How Policymakers Can Defuse a Major ESG Threat to Shareholder Rights

By | June 7, 2021

Since 2004, when the term “ESG” was first used in a report published by the United Nations Global Compact, there has been an explosion of interest in the concept, including in corporate boardrooms.

The Global Compact, in a follow-up report the next year, described the emergence of ESG corporate policies as a “powerful and historic convergence … between the objectives and concerns of the United Nations (U.N.) and those of the private sector.” An entire secondary industry of finance research, ratings, and investment products has now grown up, with several hundred mutual funds and ETFs claiming to have an ESG focus and over $100 trillion in investments managed by firms that have signed on to the U.N.’s Principles for Responsible Investment.

On paper, this seems like a major change in the world of investing and business. But the ESG construct is less serious and more problematic than it appears. Its proponents routinely invoke it without providing a meaningful definition of what it entails, while academics and ratings experts deploy detailed and complex definitions that rarely agree with one another. Despite all this, much mainstream media treatment of the topic suggests that ESG-guided entities represent an “enlightened,” “socially responsible,” or more virtuous way of managing companies and of making money.

A Brief History of ESG

Advocates for ESG-style management tend to present it as something that is new, revolutionary, and novel. Yet, they rarely cite the long history of its antecedent theories, including “corporate social responsibility,” “corporate social performance,” “socially responsible investing,” “stakeholder capitalism,” “shared value creation,” the “triple bottom line,” and “impact investing,” among others. Moreover, the current enthusiasm for ESG relies on a skewed view of business ethics that suggests that corporations routinely engage in immoral and illegal behavior unless they explicitly endorse public declarations to the contrary.

The single most consistent feature in the long history of ESG and its precursor concepts—in both academic literature and industry analysis—is the repeated distress voiced by management, finance, and economics experts at the confusion they engender. Advocates claim that its long history is one of gradual refinement and improvement toward an increasingly better system, but it would be more accurate to say that its various versions have yet to point in any clear direction.

ESG Ambiguities

ESG theory is gaining popularity among policy makers, the news media, and other elite constituencies, if the frequency with which it is invoked and discussed is any indication. Yet, the lack of rigorous agreement on what it actually requires and seeks to accomplish has made its meaning subject to different interpretations by different constituencies. In the rare cases where particular goals and outcomes are specified, those specifics are often either highly controversial, applicable only to a particular set of circumstances, or so obvious as to be conventional wisdom.

Consider some examples. Requiring employers to pay for health insurance that covers contraception and abortion, a controversial premise that became part of the Patient Protection and Affordable Care Act, has already generated a decade of legal challenges. Climate-related goals calling on all firms to work toward reducing greenhouse gas emissions have dramatically different impacts on financial firms compared to manufacturing companies. Divestment strategies for politically disfavored firms, popular for decades, call on investors to eschew holdings in politically incorrect industries like tobacco and weapons manufacturing, but otherwise leave one’s hands free. 

Some provisions are so non-controversial that they rarely change anything in practice. For example, many codes of behavior, like the “Purpose of a Corporation” statement endorsed by the CEO members of the Business Roundtable in 2019, include such pledges as “delivering value to our customers” and “dealing fairly and ethically with our suppliers.” Companies publicly refusing to deliver value to consumers or to deal fairly with suppliers are, understandably, rare.

ESG advocates tend to group disparate—often antagonistic—parties together as if they made for a cohesive movement working toward a specific set of goals. But not only do all the entities that fall under the ESG umbrella not have the same long-term goals in mind, they rarely even agree on the substance of the concept under discussion. In fact, advocates are unable to agree whether ESG theory is consistent with profit-driven capitalism, a more enlightened replacement for it, or the antithesis of it. Nor do they agree on how to measure success.

For instance, a corporate executive who endorses voluntary guidance for public companies can be part of the ESG movement. But so can an anti-corporate activist who sees industry self-policing as dangerously insufficient, and considers it merely the first step toward stricter government regulation. The founder of an organic food company might see a branding and marketing opportunity in adopting ESG goals. A finance executive might see an opportunity to launch new ESG investment products—which might require higher management fees to certify their compliance status. And consultants specializing in “sustainability” will see new opportunities to sell their services.

The Big Business of Voluntary ESG

Most ESG rules are currently voluntary, and call only for disclosure of corporate behavior, rather than prescribing specific actions and outcomes. However, for the practitioners, consultants, and managers employed in the field, implementing ESG theory has become a big business, with lucrative contracts for companies offering ESG-related services and financial professionals selling the concept. The market for ESG data and ratings alone has been forecast to reach $1 billion by 2021. Notably, prominent advocates for non-profit ESG efforts often pursue linked for-profit work. For example, Ryan Honeyman and Tiffany Jana, coauthors of a recent book on ESG-style management and voluntary, non-profit certification, are also proprietors of their own for-profit consulting firms.

