The evidence against claims related to “woke” capitalism is thin. Both sides of the ESG debate make valid points while being simultaneously guilty of overstating their case relative to the observed data. I present an agenda for inquiry that can hopefully further the debate to add value to companies and society.
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I often get asked about the ESG backlash that has been raging over the past month or so. The Economist recently declared that “ESG” amounts to “three letters that won’t save the planet. I believe their call for a singular focus only on emissions is somewhat limiting. Michael Kahn, the Chief Economist of National Conference on Public Employee Retirement Systems (NCPERS) was kind enough to invite me to give a keynote on ESG investing. I jumped on that opportunity to critically examine the objections against “woke” capitalism (part 1), highlight a few of my own questions about ESG (part 2 next week) and suggest an agenda of inquiry to move forward and make progress and if nothing to understand the world a bit better (part 3, a fortnight from now). Here are my thoughts. Feedback welcome as always.
Let’s begin by defining the term “woke capitalism.” Vivek Ramaswamy, who wrote the book Woke Inc., suggests that woke capitalism reflects the invasion of capitalism into the sphere of life properly reserved for the democratic process.
1.0 Criticism of “woke” capitalism and ESG in general
Claim 1: CEOs take leftist positions on social issues
“The largest corporations are now weighing in on almost every major (and not-so-major) public policy issue. The problem: they increasingly land on the “leftist” side of the issue.” (Heritage Foundation)
Let us start with assumption that CEOs are not irrational. Why then do they weigh in almost every major public policy issue and end up increasingly on the left of that issue? In my experience, CEOs are not very good at commenting on social policy issues. They do so to address pressure especially from their employees to take a stand on political issues. If the conservatives want to pin the blame on someone, look at employees.
As is well known, large sections of American manufacturing have been outsourced to Asia. Our iconic companies are increasingly left with smart white-collar employees who are often highly educated. Highly educated employees, on average, tend to have center-of-left views. The other explanation, of course, relates to the customer base. If taking a leftish stand on a social issue pleases a significant section of your customer base, why would a CEO hesitate? Isn’t that simply good business? Having said that, my Columbia Business School colleague Vanessa Burbano and her co-authors have found there is evidence to suggest that not all employees appreciate CEOs taking political stands, or even leftish stands for that matter.
Let’s not forget the role of the board of directors whose fiduciary duty is the corporation and its shareholders. If the CEO is getting away with value-destroying Woke initiatives, then this is an indictment of the board’s oversight function. On top of that, evidence suggests that most boards in corporate America are predominantly Republican anyway.
Ultimately, this is a matter best left to the individual CEO and her employees. If taking such a stand were consistently value-decreasing for the firm, I suspect, such activity will eventually die out by itself. I have almost never come across solid evidence to suggest that U.S. CEOs, on average, destroy shareholder value via what look like pro-social actions.
Claim 2: This will lead to corporatism
“There will be an evolution of capitalism or a devolution backwards to something like corporatism. Corporatism, by the way, is a system that would have business, government, and unions all sharing in the decision-making duties.” (Charles Payne, Fox Business)
One way to assess the claim is to look at the data of a region where the word “corporatism” is used quite often: Europe. Is it a coincidence that we have not seen a European equivalent of a Google, Amazon, Tesla or other world-beating new companies over the last three decades or so? It takes 34 more years to knock out a firm from the German DAX 30 compared to the DOW 30, a proxy for how dynamic the process of creative destruction is in the U.S. relative to Germany. A while back I wrote a paper comparing the “ESG” and valuation records of the top 50 companies in four European stock markets (U.K., France, Netherlands, Germany) with closely matched U.S. counterparts. The evidence shows a valuation discount in the Tobin’s Q of continental European firms (not the U.K., notably) relative to matched U.S. firms. The valuation discount is correlated with the presence of large block holders in European firms but not with the poorer disclosure record of U.S. firms on the environmental (“E”) and social (“S”) dimensions. In sum, poorer governance (“G”) in continental Europe appears to destroy more shareholder value than better “E” and “S” disclosure can add.
Governance, or “G,” which gets the least attention in this political toing and froing, can be highly accretive to firm value provided institutional and legal arrangements favor diffuse shareholders as opposed to block holders. Governance in the United Kingdom, for historical reasons, has favored the interests and rights of diffuse investors which in turn leads to higher liquidity and greater firm valuations.
