Tuesday, January 9, 2024

Is woke capitalism actually good for capitalism?

ESG is a bad word in finance now. It stands for Environmental, Social and Governance, essentially a fancier word to say "sustainability." It was once a really good word, and was very popular. 

The movement to bake accountability into business decisions stretches back centuries; the term ESG gained momentum after the United Nations used it about 20 years ago. Over time, the effort became divisive—derided by some state officials as “woke capitalism,” and criticized by others for putting too much focus on measurement and disclosure requirements.

There are basically two theories behind why a company should "do ESG," and they build on each other. Theory one is that you should pursue saving the environment at all costs because saving the environment is more important than making money. Theory one is more or less illegal, unless your company is registered as a public benefit corporation or some other type of organization that allows you to pursue goals other than maximizing shareholder value. Theory two is that your company should do ESG because it is important for the business to grow in the future and that actually, doing ESG will maximize shareholder value more because saving the environment and whatever is actually better for making money. 

Theory 2 is mildly compelling in some cases. You might be able make an argument, for example, that saving the environment is good for your business because if the environment is ruined, your environment-dependent business won't be able to make more money. You could make another argument that a program to hire new analysts from disadvantaged backgrounds is good because diversity creates more high performing teams that will make your company more money.  You have to essentially argue that doing some good thing will lead to making more money. 

Theory 2 seems really good, and Blackrock 1, which has almost $9 trillion in assets under management 2, even adopted ESG for many of their funds3. It is also related to "stakeholder capitalism," this idea that businesses should account for more than just their shareholders when making decisions, and that this will lead to better financial outcomes. Recently, because of all the backlash, Blackrock said they stopped requiring ESG metrics be used by fund managers for non-ESG funds. You might imagine that a firm that controls a huge amount of value would be interested in the future being better, because that would mean they can continue making money. If your firm which sells investment funds which promise to make a return for many years to come knows for a fact the world is completely doomed, it becomes much harder to convince investors to buy your funds. 

ESG is also weird, since "helping people," "saving the environment," and "good governance" are quite squishy targets that can be molded however one would like. This leads to funny things, like oil and tobacco firms scoring higher on ESG metrics than Tesla

The main reason that ESG is a bad word is really because Republican politicians are trying to crack down on wokeness, which they see as bad, because it suits their narrative. If you are a firm that sells investment funds, this is bad. The pension funds and other investing bodies governed by states are some of your most important customers, so when they want something, you have to listen. Woke companies don't care about the common man, etc. This has led to companies saying the words ESG much less when they are on earnings calls.

But it actually so happens that sometimes doing ESG is actually good. 

Revathi Advaithi, CEO of Flex, said the manufacturer has 130 factories across the world and there isn’t a question of whether they need to operate in a sustainable way.

“It’s not as though I got a whole bunch of new investors because we had a sustainability report or we were ESG-focused,” she said. “We didn’t do it for that purpose…. We wanted to focus on water reduction, power reduction, all those things. So I don’t view it as, hey, it’s a trend that came today and it’s gonna go off tomorrow.”

Also, the funny thing is that Republicans have been making their target very clear: "ESG." Renaming everything to "sustainability" seems to get around scrutiny. 

Some of the changes leaders are making are subtle. At Coca-Cola, the company published a “Business & ESG” report in 2022; in 2023, it was released as the “Business and Sustainability” report. The beverage giant also renamed committees on its board of directors.

Some of it seems like regular old anti-woke stuff. Consumers' Research4, an "educational nonprofit" which is just a regular old anti-woke outfit, published a website about Larry Fink (head of BlackRock) called whoislarryfink.com which features things like "Larry Fink believes that companies need to do more to address social issues, calling for an increase in corporate action on issues like the environment and racial inequality."

Whether or not ESG actually is good for business is still unclear. One problem with ESG is that a lot of ESG things are much more expensive now. If stuff like solar panels or wind energy is making much less money, then it is harder to use those easy "ESG" investments in order to make an ESG fund. ESG was born in a low interest era — now, with rates much higher 5, investment into capital expenditure heavy clean energy is much more expensive. The pandemic breaking supply chains has made renewables more expensive worldwide, made worse by protectionist policymaking. 

Research on ESG is not so compelling, either. HBR:

To begin with, ESG funds certainly perform poorly in financial terms. In a recent Journal of Finance paper, University of Chicago researchers analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings. Although the highest rated funds in terms of sustainability certainly attracted more capital than the lowest rated funds, none of the high sustainability funds outperformed any of the lowest rated funds.

Well, fortunately we can just go back to theory one from earlier here, that some cut financially might be worth saving the environment. The author also points out that ESG funds don't actually improve portfolio ESG companies' ESG standings, and that companies in ESG funds are not necessarily better than those outside for labor and the environment. The author highlights a problem with ESG. A good manager, he says, automatically accounts for the ESG things, and as a result maximizes shareholder value, making ESG redundant as a fund strategy.

I am a bit of ESG hater, admittedly. Not because ESG is too woke for me or something, but because it seems unclear to me that doing ESG is actually good for the environment or for social outcomes. Maybe saving the environment isn't good for individual businesses, and that is okay. 

1 BlackRock is an "asset manager," of which they are the largest. They buy assets of all types, like stocks, bonds, other securities. They are different from Blackstone, which is the largest alternative asset manager (read "private equity") and invest in things like full companies (often through leveraged buyouts), commercial real estate, and other things.
2 Assets under management (AUM) is the market value of the investments managed by a person or entity on behalf of clients. AUM is used in conjunction with management performance and management experience when evaluating a company. Investopedia
3 There are generally two kinds of funds. Exchange traded funds track some kind of underlying index, like the S&P 500, and have no actual selection underlying them. Mutual funds theoretically offer active management and better than average returns. 
4 Consumers' Research sounds a lot like Consumer Reports, a different but related organization. Consumer Reports was founded by several staffers from Consumers' Research who were fired when they tried to unionize. The founder of Consumers' Research called them communists and here we are now.
5 Higher rates mean higher costs for capital projects because debt is now more expensive. More expensive debt leads to a higher cost of capital making it harder to justify projects with lower returns.