ESG and Markets

Wall Street is known for characters like the real Jordan Belmont and fictional Gordon Gekko personifying greed. Yet today’s great Wall Street controversy involves putting societal values above profit. Environmental, Social and Governance investing, or ESG, raises significant issues regarding misuse of investors’ money.

Some have long invested “responsibly.” A United Nations sponsored group of international investors in 2005 set down six “Principles for Responsible Investment.” Over 3,000 financial institutions with over $100 trillion in assets have now signed on, committing to advance ESG to “better align investors with broader objectives of society.”

Investment is voluntary, like all market economy transactions. People with legally acquired money are free to spend or invest it as they choose. Economists model investors as maximizing their returns (or some combination of return and risk), but people can invest however they wish. This includes not investing in disliked businesses.

When enough investors share certain preferences, financial markets will respond. The emergence of ESG investment funds should surprise no one. Financial markets and the Securities and Exchange Commission should also regulate companies’ environmental and governance claims as part of investor protection.

Independent groups have long certified companies as “Green” or “Sustainable.” Today over 1,000 groups construct ESG scores using different factors. Specialists can predict company ESG scores and suggest how to improve a score. The portfolios of banks or individual investors can be scored using company scores.

Is ESG investing profitable? Proponents claim that ESG yields higher returns than conventional investing. The evidence, however, typically consists of some period over which certain ESG funds performed well.

Economic theory strongly suggests that restricted investing CANNOT outperform unrestricted investing. A portfolio potentially including all stocks and assets can mimic ESG funds when green companies perform well and do better when low ESG score companies perform well. We can also understand this by considering investor preferences. Investors must be de facto bribed with better returns to invest in disliked companies.

How does ESG become problematic? For one, when money managers use other peoples’ money to advance their preferred social goals. Pension funds offer the best illustration. The elected managers of California’s state employee pension fund, CalPERs, believe investing should change the world for the better. But the managers use the 1.5 million system members’ money for this. Many members might prefer their money be invested to ensure sufficient returns for their retirement.

The tension here involves fiduciary responsibility, meaning a duty to act in investors’ best interests. The Principles for Responsible Investing’s commitment to ESG is supposed to be consistent with fiduciary duties. But fiduciary duties are hazy because returns are realized in the future and necessarily speculative. Managers could also claim halting global warming is in their investors’ best interests.

Another problem is imposing ESG by regulation. Federal regulators may soon require corporations maintain minimum ESG scores or prohibit banks from lending to companies with low ESG scores. Regulators could put disfavored companies – from gun manufacturers to oil and coal companies – out of business. I would strongly oppose such a grievous violation of economic freedom, but if the U.S. were to consider doing so, it should ONLY be through our elected representatives, not unelected bureaucrats.

Pushback against ESG has begun. The Heritage Foundation is launching an initiative against ESG. West Virginia has forbidden its state pension plan from ESG investing. In Florida, Governor DeSantis and legislative leaders have unveiled several reforms for the 2023 session.

The market may rein in ESG investing on its own. Investors not on board with ESG can take their money elsewhere. Vivek Ramaswamy, who criticized ESG investing in his bestselling Woke, Inc., has co-founded a new hedge fund, Strive Asset Management, to depoliticize investing. If major financial institutions do not give their customers what they want, this creates a profit opportunity for others like Mr. Ramaswamy. If ESG is a fad driven by America’s out-of-touch radical elites, markets will remedy the excess if ESG is not imposed via regulatory dictate.