Poor ‘G’ renders the ‘E’ and ‘S’ moot

Op-ed views and opinions expressed are solely those of the author.

In the investment world, ESG (environment, social justice, governance) ratings remain the rage. Former President Clinton, at the recent Clinton Global Initiative meeting, celebrated the ascendance of ESG investing, and the concomitant rise of the old stakeholder theory of corporate governance. Clinton and other ESG cheerleaders fail to understand that any corporation that puts the interests of stakeholders (E and S) above those of stockholders ought to receive a zero G rating.

Think of ESG ratings as social credit scores for corporations along three main axes, their impacts on the environment and society and the quality of their internal governance. Like bond ratings, however, high ESG ratings may not correspond to reality. Skeptics wonder if the ratings, which remain numerous and heterogeneous according to an OECD report, match objective reality or if they only generate extra fees for ESG fund managers and ESG rating companies. The ratings also may simply favor corporations better at virtue signaling than those that actually improve the environment, social justice, or governance, which are all complex, multifaceted subjects little understood and difficult to measure.

Renewable energy, for example, relies on batteries made from rare earth metals acquired only through massive environmental destruction, wind turbines that kill millions of birds annually and that wear out quickly, already filling up landfills, and biofuels made from trees, among other environmentally dodgy practices. 

Similarly, social justice gains for some may impose injustices on others, and illegally at that. How can ESG rating companies possibly understand and quantify such social nuances?

Governance is also fraught because normative (ought) claims often trump positive (verifiable descriptive) propositions. Normative-based governance reforms that hurt corporate profits constitute a nefarious tax on the suppliers of capital and hence will prove unsustainable in the long run.

Separating the effects of governance changes on corporate profitability is no easy task due to statistical noise, changes in macroeconomic conditions, and industry-specific dynamics. Many optimal governance practices certainly vary over time, location, and industry.

That is why specific governance practices are best left to corporations to figure out themselves, subject only to general rules designed to ensure that corporate executives and boards do their utmost to increase profits. Ultimately, that means putting the interests of stockholders, the residual claimants on corporate value, above those of a diffuse group of stakeholders, a nebulous term for various groups that have not placed any of their wealth at risk to finance the corporation. 

Corporate activist “gadflies” like Wilma Soss (1900-1987), the Gilbert brothers, and Evelyn Y. Davis, the subjects of the recent book Fearless: Wilma Soss and America’s Forgotten Investor Movement insisted on the stockholder view of G to the point that they referred to themselves as shareowners. Backed by her nonprofit Federation of Women Shareholders in American Business (FOWSAB) and a successful PR career, Soss from the 1940s through the 1980s pressured major corporations, like US Steel, IBM, and GM, to institute more checks against arbitrary executive and board power. Powerful economists, like Milton Friedman, agreed with the gadflies that corporations do the most good when they focus on profits, not broader environmental or social concerns. 

Stockholder primacy is not a new concept but rather surfaced in the United States in the eighteenth century when stakeholders first attempted to direct stockholder wealth to themselves. The development of nonprofit corporations foiled the attempt. Unfortunately long since forgotten, the basic compromise reached in the Founding era was that “moneyed” corporations should be free to pursue profits while people interested in social goals should be free to form eleemosynary corporations that aided escaped slaves, orphans, the poor, the sick, and so forth.

That compromise helped to slow the growth of America’s governments by relegating many social problems to the Third, nonprofit, voluntary sector. From the beginning, however, governments jealously chipped away at the Third sector, rightly seeing it as a rival base of power. Over the centuries, it usurped some services traditionally provided by nonprofits and co-opted others by bankrolling them. Today, America’s nonprofit sector remains large and dynamic relative to those of other countries but is a far cry shy of what it could have become.

Now the government wants to co-opt the for-profit sector too by means of ESG ratings and a few mammoth investment funds. Even if most American stockholders oppose the actions of Woke or Green corporations, there is little they can do about it, especially if invested through an intermediary institution like a mutual fund. The Securities and Exchange Commission also recently made it more costly for individual investors to submit proxy resolutions like Soss and the other gadflies once did, often to good effect.

How is it good governance to concentrate trillions of dollars of financial power in the hands of a few people while ignoring the wishes, and even the financial interests, of stockholders? It’s not, and that is an inherent contradiction in the emerging ESG system that must be addressed lest investors wise up and start to vote with their feet out of the entire ESG edifice.

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Robert E. Wright
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