ESG and CSR Have Been Exposed for What They Are
“ When times get tough, luxury goods like the ‘social responsibilities’ of business tend to take a back seat.”
ESG and CSR Have Been Exposed for What They Are
(Lady-Photo/Getty)
By MATTHEW LAU
March 15, 2023 6:30 AM
When times get tough, luxury goods like the ‘social responsibilities’ of business tend to take a back seat.
Since 2021, the popularity of ESG (Environmental, Social, and Governance) and CSR (Corporate Social Responsibility, which involves assigning social or public obligations to businesses) has proven itself to be a mile wide, but only an inch deep. One reason, as I’ve written in the Financial Post, is that ESG and CSR are luxury goods. When people get serious about their finances — as they must when the markets are down and business profits are squeezed — they tend to throw the expensive feel-good stuff out the window, as evidenced by the ESG investing backlash, sharp reduction in ESG fund inflows in 2022 versus 2021, and the retrenchmentof corporate ESG efforts in the face of recession.
A second explanation for the waning popularity of ESG and CSR has to do with Milton Friedman’s observation in his famous 1970 New York Times essay that “the discussions of the ‘social responsibilities of business’ are notable for their analytical looseness and lack of rigor.” As the surging popularity of ESG and CSR in 2021 gave way to increased scrutiny from individual investors, workers, and consumers in 2022, the analytically loose foundation on which these doctrines sit has become evident.
Some investors, for example, might have noticed public pension plans and other asset managers preaching ESG while having exposures to Chinese companies linked to the genocide of Uyghurs in Xinjiang, which doesn’t seem very socially responsible at all. Others have grown tired of moralizing lectures from the business community and exaggerated statements of impending climate doom that do not align with reality. There is also increasingly clear empirical evidence that undermines claims made by ESG and CSR proponents about the social and financial benefits of their efforts.
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Stanford University’s David F. Larcker and Brian Tayan, for example, recently summarizedthe literature and found that “research evidence on the relation between ESG and firm performance is highly mixed” and overall there are “no clear patterns” to suggest ESG investments perform differently from non-ESG funds. But of the three studies on ESG mutual-fund performance they reviewed, all three found that investors fared worse financially by opting for ESG. Importantly, too, investors in ESG funds paid more in management fees for the same or worse financial performance.
John Cochrane notes that logically, for ESG investing to “work” — that is, to do some social good — it cannot increase expected returns. “The point of ESG investing,” he writes, “is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment.” But the cost of capital to industry is the investor’s expected return, so if ESG works, “it raises expected returns of disfavored industries, and lowers the expected return of favored ones.” In other words, if ESG investing does social good, it has to lose money. Indeed, as research cited by Larcker and Tayan suggest, while some investors are willing to pay higher fees and accept lower returns to try to achieve social good, the “cost of divestment is borne by investors, not corporations.”
In another publication, Larcker and Tayan summarize the research on ESG ratings. Their conclusions: ESG ratings are “poor indicators” of a company’s social and environmental performance, ESG scores by different rating agencies “diverge significantly for the same companies, and do not appear to predict risk or performance,” and the rating firms face “significant methodological challenges.”
Recent experience vindicates these claims of analytical looseness. Take, for instance, news reports of “ESG fund chaos” over greenwashing concerns. The cause of said chaos was that hundreds of billions of dollars in assets previously deemed environmentally responsible were said not to be so seemingly overnight, and thus had their ESG label stripped.
On top of greenwashing is the phenomenon of “diversity-washing” — companies claiming to be socially responsible through DEI (diversity, equity, and inclusion) initiatives but behaving in apparently irresponsible ways. “Diversity-washing firms,” authors of a recent paperconclude:
Obtain superior scores from environmental, social, and governance (ESG) rating organizations and attract investment from institutional investors with an ESG focus. These outcomes occur even though diversity-washing firms are more likely to incur discrimination violations and pay larger fines for these actions.
Similarly, another study found companies included in ESG portfolios had worse compliance with labor and environmental rules than those in non-ESG portfolios.
The entire ESG–CSR industrial complex in 2023, as Friedman anticipated back in 1970, sits on a weak foundation. The more analysis that is done — whether in empirical studies or simply by individual investors, workers, and consumers scrutinizing corporate behavior — the more ESG and CSR will continue to fall into disfavor.