be confusing and inconsistent.
Just like non-ESG activities, ESG activities should be only undertaken when they enhance investors' returns. Such actions should be avoided if they inflict harm on others; in such cases, internalizing the cost would improve the allocation of social resources. In this second case, reporting the cost and benefits of such externalities truthfully to a policymaker (but not necessarily mandating public disclosures) about the activities would be helpful, but only if a mechanism ensuring truthful information transmission is implemented.
