by Rupert Darwall
In the third of his four part review of Terrence Keeley’s Sustainable, Rupert Darwall writes that ESG rests on a vision of the free-market economy that says capitalism needs to be led by people with the right values, which raises the question: Whose values? This makes ESG inherently divisive, explaining the pushback ESG is now generating in red states. Keeley proposes a solution in keeping with the pluralism and diversity of modern America.
Sustainability is an open-ended concept capable of many diverse interpretations involving multiple conflicting trade-offs and real costs. Moreover, the goal of securing inclusive, sustainable growth contains a second duality: that of harmony between society and nature, on the one hand, and promoting harmony within society, on the other, the latter to address what Keeley calls our second systemic vulnerability—“growing income inequality and its corrosive impact on social cohesion.” This raises the question: Who decides? Keeley quotes Bono: “Capitalism isn’t immoral: it’s amoral. It’s a wild beast that needs to be led.”
ESG provides answers about who decides and who leads. In Keeley’s telling, the most powerful people in investing are those who curate stock and bond indices—companies such as MSCI, S&P Dow Jones, and Bloomberg. They decide what goes in and what comes out of an index, thereby skewing performance measurement. But reading Sustainable suggests a slight modification. According to Harvard Business School professor George Serafeim, a coauthor of the study cited earlier, the only way for companies to outperform will be for them to make material ESG issues central to their strategy. “If companies are bold and strategic with their ESG activities, they will be rewarded,” Serafeim claims. What counts as ESG? In a chapter titled “Hardwiring Corporate Goodness,” Keeley writes that “recognized and universally followed” standard setters like the Sustainable Accounting Standards Board (SASB) and Taskforce on Climate-related Financial Disclosures (TCFD)
must continue to identify and set the right objectives for which corporations must strive to achieve. If they prioritize the wrong material risks or set the wrong methodologies for measuring them, their essential role in directing corporations to make further progress on a range of socially desirable objectives, including the UN’s Sustainable Development Goals, will be compromised.
Until its merger last year with the International Integrated Reporting Council, the SASB’s largest funder was Bloomberg Philanthropies. In 2014, Michael Bloomberg was appointed SASB chair and, a year later, founded and then chaired the TCFD. Whereas other index providers like MSCI and S&P Global also provide ESG ratings, Bloomberg scores the trifecta of influencing ESG standard setting as well.
In contrast to traditional financial disclosures, which pertain to cash flows, financial liabilities, and monetizable assets, the motivation for ESG disclosures principally involves normative values and attaining wider societal objectives. (ESG standards are sometimes justified on the grounds of firms disclosing risks likely to affect stock prices, but the evidence suggests that this is a smoke screen. Welcoming the SEC’s March 2021 proposed rule on climate financial risk disclosure, Michael Bloomberg said that its adoption would “accelerate the transition to clean energy and net-zero emissions.”)
Two observations can be made. The first concerns differing visions of the economic process in a market economy. Whereas Bono sees capitalism as needing to be directed and Keeley writes of ESG as an effort to recalibrate the corporate world into “a more benevolent force,” the author of The Wealth of Nations famously wrote that it was not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner “but from regard to their own self-interest.” In Capitalism, Socialism, and Democracy, Joseph Schumpeter took Adam Smith’s insight into the era of the Industrial Revolution when he argued that the hunt for profits propelled the stream of inventions that characterizes it.
In his 2004 book, David Henderson also made the distinction between the motivation of individual businesses and the aggregate outcome of their activities. The immense improvements in people’s material welfare do not depend on a conscious attempt by business leaders to make the world a better place. “The advances that capitalism has brought about did not arise from the resolve of business leaders to make them possible, but from the operation of competitive market economies,” Henderson wrote. Keeley comes close to this when he writes that the most important business of business “is and will always remain the promotion of enduring prosperity, not the single-minded pursuit of cleaner air or enhanced economic mobility.”
