Is ESG based on facts? Does It Have a Number?
People who support ESG rarely say where they are starting from. That’s probably because most of them think it’s so obvious that it doesn’t need to be said. However, a few of them may realize that if it were said openly, many people would see that it’s highly doubtful, which means that ESG as a whole is built on shaky ground.
This is based on the idea that clear, objective, and sensible economic, social, and governance standards can be made, and that corporate managers can aim for them and investors can measure them to figure out how well managers are doing.
There are a lot of groups that say they can come up with ESG criteria and use them to judge companies. There are global accounting giants, investment institutions, and national and international rating and standards-setting agencies among these groups.
They don’t care about a key fact, which is that there is no ESG accounting standard or investment standard. One global accounting firm says that not only will such a standard be created, but that once it is, it will “empower companies by providing objective data that reinforces the value of the work being done to build an organization’s long-term value and sustainability.” In a short time, ESG metrics are likely to become an expected part of a company’s financial reporting and an important way to measure a company’s value today, tomorrow, and in the future.
That’s just wishful thinking. Even if these standards are made and used, which isn’t likely, they won’t give objective data. Corcoran points out that
“There is a lot of confusion in the investment world about ESG ratings and measurements. There are many rating agencies, but none of them give the same results. Since a long time ago, the ESG measurement crisis has been getting worse, leaving investors and businesses confused because they can’t solve the real problem: ESG concepts can’t be measured. How do you measure a company’s policies on gender, carbon emissions, involvement in the community, management of the environment, or worker satisfaction? One investment consultant said this about the confusion over the ratings: “ESG is subjective by definition.”
ESG supporters sometimes and reluctantly admit that there are problems, but they always insist that ESG is still young and that its inconsistencies and even contradictions will go away as time goes on. In fact, a few supporters have said that, just as the ways that bond rating agencies measure credit and default risk have become more similar over time, so will the ways that ESG ratings firms measure these things.
This comparison hides or doesn’t understand a key difference between default risk and ESG: default is a measurable and easy-to-observe event, but ESG is neither. In fact, it is inherently subjective, at best only partially observable, and in some important ways it can’t even be observed, so it can’t be measured. One investor will give “E” factors a lot of weight and “S” factors less, while another will do the opposite, and so on. So, they will have very different ideas about which companies have high ESG scores.
The Wall Street Journal reported on September 12 that “Composite ESG scores, which try to sum up all important ESG risks into a single number or grade, don’t give investors much useful information.” During a March 2020 SEC hearing, former SEC Chairman Jay Clayton said, “I have not seen a situation where combining an analysis of E, S, and G across a wide range of companies into a single rating or score would help meaningful investment analysis.” As an example, two of the most respected rating agencies say that Tesla’s current ESG scores are lower than those of Pepsi. Does this mean that electric cars are worse for the environment than soft drinks, or that investors who care about the world should put more money into Pepsi and less into Tesla? ESG ratings are all over the place because the assumptions, methods, and data used by ESG rating agents are very different.
And, since we’re talking about Tesla, should people who support ESG praise it for making people less reliant on internal combustion engines? Or criticize it for using electricity made from fossil fuels to power Bitcoin and for using lithium-ion batteries, which can be dangerous (especially to the ancestral lands of native people in Australia and South America, which ESG fans probably care about) and hard to recycle. Most other companies, including the “World’s Most Responsible Company,” are in a tough spot.
It’s important to point out that key parts of governance, environmental, and social standards are inherently subjective and, therefore, in the eyes of their beholders. What you see as a grave environmental, social, or corporate sin might not even be on my list of problems.
As an example of how ESG is inherently and unavoidably subjective, I give ethnic, gender, and racial diversity a weight of 0.0. I don’t care if a board or staff is made up of 0 or 100 women (or Aborigines or Asians or…) or any other group. Others, on the other hand, put a lot of weight on the board’s values, gender, and race. In fact, the words “diversity” and “governance” are often used as if they were the same thing. More generally, a company is sent to ESG purgatory if it releases CO2 and is said to “exclude” certain groups of people.