Claim 3: Shareholder capital is diverted to causes shareholders and employees never intended to support
“If you’re a shareholder of a corporation, you literally own the company and it’s your property in the form of capital. That capital is now being diverted to causes and purposes that you never intended to support, but it’s all because of this Great Reset that there are people that believe so much about how things should be done, that they’re using your money to advance their own initiatives.” (Andy Olivastro, Heritage Foundation)
“I really do wonder how many of these employees at these companies are really, really excited about the fact that a corporation is giving to a Black Lives Matter or some sort of Soros-funded organization, which they are giving to.” (Tim Doescher, Heritage Foundation)
The response to this claim is similar to that of claim # 1. If employees, customers and shareholders materially disapproved of CEO behavior, valuation discounts in such stocks would open up. I am not aware of evidence that such a discount has been observed.
Claim 4: This is a conspiracy cooked up by the Davos crowd
“Neo-Malthusian Luddites who think that population control and climate change are these initiatives that have to be undertaken at the behest of everybody and they’re just using their brands to do it, or they’re flying over in their corporate jets to Davos and having conversations that have no relevancy to elevating the middle-class around the world or creating more opportunity for people in America, which American multinational corporations should be focused on.” (Andy Olivastro, Heritage Foundation)
I agree that the “neo-Malthusian” sentiment about population and perhaps climate change seems to radically discount the role of technology. How do I know? I am from India, which Malthus had predicted would implode because of a population explosion. We have managed to survive, even thrive, thanks to the green revolution that radically improved crop yields to feed a population of around 1.3 billion. Will something similar occur to address climate change? I am reasonably optimistic we will see breakthrough technology in addressing the climate problem. This is not to diminish the climate challenge, which is daunting to say the least. Some of my friends on the political right tell me that I am confusing climate change with weather change when I point to 121-degree Fahrenheit days in Delhi or 100-degree Fahrenheit days in Florence. I tell them to ask the long-time residents whether their housing, sometimes built in the 18th century to suit the weather at that time, is able to sustain the new normal highs today.
The second objection mentioned here is valid as well. Who does the consulting and bureaucratic class that supposedly speaks for the underdog who is not at the table really work for? Mostly for themselves, if experience is any guide.
What should American companies do then? Needless to say focus on producing goods and services, highlight the consumer surplus you add, but also keep an eye on the future. As I said multiple times, the ESG conversation has become a defensive exercise in that U.S. firms do not seem to highlight enough the consumer surplus they create. For instance, despite our frustrations with Microsoft Office, the value that the software has produced for each of us is way higher than the $100 license fee we pay Microsoft.
But I can tell you that as educators, we see your future customers earlier than you do. The new generation of students is animated and deeply concerned about climate change. This generation is the future consumer market and electorate. Even if you resist the trends today, in the future, you will do well to adapt your products and services aimed at decarbonization or natural ecosystem friendly products.
Claim 5: S&P politicizes credit ratings of states due to ESG
“S&P Hits U.S. States with Politicized Credit Scores. The ratings agency seeks to penalize fossil-fuel producers. Its ‘ESG’ push is unlikely to end there.” (Utah State Treasurer Marlo Oaks)
Is there evidence that Utah’s cost of borrowing has increased on account of S&P’s view on the state’s environmental record? Even better, let’s go back to first principles of free markets and make the market for rating agencies truly competitive to allow entry of new rating agencies such that they can get recognized on a fast-track basis by the SEC. True competition among rating agencies might mitigate any perceived bias against certain issuers.
The event that appears to have triggered the Wall Street Journal op-ed by the treasurer of Utah is a credit report issued on March 31, 2022 by the ratings agency S&P assigning a “modestly negative” environment rating to the state of Utah. I can understand the outrage that this is the flipside of the legal bargain we seem to have struck with the credit rating agencies. I have several papers pointed out how credit ratings have been biased in favor of issuers or major investors during and after the financial crisis. The U.S. could not sue the credit rating agencies for their role in the financial crisis as these credit reports were legally considered to be “free speech.” Well, a negative environment rating for Utah is part of the same free speech bargain. Moreover, is there evidence that Utah’s cost of borrowing has increased on account of S&P’s view on the state’s environmental record?
I suggest that this “politicization” is largely a creation of the anti-Woke right. If the same rating agency gave a state a higher score because that rating agency loves fossil fuels, would they call this “political?” I doubt it. For all its many flaws, there is nothing inherently political about ESG, if defined in terms of material risks. It is the name calling by the Right that has made ESG a political issue.
