ESG (Environmental, Social, & Governance) and the Road to Serfdom

by Stuart Loren

In 1944, during the height of the Second World War, the Austrian economist and philosopher Friedrich Hayek published The Road to Serfdom. In this classic and influential work of political and economic philosophy, Hayek mounted what many consider to be the definitive case for and defense of classical liberalism.
 

 
From the libertarian-leaning Mises Institute:
 
“This spell-binding book is a classic in the history of liberal ideas. It was singularly responsible for launching an important debate on the relationship between political and economic freedom… It warned of a new form of despotism enacted in the name of liberation. And though it appeared in 1944, it continues to have a remarkable impact…
 
“What F.A. Hayek saw, and what most all his contemporaries missed, was that every step away from the free market and toward government planning represented a compromise of human freedom generally and a step toward a form of dictatorship–and this is true in all times and places. He demonstrated this against every claim that government control was really only a means of increasing social well-being. Hayek said that government planning would make society less liveable, more brutal, more despotic…
 
“Capitalism, he wrote, is the only system of economics compatible with human dignity, prosperity, and liberty. To the extent we move away from that system, we empower the worst people in society to manage what they do not understand.”
 
Over the course of this article, I hope to make a compelling case for how ESG investing, as currently implemented by large asset managers, is a threat to our free-market, capitalist system and democracy itself. I am not trying to be overly alarmist or sensational here for the purpose of getting attention. I have given these issues deep thought and am concerned about the road the investment community is leading us down and what I see as its final and inescapable destination if we don’t course correct.
 
* * * * *
 
I’m an investor with a contrarian streak. My approach is to figure out where markets may have materially mispriced something and then to take calculated risks that would benefit from catalysts bringing about a return to rationality. Most of the time this is hard because markets are rational and efficient. But as any investor knows, they are also prone to irrational extremes, as well as inefficiencies often driven by technical factors, like liquidity. (See Andrew Lo’s Adaptive Markets for a deeper dive on this.)
 
The reason markets are usually rational and efficient is because the wisdom of the crowd is incorporated in prices. And the crowd is often more accurate and insightful than any one investor – especially over the long-term. That said, the crowd’s collective wisdom sometimes morphs into collective foolishness, especially during periods when seductive narratives and ample liquidity trump fundamentals. (For more on this, see Robert Shiller’s Narrative Economics.)
 
Most bouts of irrationality are harmless and even entertaining (like GameStop and AMC earlier this year), except for those holding when the music stops. Sometimes frenzies result in productive investments though investors end up losing money – such was the case with the investment in fiber optic cables during the 1990s Tech Bubble.
 
But as we all know, market frenzies can sometimes be destructive – especially when the harm reaches beyond the group of involved companies and investors. The aftermath of the 2007-08 US housing/Financial Crisis is the most recent and perhaps most salient example. Widespread financial misjudgments are bad for society, as they result in malinvestment, the destruction of capital and, unconscionably in the past few crises, socialized losses. When this happens, we often get intense public backlash to the market-based system. “Occupy Wall Street.” “Democratic Socialism.” This is unsurprising but unfortunate.
 
Historically, the sensible deployment of capital and socialized gains are trademarks of a functional free-market economy. Promising firms attract investor funds, enabling productive innovations. Yes, in a capitalist system some will succeed more than others, but we all reap the benefits of new products and services.
 
I’d go further and argue that ever since the inception of market-based economies, the human condition has been improving. You can basically trace a chart back of global progress in living conditions, for which I’ll use GDP as a rough proxy, with the beginning of financial market operations in Belgium and Amsterdam in the 16th and 17th centuries.
 

 
Market-based economies excel for many reasons. Three high-level ones worth highlighting:
 
1) Profit is a motivating factor that leads to hard work and innovation. But funding that work used to be arduous and personally risky. Ever heard of debtor’s prison? The advent of the “joint-stock company” enabled start-up risks and potential profits/losses to be spread across a broad investor base, allowing entrepreneurs to raise capital – via freely tradeable shares – for ventures for which they would have otherwise had to assume personal liability or lacked the means to launch. (For a great discussion on this, see The Ascent of Money by Niall Ferguson).
 
2) Decentralization: Capital allocation decisions are decentralized in free-market economies. The wisdom of many investors – motivated by profit and prudence – is usually superior to the subjective decisions of state or central planners. This is central to the thesis of Hayek and history has borne it out over the last 100 years. As the baseball announcer Vin Scully succinctly and memorably stated:
 
3) The market signal: Let’s say a company develops a successful new product or service and gets rewarded by investors. Businesses respond to the positive market signal, iterating and competing. Investors and companies can redeploy profits into further innovations. This create a virtuous cycle of wealth creation, improvements in living standards and economic progress.
 