In contrast, Warren Buffett’s criteria for choosing directors for Berkshire Hathaway’s board are a refreshing dose of common sense and a deep breath of fresh air. In the 2006 Annual Report, he said:
Charlie Munger and I use our long-standing criteria to choose a new director. These are that board members should be owner-focused, business-savvy, interested, and truly independent. Charlie and I think these four things are important for directors to do their job, which is to faithfully represent owners as required by law. But these criteria are often not taken into account. Instead, consultants and CEOs who are looking for board members will often say things like, “We’re looking for a woman” or “a Hispanic” or “someone from another country” or whatever. Sometimes it sounds like the goal is to fill up Noah’s ark. I’ve been asked a lot of questions about potential board members over the years, but I’ve never heard anyone ask, “Does he think like an intelligent owner? ”
The questions I get instead would seem silly to someone looking for people to join a football team, an arbitration panel, or a military command, for example. In those cases, the people in charge of hiring would look for people with the right skills and attitudes for a specific job. At Berkshire, we specialize in running a business well, so we look for people with good business sense.
The editorial board of The Wall Street Journal went even further on December 2, 2020, when they said that some ESG criteria are so silly that they are laughable:
Nasdaq announced new requirements for corporate directors on Tuesday. The more we think about them, the more ridiculous they seem. How is a company supposed to find out if a board candidate is gay if they don’t already know? Should private investigators be hired to look into it? Once that person joins the board, does the company have to say in the annual report what that person’s sexual orientation is so progressives can feel like the quota has been met? We could continue…
As ESG scores and ratings stick to many investors’ portfolios like barnacles, researchers are looking into the things that help companies get high scores and good rankings – and keep them over time. Studies show that the size and location of a company affect its score. Larger companies are ranked higher than smaller ones, and companies in developed markets are ranked higher than those in emerging markets.
It’s possible that big companies are better corporate citizens than small ones. But it’s also possible that big companies have the resources to play the ESG scoring game and that “ESG disclosure” is a smart strategy used by big companies that want to brag about themselves and hide operational problems instead of letting people know about them.
Who are the most naive and easily fooled people in the room?
The similarities between ESG and the “corporate governance” movement of the 1990s and early 2000s are eerie, and investors should be very worried about this. During those years, consultants were in a hurry to come up with governance principles, while accountants and regulators added hundreds of pages of disclosure and a wide range of other rules. Corporate governance supporters were happy that shareholders were better off because of their work.
Enron Corporation was their biggest problem. Fortune magazine called it “America’s Most Innovative Company” for six years in a row, from 1996 to 2001. Academics praised it, and MBA graduates fought to join its ranks. Still, Enron filed for bankruptcy on December 2, 2001.
It was the biggest bankruptcy in U.S. history at the time. By that time, even some of its supporters could see that institutionalized and systematic lies had been used to keep it going for a long time. Since then, the name “Enron” has come to mean corporate fraud and corruption, or bad and even illegal corporate governance.
How did people who support corporate governance miss these egregious mistakes? Wikipedia says that the Enron scandal “also affected the business world as a whole” because it led to the end of the Arthur Andersen accounting firm, which had been Enron and WorldCom’s main auditor for many years. WorldCom’s bankruptcy in 2002 was an even bigger fraud.
Enron: The Smartest Guys in the Room is a 2005 documentary based on Bethany McLean and Peter Elkind’s best-selling book of the same name from 2003. “How come nobody saw it coming? ” was a question that Queen Elizabeth asked in a very direct way after the GFC.
That question could have been asked just as easily about Enron and WorldCom, and to those who supported them. So, the uncomfortable question is: During the 1990s, were the people who believed in “corporate governance” the most mistaken? Even more awkward is the question of whether or not the people who support ESG, responsible, and sustainable investing are the most gullible and easily fooled people in the room.