The emphasis on ESG, linking executive remuneration to ESG objectives rather than to long-run value generation, along with the belief that ESG ratings drive stock prices (which they do, in the short term)—when trillions of investment dollars are chasing limited ESG investment strategies—risks displacing investor analysis of the factors that maintain and sustain the viability of a company’s business model and distracts management from giving attention to continually investing in a company’s intangible capital to sustain its long-term profitability. The vibrancy of capitalism depends on companies competing against one another to innovate new products, services, and processes. Capitalism’s continued legitimacy depends on sustaining its capacity to keep raising people’s material well-being—what Keeley rightly calls “the most important business of business.” Rather than in some way redeeming capitalism, ESG threatens the ability of free-market capitalism to deliver this good and thereby imperils its survival in anything like its current form.
The second observation relates to politics. Values are inherently subjective. In the opinion of Karl Popper, an open society is based on the idea of not merely tolerating dissenting opinions but respecting them. Respect does not require agreement, but it does mean that when collective action is required that elevates one set of values and priorities over others, it is legitimized via the mechanism of representative democracy and the ballot box. ESG dispenses with that, short-circuiting the democratic process and popular sovereignty.
This is not an abstract or a theoretical concern; as Keeley observes, getting to net-zero carbon emissions—something that BlackRock currently demands of its investee companies—requires the behaviors of every human to change. The energy transition has a direct and deleterious impact on the livelihoods of hundreds of thousands of people working in the energy sector. Keeley cites an estimate by the International Renewable Energy Agency that a shift to renewable energy could create three times more jobs than it destroys. The International Labour Organization reckons that the energy transition would eliminate 6 million jobs and create 24 million new ones. These estimates imply labor productivity declines of 75%–66%. This is not how economies grow.
In addition to their poor labor productivity, wind and solar suffer from steep curves of output value destruction. Their output is uncorrelated with demand, so when the weather is favorable, they all produce and the value of their output falls. Wholesale electricity prices—affecting generating technologies that did not cause the problem of market oversupply—can even go negative. Despite huge subsidies—federal, state, and hidden noncash subsidies from the rest of the grid—wind and solar employees cannot escape the inferior economics of renewable energy. Last year, average annual wages for workers in the oil and gas extraction sector, at $100,007, were very nearly double those of a solar PV panel installer ($50,710) and 70% more than for wind turbine technicians ($58,580). By threatening to eliminate high-paying blue-collar jobs and advancing an agenda that many communities oppose, ESG deepens divisions in a politically polarized nation without earning the democratic legitimacy of winning elections. ESG’s twin goals of sustainable growth and inclusive growth are not only in conflict; ESG is a force deepening the political division of America.
Keeley’s deconstruction of ESG proceeds almost subliminally as a counterpoint to his praise. “ESG has been an unqualified force for good,” he says, but 131 pages earlier, he suggested that it’s too late for marital counseling to save ESG: “In the interests of all sides, it may be best for ‘E,’ ‘S,’ and ‘G’ to divorce.” Rather than “doing well by doing good,” as ESG promises, the logic of Keeley’s case is that investors in conventional ESG products are likely to end up not doing very well and feeling good, rather than doing good. The weight of ESG money has propelled highly rated ESG stocks pushed to unsustainable valuations. “Profits must eventually justify inflated price-earnings (PE) multiples, or those inflated multiples must come down,” he argues. “This is simple financial physics.”
Rather than loading up on already-expensive stocks with high ESG scores, investors should seek out less highly rated ones that are likely to improve their ESG ratings. “Financially, it will always be preferable to own companies before they adopt best practices,” Keeley points out. On the “doing good” part of the ESG dual mandate, Keeley shows that ESG strategies that exclude carbon-intensive stocks don’t result in lower emissions. All investors are doing is buying a bit of carbon accounting with no real-world impacts. “What should be targeted instead is additionality—that is to say, improvements that wouldn’t have occurred but for specific investments.”
When investing to do good, impacts should be knowable rather than presumed. “When one knows that an ethical or values-based decision may create negative tracking error, every effort must be made to ensure potentially foregone income is compensated for by attaining one’s other desired goals,” Keeley argues. Investors should be aware of what their non-risk/return objectives are costing them in order to ensure that society gains at least as much positive impact as the investor’s sacrifice of financial return. “Verifiable impact is the sine qua non of all impact investing,” according to Keeley.