Again, markets aren’t always right. My wife’s claims to the contrary, no one is. But by rewarding success, decentralizing decisions and enabling the input of the masses, free markets have a track record of producing beneficial results for investors and society over time.
 
My fear is that we are now in the early stages of a detrimental shift: from a dynamic free-market economy to an inefficient, centrally planned one. Where investors’ collective wisdom is being replaced by the imprudent preferences of an elite – and, dare I say, out of touch – few. This brings us to ESG.
 
Let’s start with a seemingly simple question: what would you think makes more sense to overweight in an ESG fund? (A) Well-governed firms whose products provide basic sustenance to billions the world over? Or (B) firms with dual class share structures, whose services are addictive and eroding public discourse and trust in democracies, and whose employees and management have repeatedly recoiled at the idea of working with Western governments? Surprisingly, or maybe not… B wins.
 
In the largest ESG EFT, the iShares ESG Aware MSCI USA ETF (ESGU), Facebook and Alphabet make up about 6% of holdings, while Exxon Mobil and Chevron combine for 1%. Apple is close to another 6% of ESGU despite kowtowing to China’s censors and sourcing products from suppliers with potentially suspect labor practices.
 
In the Vanguard ESG U.S. Stock ETF (ESGV), the total weighting of conventional energy producers is 0%. Likewise in the largest active ESG mutual fund, the $29b Parnassus Core Equity Fund. Similar examples are easy to come by.
 
Let’s be honest. ESG as practiced today is more like EEESG. But who is to say ESG factors should prioritize environmental considerations over all others? How are ESG factors even balanced? Unfortunately, this is not straightforward.
 
Below is part of the ESG evaluation rubric from MSCI, which manages the underlying ESG Index tracked by the iShares ESGU ETF. As a former lawyer, I give these charts and the accompanying document an A for obfuscation.
 

 

 
Unlike GAAP accounting, ESG reporting is not standardized. Despite ongoing efforts from groups like the UN-sponsored Principles for Responsible Investment (PRI), my belief is that in finance, once you move outside the realm of numbers, you quickly move into the realm of qualitative and subjective judgments.
 
I’m not the only one to come to this conclusion. This is what BlackRock’s former CIO for Sustainable Investing – Tariq Fancy – had to say recently in a scathing essay on ESG: “Unfortunately, there’s no clear definition of what [ESG] means — and much of it is believed to be a surface-level, box-ticking compliance activity.”
 
While investing is a serious analytical business, it’s not a hard science where you can quantify things that are subjective by nature. But qualitative judgments are fine. I make them all the time when investing. And if you are choosing to invest in an ESG fund, you are making some qualitative judgment about your priorities. Which is great – you should, it’s your money! One’s personal beliefs should align with their portfolio – you have to be able to sleep well at night.
 
Unlike many allocators, at least the Parnassus fund I mentioned is more transparent about how they screen companies: The fund excludes stocks “that derive 10% or more of their revenue from alcohol, fossil fuels, gambling, nuclear power, tobacco or weapons.” As “Parnassus believes that these companies … don’t provide a net-positive contribution to society.” I disagree about nuclear and fossil fuels, but no one is forcing me or anyone else to invest in their fund. So if no one is forced to invest in ESG funds, why is any of this problematic?
 
Well, for one my suspicion is a lot of money flows into ESG products thanks to their marketing appeal, more than a careful consideration of their actual impact. But again, investors should be free to choose how and what they invest in.
 
Second and far more concerning is the implementation of ESG principles in non-ESG products. Investors managing over $80 trillion in assets have signed up to the Principles for Responsible Investment initiative. This includes BlackRock, Vanguard and State Street, as well as many endowments and pensions.
 
This is seemingly good, and PRI’s aims are noble. But when we have most of the world’s large asset managers pledging to integrate subjective ESG factors into firmwide investment analysis processes, we – as a society – may get some unintended results.
 
The most notable unintended results (though I’m sure some would say intended) are in the commodities and heavy industrials sectors, given the almost universal consensus of ESG adherents that carbon emissions are an unforgiveable sin.
 
At the outset, let’s put aside the question of the fiduciary duty these asset managers have to their clients. Another topic for another day but suffice to say, I’m not sure prioritizing ESG is always consistent with promoting client financial interests. Especially for those invested in non-ESG products.
 