“Corporate governance” made a lot of its supporters rich at first, but in the end, most shareholders got poorer and some of them got much poorer. This should serve as a warning to ESG’s supporters and investors in general. So should the fact that, according to Forbes (2 May 2021), Warren Buffett and Charlie Munger “certainly aren’t leading the charge on ESG investing.” Unfortunately, these key facts probably won’t bother most investors until it’s too late.
ESG admits in a subtle way that Milton Friedman was correct.
ESG’s supporters imply and sometimes say outright that “good” (high ESG score) companies grow their revenue faster, make more money, and are less likely to face key risks than “bad” (low ESG score) ones. (Note that the assumption that companies with a high subjective ESG score are ethically good and companies with a low subjective ESG score are ethically bad is not stated. This is likely because it is illogical because it mixes up a subjective assessment and a normative judgment.)
This second core idea and intermittent (or “renewable”) energy have something in common that is important and can be used against them. If solar and wind energy really were cheaper than coal and gas-fired power, as their supporters say (but see Investors beware: “Cheap” renewables are very expensive), then why do they need so much money from the government, and will likely continue to need so much money in the future? Also, if the second main idea of ESG supporters were true, why would companies, their management, or their shareholders need to be forced to follow ESG?
In his (in)famous article, “The Social Responsibility of Business Is to Increase Its Profits,” published in The New York Times on September 13, 1970, Milton Friedman explained what shareholder capitalism is all about. Friedman warned about the dangers of “corporate social responsibility” and said that the main job of a business was “to use its resources and do things that will increase its profits as long as it stays within the rules of the game, that is, as long as it competes in an open and honest way.” Friedman was right to stress that in a market economy, profits are a measure of how much value a business has created for its customers. Corporations exist to make money and serve their customers. They do not exist to promote authoritarian goals. As corporate officers, businessmen would do their companies the most good if they paid attention to their bottom lines.
If ESG’s second main premise were true, companies would do it on their own, and they would do it with great enthusiasm. They would do this because it made them bigger, more profitable, and less likely to face key risks. They wouldn’t do it because ESG advocates keep talking about how moral ESG is or because big institutional investors and regulators will punish them if they don’t. The irony is great: if ESG’s second main premise were true, Milton Friedman, whom ESG’s zealots hate, would be proven right.
Does ESG Improve Corporate Outcomes?
ESG will help companies in at least four ways, according to its supporters: it will increase (1) revenue and (2) profitability, reduce (3) the risk of disaster, and (4) the cost of debt. There is a lot of research on how ESG affects how businesses run, and it is growing quickly. From what I’ve read, the evidence that ESG is good is at best weak, mostly inconclusive, and definitely not convincing.
There’s some evidence that it doesn’t pay to be a low ESG score company: such a score increases the cost of funding and insurance. Most of this evidence, however, comes from fossil fuel companies (many of which have been abandoned by banks and insurance companies) and “green” energy companies (all of whom have been lavished with government subsidies).
On the other hand, there isn’t much evidence, let alone convincing evidence, that ESG affects sales and profits. In particular, every study that claims to find a positive correlation between profitability and ESG score (though not all of them do) flounders on the rocks of causality: are “good” companies more profitable, or are companies that are more profitable able to do things that make them look “good”?
Does ESG help investors make more money?
Even if ESG could be measured in a valid and reliable way, which it can’t, this premise is also fatally flawed.
If the claim that ESG makes companies make more money and make more money isn’t very strong, then the claim that putting ESG into your investing will make you more money fails a very simple test.
If you want to make “excess” money, you should first ask yourself if others see the same value that you do. So, do the prices on the market already reflect these ideas? In short, that’s why a high-growth company or one in a high-growth industry, etc., usually doesn’t produce above-average returns (see Do tech stocks really outperform their value counterparts? ): others have already seen what you claim to (fore)see, and the market has already priced in things like quality management, growth prospects, etc.
When you think about these things, three options come to mind.
