Environmental, Social, and Governance Theory: Defusing a Major Threat to Shareholder Rights

Richard Morrison is a Research Fellow at the Competitive Enterprise Institute. This post is based on his CEI memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

The concept known as environmental, social, and governance (ESG) theory has a long history of similar, predecessor concepts both in academic literature and in the business world. For over a century, critics of the market economy, largely inspired by progressive political goals, have argued that for-profit corporations should not limit themselves to seeking profits for their shareholders, but should engage—or be required to engage—in various sorts of activism to address social problems and concerns. This movement grew up alongside evolving expectations of social responsibility within the business community that motivated many managers and executives to provide a range of services voluntarily to employees and to their local communities.

Some of the progressive-minded reforms of yesteryear have been beneficial, some have had little observable effect, and some have been disastrous. Many others have simply been superseded by evolving social attitudes that eventually rendered previously cutting-edge theories out of date, including cases in which the benefits bestowed by corporate benefactors were soundly rejected by subsequent generations of intended beneficiaries.

More recently, the ESG framework has been embraced by government agencies, quasi-government entities such as those affiliated with the United Nations, non-profit advocacy groups, financial ratings firms, and influential policy organizations like the World Economic Forum. Many of these organizations have taken it upon themselves to create complex sets of principles and rating systems for all the various environmental, social, and governance priorities companies should ostensibly be pursuing.

Advocates often cite the proliferation of various ESG implementation schemes as evidence of the popularity of the movement, but the actual result has been one of confusion. These competing frameworks sometimes agree on what topics should be considered—limiting and mitigating the impacts of anthropogenic climate change, for example— but rarely provide any useful guidance for which goals to prioritize as the most important or how to reconcile the conflicting demands of multiple stakeholders.

This should not be surprising, though, because ESG means very different things to different people. Some advocates want to advance specific environmental or labor policy outcomes. Some are individual investors who want a competitive rate of return but want to minimize their carbon footprint. Others are professionals looking to sell ESG-themed financial products and consulting services or to carve out a lucrative niche for themselves in a burgeoning field.

With every major public policy issue potentially coming under the umbrella of ESG, it also should not be surprising that implementing such a management and investment strategy yields mixed results.

Proponents routinely cite research findings that claim to validate ESG as a comprehensive theory, but detailed analysis reveals that only governance reforms—the most traditional and least controversial— generally yield improved business performance. But even those findings are suspect, given the inability of professional research firms to agree on what constitutes compliance with environmental, social, and governance goals in the first place. Auditing the results of leading finance ratings firms reveals a shockingly low level of agreement, even when the topics being examined are objective and specific.

The problematic nature of ESG demands goes even further, however. Many assessments simply assume that the progressive policy positions called for are universally desirable, and focus on how those can be integrated into the operations of a firm or investment portfolio without costing shareholders too much money. But many of the goals specified are highly controversial and far from universally accepted. For instance, the expectation that all employers include abortion in health coverage would offend religiously observant shareholders. Demands to end child labor internationally could force many people in developing countries into more dangerous living conditions. Requiring firms to invest only in politically popular renewable energy sources, like windmills and solar panels, could hurt nuclear power development and slow the creation of a low-carbon economy.

Despite the significant problems with inconsistent definitions and controversial policies, many proponents now suggest that ESG goals should be mandated by government policy. Recent legislation proposed by members of Congress, including Sen. Elizabeth Warren (D-MA), and regulatory proposals advanced by the current leadership of the Securities and Exchange Commission would require that U.S. corporations move from the longstanding legal presumption of shareholder primacy to one in which government agencies manage the priorities of business entities, but bear none of the cost for their mandates. This shift would constitute a major threat to the property, due process, and association rights of investors.

However, there is another way. Many of the conflicts described above can be avoided if policy makers embrace a voluntary system of “benefit corporation” charters, augmented by private certification standards. Legally binding corporate charters that elevate other stakeholders above shareholders are available to those founders and board members who want to embrace them, as are the private, voluntary standards that publicly certify a similar balance of priorities. If the wave of enthusiasm for ESG investing is anywhere as significant and broad-based as its proponents claim, these non-coercive alternatives should be sufficient for the enlightened investors and managers of the 21st century to structure their commitments.

Conversely, a legally mandatory process—in which detailed lists of rules for all firms are drawn up and enforced by the federal government—would be expensive, time-consuming, and afflicted by the same problems that beset most regulatory policy. Regulatory capture, privileging of incumbent firms, and negative effects on growth and innovation would likely all result from the policy making and enforcement processes. Moreover, flawed rules would become entrenched and become extremely difficult to change once regulated entities start spending money and making long-term compliance plans. This would achieve few of ESG advocates’ progressive goals and leave dominant firms even more powerful than before.

The complete publication, including footnotes, is available here.

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One Comment

  1. Ron
    Posted Wednesday, May 12, 2021 at 10:42 am | Permalink

    With the advent of benefit corporations, shareholders can make their choice of whether they want a legally-compliant shareholder-wealth focused corporation or a legally-compliant corporation with an ESG co-mandate. ESG should not be required by governmental authorities. Not only is it not necessary, but it will be wealth destroying because it will prevent any number of purely shareholder-wealth enhancing transactions that have not articulable ESG component. This is not to mention that ESG is hardly a fixed and determined set of rules.