Advocates of ESG intend it as a force for economic and social good. Instead, it has brought nothing but controversy.
ESG—short-hand for environmental, social, and governance—is intended to reorient capital and governance around stakeholder welfare, away from its traditional primary focus on shareholder value.
ESG suffers at its core from three main problems: It brings uncertain benefits, at uncertain cost, with no clear identification of who will pay for it.
First, the promise. Advocates pitch ESG as a more inclusive form of capitalism, one where companies consider the needs of all stakeholders in the planning process—employees, customers, suppliers, and society at large—and not just shareholders. While shareholder returns continue to be important, they are pursued through a framework that also addresses societal and environmental concerns.
Doing so, however, is costly. Companies cannot improve upon what they are already doing unless they invest significant sums of money. In the long run, ESG advocates expect the returns from these investments to outweigh any cost, leading to profits that are larger, more sustainable, and more equitably distributed across stakeholders.
Many large companies have publicly embraced ESG, in one form or another. Either they believe in the promise, or they enjoy the reputational advantages of publicly claiming to do so by “virtue signaling.”
COVERAGE: ESG Investments: Prudent or Perilously Political?
But are these promises being realized? This is much less certain. The research is coming in piecemeal. What we know so far is that companies that embrace ESG are not necessarily more profitable. They also do not appear to perform better along environmental, social, and other stakeholder metrics, despite a commitment to doing so. And their stocks do not appear to outperform, with some evidence they underperform.
This should not be entirely surprising. If ESG actually delivers such large benefits, you would have to wonder why capitalistic companies did not embrace it sooner. It would call into question the governance system we have had in place in the United States over the last century—one that has created trillions of dollars in wealth and millions of high-quality, safe jobs across all states and educational levels. It is worth noting that a very long list of organizations (e.g., auditors, consulting firms, ESG rating companies) stand to benefit financially from widespread adoption of ESG without regard to its impact.
At the same time, the challenges of ESG are becoming more evident. Most CEOs and CFOs do not subscribe to the belief that ESG brings long-term gains despite near-term costs. They are most likely to say its costs will never be fully recovered. General Counsel express significant concern about the legal and regulatory risk of ESG activities.
While investors seem to be generally supportive, they are not uniformly so. Younger and wealthier investors claim to be largely in favor of ESG and willing to forfeit substantial personal wealth to advance it. The most vulnerable members of society—older investors and those with low retirement savings—are not willing to give up anything. Stated differently, these groups are not willing to pay the cost of ESG.
Institutional investors, who are compensated based on the returns they earn relative to benchmarks, are also not willing to give up returns to finance ESG. In a recent study of “green bonds” used to finance environmental projects, researchers find that institutional investors are only willing to forfeit one one-hundredth of a percent in yield to buy a green bond over an identical bond not used for environmental financing.
At the same time, ESG has become highly politicized. Those on one side of the aisle are doubling down that ESG is critical from a societal perspective. Those on the other are equally adamant that the benefits are too uncertain and the costs too high to bear.
The only way to resolve the controversy is to have a clear accounting of ESG. What specifically are the benefits that ESG is intended to achieve, and how much will they cost? Then, we need agreement over who is going to pay for it. Will it be shareholders through lower returns? Workers through lower employment compensation? Or customers through higher purchasing costs? A measurement system will need to be put in place to track whether objectives are being met.
Until we try to actually measure the true costs and benefits of ESG, in cold hard dollars, the division will only grow. Otherwise, it might just come down to a shouting match where those with the louder voices, and political control, win.
• David Larcker is a Distinguished Visiting Fellow at the Hoover Institution, and the James Irvin Miller Professor of Accounting, Emeritus, and director of the Corporate Governance Research Initiative at the Stanford Graduate School of Business. Amit Seru is The Steven and Roberta Denning Professor of Finance at Stanford Graduate School of Business, a senior fellow at the Hoover Institution and Stanford Institute for Economic Policy Research (SIEPR), and a research associate at the National Bureau of Economic Research (NBER). Brian Tayan is a Senior Researcher at the Corporate Governance Initiative at Stanford Graduate School of Business. Together, the coauthors on a survey that Stanford GSB and Hoover did middle of last year (referenced in here).