Don’t Buy the ESG Hype

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The United States has exported many ideas to Brazil and the world, some good and some bad. A bad one that is now prevalent is known as corporate ESG, which stands for “environment, social, and governance.” Companies should pay attention to ESG, so the argument goes, because it is good for the bottom line and/or it is the right thing to do. Good governance is a red herring, because everyone cares about that; even greedy shareholders. If being environmentally or socially conscious is profit-maximizing behavior then companies should act that way. No one disputes this. The only interesting case is when acting a particular way trades off one thing, say the environment, for something else, such as profits.

ESG is complicated and alluring, however, because it is based on a simple and profound idea.

ESG started with churches. In the 1970s, several prominent American churches with valuable real estate and investment holdings decided that they should divest from various businesses that were incompatible with their moral mission. So-called sin businesses—gambling, cigarettes, alcohol, pornography—made the list. It is hard to object to investors choosing the kinds of companies they want to support or profit from.

The same goes for customers. Some people may care about the moral values of those who brew their beer or make their clothes. Others may not, preferring to focus on price, quality, or return on investment. Workers may also care about the morality or other attributes of the companies they work for, or just choose the place that offers the best combination of benefits and opportunities.

Just as companies tailor their products and services to meet the needs of customers, so too might they try to satisfy the preferences of the three markets in which all companies compete: for customers, for labor, and for capital or investment.

Zooming out, a corporation is nothing more than a means of enabling many humans to collaborate to accomplish some goal. That goal could be to make money, to save the Amazon rain forest, or anything in between. In the United States, Apple, the New York Times, and the Black Lives Matter organization are all corporations.

In this way, we can see corporations as just one of many ways of collective action. Government is another example. If you want to help solve a social problem of some kind, both are options to do this. For instance, imagine you want to stop clear-cutting in the Amazon. You could pay taxes to the Brazilian government for use in buying up or preserving land. (In the U.S., I can pay taxes to the American government, which can give aid to Brazil for this purpose or take other actions with that end.)

Alternatively, you could choose to shop from/invest in/work for a company that is committed to preserving the rain forest. You might buy pay more for “sustainable” coffee that promises it is grown in ways that preserve wild places. The extra you pay is like a donation to save the rain forest, but instead of trusting government or a non-profit to do that work, you might trust Starbucks instead. Corporations may be better at saving the world in some cases.

Although this is an argument to let companies compete on ESG, there is a big problem. Enter Milton Friedman. He wrote a famous essay for the New York Times Magazine in the 1970s in which he declared that the purpose of the corporation is to maximize shareholder profits, nothing else. His argument is simple: business leaders are not politicians and therefore should not take on political goals. If business leaders focus on making as much money as possible (within the boundaries set by law), then there will be more tax money to spend on political programs. In addition, there will be more jobs and more valuable stuff. Companies should make the pie as big as possible, and then let democracy divide it up.

The logic here is compelling. While in theory one might want to maximize E (environment), S (social), and G (governance), but how should tradeoffs be made by businesses when they conflict? Shutting down a factory in Rio and opening a new one with cleaner technology in Taiwan might be good for the environment but bad for the local society in which the company operates. These kinds of questions are for legislatures, not businesses.

The United States has exported many ideas to Brazil and the world, some good and some bad

Once we admit that businesses should think about a whole panoply of other issues in such vague terms as the environment or social factors, then the pressure to perform well is greatly reduced. Instead of the discipline created by the demands of shareholders interested in the stock price or the annual return on investment, we get a world in which CEOs can excuse poor performance on account of saving the rainforest or serving society.

If the CEO is actually saving the rainforest, then shareholders and others might be fine with the tradeoff (less money for more rainforest), but it is possible, even likely, that the CEO is skimming profits or not working hard or well and using the ESG story as an excuse. We call it “greenwashing,” and academic studies show it is much of ESG. Moreover, a recent study showed that different ESG-rating companies, which we have to rely on to aggregate all the information, come to wildly different conclusions about the same companies. We do not even have good data, let alone fool-proof moral judgments.

This all leaves us in a complicated spot. In theory, corporations allow any group of people to come together to accomplish whatever goal they want. A business might be started on the idea that half of its profits would be given away to charity, and so long as this is clear from the start, no one can or should complain. This corporation-as-a-contract model has always been true. But it is the exceptional case, not the rule for most companies.

The rise of ESG as an overriding philosophy for all businesses, however, is more likely a smokescreen for lazy or greedy managers to justify their own shortcomings or to dupe unsuspecting investors, customers, or workers into thinking they are morally superior. In this sense, Milton Friedman was right—most businesses should stick to business. Democratically elected political leaders can make the tradeoffs.