And let’s also put aside questions of whether major ESG proponents actually lead the kind of low carbon lifestyles it would take to make a serious near-term dent in emissions. My hope is that many do, but my guess is that many don’t. The reality is not many people in developed markets are probably that eager to reduce their consumption habits back to 1950s levels, or pay more for services or goods that use less energy. But that’s what it would take to make a meaningful near-term impact.
 
I’m going to highlight BlackRock here because its CEO Larry Fink is the most vocal and impactful large investor on ESG issues, particularly related to climate. In his 2021 letter to the CEO community Fink wrote at length about “climate risk” and accelerating the path to a “net zero economy.”
 
Even if well-intentioned and sensible, though, do we really want a handful of senior management at BlackRock and the world’s largest asset allocators pushing for policy-related changes? Isn’t this the role of government?
 
By virtue of managing tens of trillions of dollars in investor capital, BlackRock and other large PRI signatories have an outsized voice in company affairs. They clearly view environmental risks as a long-term investment risk and are engaging companies accordingly.
 
In Fink’s words again: “Investors are increasingly reckoning with these questions and recognizing that climate risk is investment risk… Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.”
 
Just as a quick aside, I think it’s a faulty hindsight narrative to say that climate risks are investment risks. Energy, industrials and other cyclical firms performed poorly in the last decade not because of their climate attributes. Rather, we were in a low growth, low interest rate environment with oversupplied commodity markets. This type of macro backdrop favors growth and duration over value, cyclicals and near-term cash generators. (See my article from July – The S&P 5(00) – for a bit more detail on this.)
 
And the notion that climate risk equates to investment risk has at least been poor foresight year-to-date. This year, firms with higher carbon profiles have been market leaders and as I’ve covered in prior discussions, I expect their outperformance to continue due to an inflationary macroeconomic regime and demand for commodities outstripping supply. (See my article from September – History 101 – for a deeper dive).
 
I do wonder if ESG will remain so popular if the holdings are green, but the returns are red.
 
Anyways, as the ESG voices like Fink’s have become more prominent and impactful, it’s fair to ask some critical questions.
 
Question: What have we got as a result of the call for curtailing emissions? 
 
Answer: A loud signal to energy and materials industry firms to reign in capital expenditures.
 
Spending on Upstream Oil and Gas Field Development from the IEA’s 2021 World Energy Investment Report
 

 
Select Mined Commodity Capital Expenditures from the Financial Times
 

 
Question: What have we got as a result of large-scale managers either divesting from conventional energy and materials firms or supporting activist board engagement pushing for lower carbon business transformations (as was the case with Engine No. 1’s activist campaign at Exxon)? 
 
Answer: A higher cost of capital for industry operators.
 
Unfortunately, by raising these industries’ cost of capital and decreasing their willingness to invest in new production (Exxon’s new Engine No. 1-supported directors are now pushing to curtail large oil and gas projects), ESG-minded asset managers are indirectly increasing the cost of living for many in society who can least afford it. An “ESG consumption tax” on those least able to pay.
 

 
Yes, I am aware that lower commodity prices and investors pushing for greater capital discipline have contributed to the emerging commodities deficit, but ESG priorities have surely also helped get us here.
 

 
Based on ESG portfolio constructs and asset manager comments/actions, it sure seems like the movement is prioritizing environmental considerations at the expense of societal and governance ones. Yet, who is to say that emissions reductions to benefit future generations are a more important priority than improving the quality of life for current ones? I have a son and care deeply about his future, but I can’t truly put myself in the shoes of someone in poverty.
 
According to the World Bank, 43% of the global population lives on less than $5.50 a day and 9.3% on less than $1.90.
 

 
As reported a few days ago in The Wall Street Journal, 40% of Americans are experiencing financial distress, and 19% of households have lost all savings since the Covid outbreak.
 
Per the World Bank and BP, 13% of the world population (some 940m people) lacks electricity access. As seen in the below charts, the differences in energy and electricity consumption between people living in developed market countries vs emerging market ones are orders of magnitude.
 

 

 

 
Again, who is to say that access to affordable energy and poverty alleviation aren’t basic human rights that also warrant ESG consideration? Is it ideal that ESG priorities have contributed to the rise in daily living costs and a potential future energy shortfall?
 
Both BP and the IEA in their widely followed energy outlook reports predict that even in a rapid clean energy transition scenario, the world will be short on conventional energy supplies if we do not ramp up investment in oil and gas production. Especially over the next decade.

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