First, according to traditional finance theory, if ESG’s supporters have correctly and fully priced both “good” and “bad” companies, then investing in “good” companies or selling (or staying away from) “bad” companies won’t change returns. Also, if being “good” makes a company less risky, investors in “good” companies will get lower returns than investors in “bad” companies, even before risk is taken into account, and the same returns after risk is taken into account.
From the point of view of those who want to improve ESG, the second possibility is even worse:
If its supporters are overconfident about ESG’s effects (which I think they are) and therefore overestimate how much being “good” will help a company grow and make money (which I think they do), then investing in “good” companies will give you lower risk-adjusted returns than investing in “bad” companies (see also Why you’re probably overconfident and what you can do about it).
Third, investments in “good” companies will have higher risk-adjusted returns only if the people who support ESG don’t give it enough credit, which I doubt.
What do analyses of facts say? Several studies have found that investors who use ESG strategies don’t do very well or very well at all. According to Terrence Keeley, who used to work at BlackRock as a senior executive (The Wall Street Journal, 12 September),
Bradford Cornell of the University of California, Los Angeles, and Aswath Damodaran of New York University (“Valuing ESG: Doing Good or Sounding Good?”) looked at the shareholder value created by firms with high and low ESG ratings. Their conclusion: “Telling firms that being socially responsible will lead to more growth, profits, and value is false advertising.”
What Cornell and Damodaran found on a small scale is also clear on a larger scale. Over the past five years, global ESG funds have done worse than the overall market by more than 250 basis points per year, with an average return of 6.3% instead of 8.9%. This means that an investor who put $10,000 into an average global ESG fund in 2017 would have about $13,500 today, compared to $15,250 if he had invested in the broader market.
In The Journal of Portfolio Management, November 2020, Elroy Dimson, Paul Marsh, and Mike Staunton all say the same thing:
Many asset managers say that ESG ratings can help investors choose assets with better financial prospects. The authors look at the investment performance of portfolios and indexes that were screened for their ESG credentials. The authors think that ESG ratings are unlikely to make a big difference in how well a portfolio does.
Is ESG just a way to charge more money?
“You need to understand two basic facts about ESG or “sustainable” investing,” says Jason Zweig (“You Want to Invest Responsibly; Wall Street Smells an Opportunity,” The Wall Street Journal, April 16, 2021). “First, ESG is in the eye of the beholder. What one investor sees as a shining example is a pariah to another. Second, ESG is the last best chance for investment firms that want to keep getting big fees.
“Asset managers are saving vehicles that aren’t doing their jobs by changing them to a greener way of doing things. Morningstar says that one in six ESG funds were made from an old strategy that was often failing. Last year, 25 portfolios were reborn as sustainable funds. It seems that investors are more likely to accept low returns and high fees if you make them feel good about themselves.
Zweig looks at two of BlackRock’s funds as an example: its U.S. Carbon Transition Readiness ETF and the index fund for it, iShares Russell 1000 ETF. Which fund is ESG?
The purpose of U.S. The goal of the Carbon Transition Readiness ETF, according to the global product head for iShares and index investments at BlackRock, is “to change corporate behavior” by “rewarding the winners and going light on the potential losers” in the “transition to an economy that consumes less carbon.” The result, Zweig jokes, is “a basket of stocks that the average investor might not be able to tell apart from the market as a whole.”
Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), Amazon (NASDAQ: AMZN), Facebook (NASDAQ: META), Google’s parent company (NASDAQ: GOOG – Alphabet), Tesla (NASDAQ: TSLA), and Berkshire Hathaway’s Class B (“baby”) shares make up the top seven holdings in the Carbon Transition ETF. After a fee waiver, the fund costs 0.15 percent of its value each year. Its sibling, the iShares Russell 1000 ETF index fund, has the same top 7 companies in the same order and with the same weights, making up 20.1% of the total assets and costing only 0.03% per year. That’s only a fifth of what the (so-called) ESG fund has! “The Carbon Transition Fund looks a lot like a carbon copy of a broad-market index, but with (much) higher fees.”