However, taking ESG to its logical conclusion does present dangers. That is because the alleged moral necessity of ESG suggests that its requirements should eventually be required by law. If diversity goals, carbon reductions, and “living wage” guarantees are as important as ESG advocates claim, it would be negligent for them not to be made mandatory. Accepting that view, CEOs and other corporate managers who sign a voluntary statement of high-minded principles but balk at expensive implementation efforts will have little moral authority for opposing the eventual burdens.

Not every booster of voluntary ESG guidelines today will support mandatory regulations. Many investors would likely end up worse off under such a regime as the focus on shareholder profits is downgraded. There will be winners, though: activist groups whose goals have been adopted as mandatory, professionals trained to work as ESG compliance officers, government officials writing and enforcing the new rules, and firms that have already arranged their operations to comply with the new requirements.

That big players in finance support the movement in its current, mostly voluntary, iteration does not mean ESG will remain voluntary in nature. Future policymakers will not be limited by the boundaries of the current debate. Once industry standards are set, “sustainability” reporting will likely become an industry norm, and more money will be invested to comply with and promote ESG frameworks.

The inescapable logic of ESG priorities—whereby firms must routinely forswear otherwise legal and profitable business opportunities—will result in “virtuous” companies having potential profits poached by “rogue” non-ESG compliant rivals. That, in turn, will fuel calls to make ESG principles binding. If all of the firms in a particular industry or all of the players in a market are equally burdened by ESG compliance, those requirements simply get priced into the cost of doing business. But when a rival firm is able to cut its costs significantly by not joining a voluntary operational framework, that puts a painful burden on the backs of those firms that have agreed to attain the ESG goals in question. Lobbying for mandatory regulation on ESG issues thus becomes both an offensive and defensive strategy, for individual firms and for entire industries.

The natural logic of most ESG demands is not to attain an objective standard of good behavior but to adopt a compliance metric that grows increasingly more strict—and expensive—over time. A company that proudly announces a modest 3 percent reduction of its carbon footprint in its first year will be subsequently greeted with demands for increasingly expensive reductions of, say, 5 percent, 8 percent, and 15 percent in future years, or risk being labeled a climate criminal. This ratchet effect comes with increasing marginal costs that could quickly dissipate a firm’s initial reputational advantages. Prominent proposals for increasing government oversight over ESG goals also include legal changes that would radically curtail long-established property and due process rights.

Pushing Back

There may be a way to head this off at the pass. Corporate governance law in the United States calls for boards of directors to manage their companies to maximize returns for shareholders. That has prompted some pro-ESG investors, directors, and founders to say that they need changes to the law, so shareholders cannot litigate corporate decisions to spend money on things like diversity and environmental advocacy rather than on increasing dividends. Normally, this would lead activists to demand more law and regulation to enforce an ESG-style framework, and most shareholders to oppose them via lobbying and advocacy expenditures.

The same goals should be available, however, with none of the threat to existing shareholder rights, through the alternate legal framework of the “benefit corporation” and private certification. The option of incorporating a new company, or reincorporating an existing one, as a benefit corporation is currently available in 35 U.S. states—including corporate-chartering favorite Delaware—and the District of Columbia and Puerto Rico, and internationally in Italy and Colombia.

The benefit corporation designation—or “public-benefit” corporation, as it is known in some jurisdictions—calls for company directors to “take the interests of a broad range of stakeholders into account, eliminating the concept of shareholder primacy,” according to corporate law expert Frederick Alexander. This eliminates the threat of shareholders of a benefit corporation suing its management for using the firm’s resources to pursue goals that benefit other stakeholders, thus giving CEOs and directors the green light to shift resources away from maximizing profits and toward other ESG-related goals.

In addition, or as an alternative to legally incorporating as a benefit corporation, companies can pursue private certification attesting to their compliance with ESG standards. The most popular current standard is administered by the non-profit group B Lab, which designates companies that meet its requirements as “Certified B Corps.” Companies that wish to attain this certification must complete a detailed questionnaire on corporate operations and management and subject themselves to auditing of their responses by B Lab. Companies that display a high enough score on B Lab’s assessment tool are invited into the “B Corp community” and allowed to display a registered trademark on their packaging and in advertising materials, among other benefits.

Existing ESG ratings by industry analysts, though flawed in some ways, could also develop to provide more detailed and reliable reputational signals for ESG-motivated investors. That evolution, however, will likely only take place if standards for disclosure and corporate policy remain voluntary and driven by market forces rather than government mandate. 

Richard Morrison is a research fellow at the Competitive Enterprise Institute. 

This post is adapted from his paper, “Environmental, Social, and Governance Theory: Defusing a Major Threat to Shareholder Rights”, available on SSRN. Study published by the Competitive Enterprise Institute in May 2021.

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