Claim 6: ESG scores are noisy and biased
“ESG scores are not only inherently political, as evidenced by the attack on Tesla and Mr. Musk, but they are completely subjective, and often hypocritical. In one particularly egregious example, Exxon Mobil and Chevron received less favorable ESG scores than Russian energy companies Gazprom and Rosneft, in which Vladimir Putin‘s government is a major shareholder.” (Vice President Mike Pence)
“Such indices’ scores depended on how compliant a business was with “the leftist agenda”, [Elon Musk] claimed in a meme shared on Twitter.” (Financial Times)
I agree with Vice President Pence that ESG ratings are biased and noisy. In essence, ESG ratings represent unfalsifiable claims. How would I know that credit ratings potentially messed up? If I observe a significant number of cases where the credit rating agency assigns a “AAA” stamp to securities that defaulted in droves during the financial crisis, I can make a case that the rating agency messed up. I don’t know what a “default” for ESG ratings look like. And, as Elon Musk points out, how did the index maker trade off “S” and “G” for Tesla with its “E” rating?
Some like Bob Eccles and Judith Stroehle believe that the ESG rating process will never be standardized. As I have written earlier in the month, one way out of this mess is to inject much needed focus to the sprawl of individual factors under E, S and G and the associated metrics. Investors and analysts should ask the CEO to declare two stakeholders that they care the most about. Rating agencies and investors can then assess the ESG performance and the associated valuation implications, if any, of those two stakeholders. Sophisticated active investors have quit relying on a single ESG score a long time ago. They want and are getting the underlying data. They study differences across rating agencies. They collect their own data. They talk to the companies.
Having said that, we almost have no choice but to fix the ESG ratings as they are unlikely to simply go away. Most money in markets is managed passively by computer programs. That’s the only way to keep expense ratios low for retirement investors like me. Computer programs need a score to pick stocks as long as there is demand for ESG strategies.
Having said all that, I cannot help but wonder whether Tesla and the electric car revolution is not part of the leftist agenda. Let’s not forget that “leftist” states like California have showered Tesla with taxpayer subsidies. What did the Californian taxpayer get for such subsidies? And, is the electric car, that still relies on dirty energy for recharging, truly green? What about the cobalt and the lithium and how these minerals are mined? I agree that the perfect is the enemy of the good and we need to start somewhere. Hence, I don’t want to quibble too much about Tesla’s “E” credentials.
Claim 7: Cost of debt for oil and gas firms are higher because of ESG
“The president’s climate envoy, John Kerry, is pressuring banks to refuse to make loans to U.S. oil and gas companies, leaving them unable to increase production.“ (Vice President Mike Pence)
Oxford University Professor Bob Eccles, Hong Kong Polytechnic University Professor Jing Xie and I took a closer look at the idea that the so-called “sin stocks” have a higher cost of capital and hence lower stock valuations. Sin stocks are defined as equity in firms involved production of alcohol, tobacco, and gaming, and fossil fuels such as coal and gas or oil. We find that this result is somewhat oversold. When we control for firm fundamentals such as operating performance, firm size, leverage and future sales growth, there appears to be no difference in the valuation of sin stocks relative to other stocks that share the same fundamentals.
In particular, we find no difference in the cost of equity capital for secondary offers of equity issued by sin firms relative to other firms. However, consistent with VP Pence’s statements, we did find a higher cost of new debt especially for tobacco and oil and gas firms. We conjecture that the pool of lenders to such sin firms is smaller than pool of buyers of equity. Predictably, sin firms issue more equity than other firms. Note the sizeable increases in the stock prices of oil firms over the last two years or so. I wonder why oil firms do not issue more equity to finance production increases.
Having said that, the economics of the oil industry is complicated. The period between 2010-2020 was considered a lost decade for the industry. Facilitated by fracking and other such technological breakthroughs, U.S. oil production skyrocketed. However, weakness in demand for emerging markets for oil and a strong dollar led to lower profits. The mood of the capital market toward the oil industry soured, leading to lower stock prices and higher cost of debt. We do not know for sure that the higher cost of new debt for oil firms is simply a hangover from such a sentiment as opposed to ESG negative screening, but it is worth finding out.
Unless we offer the end customer a viable and economic alternative to oil and gas, we are unlikely to make a dent on the climate problem by pressuring Western oil and gas firms. As Bob Eccles and I pointed out, a carbon tax on Western oil majors will simply lead to a migration of production to state-owned enterprises in foreign lands that may not be very friendly to U.S. and Western interests, as we have discovered during the Russian invasion of Ukraine.
Claim 8: ESG needs to be banned
“Most important, the next Republican president and GOP Congress should work to end the use of ESG principles nationwide. For the free market to thrive, it must be truly free.” (Vice President Mike Pence)
This is a strange request. ESG is an organic movement organized somewhat spontaneously by the capital market. Yes, we can complain about agency issues in that managers may not reflect the wishes of their real shareholders. As I have written before, we do not seem to have invested resources in understanding what the real shareholders, as opposed to asset management intermediaries, want in general. But banning ESG will make the market less free, not more.