Morningstar says that the average annual costs of sustainable ETFs are 0.34%, which is more than 10 times the costs of the cheapest index funds. In this way, ESG funds are the latest way for Wall Street to take something old, call it something new, and raise the price. Greenness depends a lot on how you look at it. Investors are always in the red because of fees.
In other words, is ESG just another way, like climate change alarmism, for advocates to hide their greed and hypocrisy? Some people who say loudly that they want to “change the world” seem to be doing quite well for themselves behind the scenes.
ESG isn’t good for investors, so who is it good for?
Why have so many businesses welcomed the huge push for ESG? Why have so many funds poured into the coffers of asset managers who care about ESG? To answer these questions, we only need to ask: “Cui bono?” ” Who gets what? We’ve seen that companies as a whole don’t benefit, and neither do their shareholders. In fact, both groups end up losing money. On the other hand, the more they try to make corporations have a “ESG culture,” the more ESG rankers, score managers, and consultants benefit. The more ESG disclosure requirements there are and the harder they are to meet, the more accounting and auditing firms benefit, and the more ESG funds there are and the bigger they are, the more ESG fund managers benefit.
One smart blogger (Musings on Markets, 14 September 2021) says:
Given how much ESG disclosure advocates, measurement services, investment funds, and consultants rely on each other, it’s not surprising that they have a reason to sell you on its unstoppable growth and success. Shareholders and investors in funds pay for this gravy, so you might wonder why CEOs not only go along with this charade but actively encourage it. The answer is that it gives them the power to avoid shareholders and avoid being held accountable.
After all, these are the same CEOs who, in 2019, made the ridiculous-sounding argument that it is a company’s job to maximize stakeholder wealth instead of serving shareholders. In other words, being accountable to everyone means that CEOs are accountable to no one. Some founders and CEOs try to hide flaws in their business models or go too far by showing off how good they are. I’ve already said that Elizabeth Holmes and Adam Neumann lied and were self-centered while using their “noble purpose” credentials to cover it up.
On a personal note that is also very important, I’ve been lucky enough to know people who have actually done good things. Their activities and personalities are very different, but they all have one thing in common: they do good things all the time, but they never talk about it or tell other people what to do. I think that’s a big reason why so many different kinds of people are sad about the death of Queen Elizabeth II.
This key difference also applies to companies and investment funds: I’m very skeptical of companies and executives who brag in their reports, regulatory filings, public statements, etc., about how much “difference” and “good” they claim to make. H.L. Mencken was an American journalist and author. Mencken was right on the mark. “The desire to save people is almost always just a cover for the desire to rule them. “Power, not the chance to serve, is what all messiahs really want,” Elizabeth Regina, requiescat in pace.
“The Most Honest Company in the World”
According to ABC (“Patagonia Founder Gives Away $4.4 Billion Company so All Profits Will Fight Climate Change,” September 15), “Yvon Chouinard, the billionaire founder of the outdoor clothing brand Patagonia, is giving away the company to fight the climate crisis.” Mr. Chouinard, who has a net worth of $US1.2 billion, is giving his family’s ownership of the company to a trust and a non-profit organization. On September 14, he wrote on the company’s website, “Each year, the money we make after putting it back into the business will be given out as a dividend to help fight the crisis.”
The end of the ABC report said, “Rich people often give money to good causes, but The New York Times said that the way Chouinard did it meant that he and his family would not get any money out of it and would actually get a tax bill because of it.”
Devon Pendleton and Ben Steverman of Bloomberg disagree. The article “Patagonia Billionaire Who Gave Up Company Avoids $700 Million Tax Hit” (16 September) says, “Yvon Chouinard structured the transfer of his firm in a way that keeps control within the family and avoids hundreds of millions of dollars of taxes.” He “won’t have to pay the federal capital gains taxes he would have owed had he sold the company.” He also avoids the 40% U.S. estate and gift tax when he gave his company to its heir
But wait, aren’t the same people who say “do something about climate change” also angry at billionaires who don’t “pay their fair share” of taxes?