Keeley’s logic leads ineluctably to the dissolution of ESG’s dual mandate into two separate ones. As an investment advisor of 40 years standing, Keeley says that he does not believe that every investment should include measurable impact as a determinant factor. His “solution”—like Henderson, he uses quotation marks, and explains that a unidimensional, comprehensive solution to humanity’s environmental, social, and economic challenges does not exist—involves partitioning risk/return optimized investments in one portfolio and impact investments in another. Here we arrive at Keeley’s formal dissolution of the ESG dual mandate and, with it, justification for ESG index products and ESG exclusionary strategies. Instead, focused investment motives reign supreme.
Keeley sizes the impact portfolio on there being an annual investment requirement of $3.5 trillion, made up of $2.5 trillion a year to fund the UN’s 2030 agenda for sustainable development and $1 trillion a year estimated by the BlackRock Investment Institute to finance additional energy-transition investments. This works out at 1.6% of over $220 trillion of financial assets under the direct control of ultra-high-net-worth individuals and global institutions, an annual allocation which runs for 10 years, which Keeley dubs his 1.6% solution.
Doubtless there will be questions about the willingness and the ability of these institutions—Keeley does not examine the implications for fiduciaries and their exclusive duty of exclusive loyalty to beneficiaries—to apportion assets to the 1.6% impact pocket, but those questions also arise with respect to any assets invested in ESG products. On the deployment side, the BlackRock Investment Institute’s estimate of $1 trillion a year to finance wind and solar projects in developing economies rests on a widespread misconception about the fundamental economics of renewable energy.
Wind and solar are inferior, inadequate, and partial substitutes for hydrocarbon-derived energy. Widespread deployment of wind and solar in Western nations depends on massive, recurring subsidies from consumers, the model used in much of Europe, or a mix of government subsidies and portfolio standards, as in the United States. The Congressional Budget Office estimates that the Inflation Reduction Act will cost taxpayers $161 billion with respect to new clean energy-tax credits over the next 10 years while Credit Suisse reckons that federal climate spending over this decade will run at $66 billion annually. This is money that goes out and doesn’t come back.
Furthermore, developed nations have mature, often overengineered, grids that are connected to nuclear, coal-fired, and gas-fired power stations. The essentially parasitic relationship between, on the one hand, existing grid infrastructure, power generators, and customers, and, on the other hand, renewable energy explains the attractive returns available to wind and solar investors when the underlying economics are not attractive. Because those investors are shielded from the worsening grid economics their investments cause, they have no financial interest in learning about this exploitative relationship. We are still in the emperor’s-new-clothes stage of renewable energy, even though the facts are plain.
This has major implications for the composition of the $1 trillion in annual funding. Rather than being a financing flow of private-sector debt plus about $100 billion of government and development bank de-risking finance, it needs to be a 100% outright resource transfer, with no expectation that it will be paid back. Even then, developing countries will be worse off than if they had been allowed to pursue a conventional power-generation pathway due to the inherent shortcomings of weather-dependent power generation. Burdening developing economies with trillions of dollars of new debt to finance low- or negative-return renewable assets is the very last thing they need.
Whatever objections there might be to Keeley’s numbers, 1.6% is a solution—no quotation marks required—to the contradictions of ESG. It recognizes that the ESG dual mandate does not and cannot operate as advertised. It materially reduces the threat to financial stability posed by inflated ESG valuations. It replaces ESG ratings with granular impact analysis of individual investments. By unbundling the ESG conglomerate, it better reflects the pluralism of modern America and the diversity of its values and economic interests.
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Rupert Darwall is a senior fellow at RealClearFoundation, researching issues from international climate agreements to the integration of environmental, social, and governance (ESG) goals in corporate governance. He has also written extensively for publications on both sides of the Atlantic, including The Spectator, Wall Street Journal, National Review, and Daily Telegraph.