Claim 9: ESG is cover for corporate malfeasance
“Ramaswamy argues that wokeness is used as a cover to distract people from corporations’ unsavory, but presumably profitable, dealings.” (Discourse Magazine)
I have sympathy for this sentiment. Aneesh Raghunandan and I have shown that the 181 signatories of the much-praised Business Roundtable’s statement’s pivot towards stakeholder capitalism appear to have worse carbon emissions and a worse regulatory rap sheet with key regulators affecting employees (OSHA) and the environment (the EPA) relative to non-signatories of similar size, profitability, debt levels and so on. One of the strengths of the ESG movement is the focus on corporate malfeasance. For instance, I have asked why firms do not publicly disclose their tax returns. Why do some rely on labor cost arbitrage and set up muscle lite firms? Why do very few firms disclose their spending on lobbying given that the payoff to lobbying can be as high as 20X?
Claim 10: The Damodaran critique:
“What is ESG? How does ESG affect firm value? As an investor, will or can you make money investing on ESG? Is society better off with ESG” (NYU Stern School of Business Professor Aswath Damodaran)
What is ESG?
Prof. Damodaran is rightly worried about the definitions of what is E, S and G and how these risk or cash flow factors affect future cash flows (known as ESG integration in the trade), does ESG investing make you alphas (excess returns) or lower beta (reduced risk) and what, if anything, is the societal impact of ESG. I have raised similar questions as well and tried to propose solutions to these great questions. Last week, I suggested that the CEO could consider declaring two stakeholders she cares about and investors and analysts could assess the firm’s performance associated with these stakeholders. Earlier, I had suggested that investors review the list of risk factors in the 10-K, label these as “E,” “S” and “G,” consider which risk factors are not included, then go to the sustainability report to quantify non-financial information about such risk factor and eventually model out the potential cash flow or risks associated with such an item into future cash flows.
How does ESG investing make money?
Not by simply overweighted tech stocks and underweighting energy stocks, as done during Covid before oil prices started skyrocketing. ESG, at least related to decarbonization or investing in companies that provide green products and services, will have a bright future considering the desire of the upcoming generation’s concern about climate change and green products. I suspect that truly innovative products and services that address climate change and chemical free concerns are less likely to come from large established firms, as opposed to upstarts.
Hence, I wonder whether venture capitalists and private equity are potentially more likely to identify these innovators. A few established players will pivot to exploit the coming greening trends but the history of large companies reorienting themselves to new trends is not all that encouraging. Hence, one has to wonder about the extent to which ESG strategies can make money while following a strategy of investing only in public companies. Perhaps, by picking stocks of public companies whose business model explicitly deals with decarbonization or relatively green products such as electric vehicles, carbon capture, alternate energy and the like.
Moreover, to make money, ESG has to be, by definition, be a long run strategy suitable perhaps only for pension funds and endowments whose payment obligations stretch way out into the future. Ephemeral short-term trades such as long on technology and short on energy are not going cut it.
Some commentators like Bob Eccles argue that I am potentially confounding ESG (a company’s operations and activities) with impact (positive and negative externalities of its products and services). Bob suggests that ESG integration applies to companies in any industry. It is about the material ESG issues in a company’s operations that matter to financial performance. An oil and gas company can rank highly on a number of ESG topics, such as safety on the oil rigs and methane emissions, but this begs the question of the negative externality of carbon emissions created by its products.
Fair enough. The answer to Prof. Damodaran’s critique would then have to be that ESG integration, if done well, can reduce the beta (loosely speaking risk) and even the alpha (abnormal return) of a stock by anticipating violations or regulatory minefields.
Does ESG make society better off?
That is an appropriate question related to measuring impact. This relates to Bob’s distinction between ESG integration and ESG impact, as mentioned above.
We need to make a lot of progress to show that corporate actions have had an incremental impact on the outcomes they purport to influence. I do not mean to excuse away impact under-performance related to social impact, but it might be useful to point out that showing impact for any social outcome is not all that easy. For instance, the biggest determinant of emissions is GDP. How successful have global non-corporate initiatives been in cutting emissions within a short time frame of say a decade? Is that the appropriate counterfactual we should try and judge corporate actions against? If not, please propose your counterfactual that we should compare corporate emission cutting efforts to.
Next week, I look at the relatively exaggerated claims made by ESG advocates. Comments and reactions welcome in the meanwhile.