Ray Madoff, a professor at Boston College Law School, told Bloomberg, “We are letting people opt out of paying for all of the government’s costs so they can do whatever they want with their money. This is very bad for democracy, and it could mean higher taxes for the rest of the American people.” Ellen Harrison, a tax attorney at McDermott Will & Emery in Washington, confirmed to Bloomberg that Chouinard and his family will keep control of Patagonia after the transaction.
The Green Market Oracle gave “10 Reasons Why Patagonia Is the World’s Most Responsible Company” on September 21, 2021. Reason #2 is “transparency.” A Patagonia spokeswoman said, “The Chouinard family never asked us to structure the deal in a way that would help them avoid taxes.” Chouinard and Patagonia’s self-congratulatory statements, on the other hand, didn’t say a word about the huge tax benefits for the family. “Patagonia welcomes constructive criticism as part of the growing transparency movement at the heart of sustainability,” says GMO.
The American Petroleum Institute has agreed. It says (“Patagonia and Petroleum,” April 16, 2019) that “Patagonia has mixed feelings about petroleum. Even though the company is against fossil fuels because of their effect on the climate, it is honest about the fact that nylon and polyester are made from petroleum and are used in some of its products. Patagonia is right to say that there is no other choice:
It is very hard to make our technical gear, especially our shells, less harmful to the environment. Unlike the other things we make, a shell is a life-saving tool that has to work even in the worst weather. Unfortunately, we have to use fossil fuels to reach that level of functionality. Even though Patagonia is always looking for new materials and ways to do things, our environmental goals are still higher than what our shell technology can do.
In other words, Patagonia says that other people don’t have the right to use fossil fuels because they cause climate change, but it defends its own right to do so because “we can’t live without them.” API says, “Petroleum-based materials are a big reason why Patagonia’s products are what they are: light, water-resistant, and even life-saving. We’d say that natural gas and oil are great now and in the future because they can be used in many different ways to make things.
ESG and related ideas like corporate social responsibility, ethical investing, impact investing, socially responsible investing, and sustainable investing are fatally flawed. They are bad for investors, businesses, and society as a whole, but they are good for a small group of supporters. ESG doesn’t make sense on its own, and the way its supporters think about “ethics” and “responsibility” shows how Western societies are becoming more authoritarian and hypocritical.
That’s why I don’t like how ESG often uses these and other nice-sounding terms. In reality, it wants to take away other people’s choices and their right to be moral and responsible. To add insult to injury, it also wants to use investors’ money to fill its own pockets. ESG supporters, on the other hand, show off their egos, don’t care about shareholders, and avoid their moral and legal responsibility to shareholders in this way. In this very important way, ESG is the exact opposite of what it says it is: it is authoritarian and careless.
I’m not the first person to think that ESG and similar ideas are completely wrong. Milton Friedman sounded the alarm more than 50 years ago: “Businessmen who talk (the language of corporate social responsibility) are unwitting puppets of the forces that have been undermining the basis of a free society.”
In the same way, I’m not the only person today who thinks that ESG and similar ideas are fatally flawed. In a series of articles over the past few years, Zero Hedge has called it a “fraud,” “scam,” and worse. The Wall Street Journal’s editorial board has called it “absurd,” and Warren Buffett calls it “asinine.” Terence Corcoran of Canada’s National Post says it is “a wildly unscientific collection of investment models that have no consistent basis in fact or data, no measurement systems, no objective standards, and no scientific basis.”
Like the smart blogger I just mentioned, “I’m more convinced than ever that ESG is not only a mistake that will cost companies and investors money, but also that it will do more harm than good for society.” The last word goes to Terrence Keeley, a former senior executive at BlackRock, who says:
The left makes fun of ESG for being too shy, and the right makes fun of it for being too aggressive. The hard truth is that ESG is mostly failing because it doesn’t meet its own goals. Even though investors have put tens of trillions of dollars into ESG investments, they haven’t done very well or done much good. People who support ESG should do better or stop saying they can.
Those who make money. Value investors.