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Could this year be the end of the beginning for environmental, social, and governance (ESG) investing?

Buzz in the business press suggests the ESG craze is over or even that ESG is dead. Not quite. The movement’s frameworks, guidelines, and regulations are not about to vanish. Yet the initial phase of fast growth and rapid adoption has played through, evidenced by the fact virtually every big company has adopted ESG metrics and reporting, and most of the largest financial firms have signed on to public ESG commitments. What comes after should include firms delivering greater clarity and specificity and governmental regulators allowing market actors to determine which corporate initiatives are producing value.

ESG advocates have been spectacularly successful at signing up corporations to international partnerships like the United Nations’ Principles for Responsible Investment and the Glasgow Financial Alliance for Net Zero. Having achieved such a prominent position, however, comes with the burden of actually implementing the movement’s lofty goals.

The aura of the early insurgent era, during which ESG activists thought themselves scrappy underdogs storming the old boys club of corporate finance, is difficult to maintain once most of the largest financial firms in the world have signed public pledges endorsing your position. Indeed, it would be difficult today to find a major corporation that lacks a detailed report extolling its impressive ESG score.

Lest you think I’m joking, fossil fuel giant Halliburton was once so controversial its name was said to be “synonymous with the word ‘evil’.” Last year, it was named to the Investor’s Business Daily Top 100 Best ESG Companies list. This sort of thing has led to confusion among regular people about what ESG investing is supposed to accomplish.

Many Americans are familiar with the old-fashioned version of ethical investing - don’t directly invest in a company you deem unethical. If enough people do the same, the theory goes, problematic companies will either be forced to change or will go out of business. But the individual ethical investor will have a clean conscience, not personally holding shares in companies doing the wrong thing, whether that’s selling cigarettes, manufacturing weapons, or pumping crude oil.

Individual investors today could be forgiven for supposing, wrongly, that’s what ESG is all about. But as industry observers already know, that’s not how it works.

Large asset managers, including those with strong public commitments to ESG goals across their portfolios, continue to hold all of those companies that the naïve ethical investors of yesteryear promised to boycott. Fossil fuels, firearms, tobacco, you name it – big firms are still in all of those industries.

Top asset manager BlackRock is led by outspoken ESG advocate Larry Fink. The firm made clear years ago that screening out bad companies and only investing in good ones was no way to do business. BlackRock and most other large financial firms with ESG commitments practice engagement rather than divestment. They use their equity positions as leverage to pressure company management to adopt ostensibly enlightened policies while continuing to profit from those holdings. 

There’s an argument to be made that engagement rather than divestment allows for more market leverage in the long term. Yet the strategy is fundamentally at odds with why most people seek out ESG investment options.

If you think, for example, BP is an evil company destroying the climate by selling oil and gas, you’ll want a portfolio that allows you to steer your financial tanker clear of that moral harm. Investing in an ESG fund that passes through dividends to you while its advisors occasionally vote against allegedly nefarious board candidates over at BP is unlikely to be emotionally satisfying.

If you hate guns and cigarettes, how many years are you going to wait around while Fink’s investor engagement team tries to persuade Smith & Wesson and R.J. Reynolds to pivot to making organic vegan snacks instead? Ethical objections to a company’s core products can’t coexist with holding their shares as a long-term investment. That’s not a credible premise.

The strategy of shaming particular firms and market sectors fosters political dysfunction as well.

Many states have passed anti-ESG legislation to protect local industries and the jobs they support. Other states have changed the way they manage state pension funds to stop environmental and social activist campaigners from dictating investment strategies.

On the other side of the debate, the Biden administration recently reversed a sensible Trump-era rule that would have required fiduciaries of private pension funds to focus solely on financial return for beneficiaries. Critics of the original rule complained that those restrictions would keep them from addressing vital social goals. However, as then-Secretary of Labor Eugene Scalia wrote in 2020, for fund managers, “one ‘social’ goal trumps all others—retirement security for American workers.” Half of the nation’s state attorneys general are challenging the Biden reversal.

If a corporation decides a particular environmental or social initiative is consistent with profitable operations, management should explain that to potential investors and let them decide if they like the plan. ESG frameworks, however, attempt to conjure up a comprehensive theory of all ethical business practices. That is a fool’s errand, because no system will satisfy everyone. Different groups of people have legitimately different opinions about what the most desirable business practices are.

Moreover, the desire to invest by cherry-picking firms with the highest social justice score isn’t compatible with modern index-driven passive investing, which is the popular, low-risk kind most Americans count on to fund their retirement.

There is no one best way to manage a corporation or invest in general. Unfortunately activist groups and government agencies have so far failed to understand that. 

Richard Morrison is a senior fellow at the Competitive Enterprise Institute and the host of the Free the Economy podcast.  

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