The Woke of Wall Street: Politicizing ESG

Investments that take into account the environmental, social, and corporate governance aspects of an organization, or ESG-focused investments, have been under scrutiny for a while now. These investment themes, which some regard as the shape-shifters of old-school capitalism, have been accused of being ‘too woke’ and a part of the larger liberal scheme to revolutionize business as we know it. But the debate is much deeper and runs into questions about what are the duties of a fiduciary and to what extent is ESG material - the answers to both of which are, well, political.

At the outset, it is important to mention that ESG investing lacks a standard definition. Some investors use ESG as a qualitative factor that helps them screen out poor investment options while others use it to calculate a quantifiable risk factor. Given the broad range of strategies that investors can apply before classifying a fund as ESG, the returns of the portfolios can differ drastically. This makes obtaining a correlation between ESG investing and their financial returns extremely difficult. Although existing literature does not give a unanimous verdict on ESG, recent industry and academic studies suggest that ESG investing can, under certain conditions, help improve risk management and lead to returns that are higher than, if not the same as, traditional investments. But what boosted the ESG wave post-pandemic, was not just a need for higher financial returns but also increasing societal attention toward how corporations deal with climate change. The BLM protests in 2020 called upon businesses to focus more on their social impact, which in turn led to a higher demand for diversity and better governance, from investors and consumers alike. All in all, the primary motivation behind banks chasing ESG is hard to trace but it was certainly driven by a greater demand for transparency and positive impact.

So are republicans who are pushing anti-ESG legislations, just a bunch of lobbyists working for businesses that fear this demand for transparency? Possibly, but not necessarily. While it might be tempting to discredit the entire anti-ESG stance by calling them political sellouts, let's try and tackle them in their best-case scenario.

Investors who handle billions of dollars on behalf of their clients are mandated to meet certain fiduciary duties. These legal mandates are aimed at protecting consumers. Essentially, these duties require the investors to carefully research and analyze the potential investment risks in order to ensure that the clients’ interests are being met. This includes studying the potential material risks of an investment. However, what can be considered material is largely discretionary and depends on how the government chooses to define it. The anti-ESG agenda is based on the idea that ESG investments ignore potentially good returns (such as from Oil and Gas investments) and therefore are not aligned with the clients’ best interests. This agenda was strengthened when Oil and Gas companies, which are typically excluded from ESG investments, reported big profits in the last few months (largely because of the war and the subsequent energy crisis).

Now, regulating banks to protect consumer interests does sound like a bad idea (although very atypical of a republican to propose) but the problems with anti-ESG legislations are multi-fold. Firstly, they stem from a lack of urgency to respond to climate change. To discredit environmental risks associated with climate change altogether and to go to the extent of stopping an investor from doing so, is just plain stupid. Moreover, the growth in ESG investing was seen as a driver in promoting responsible environmental behavior from corporations. In the absence of stricter and better-enforced regulations, this investor pressure becomes extremely important. These legislations also stand in stark contrast to decarbonization mandates that are propping up all over the world. Research has also indicated that anti-ESG legislations might end up costing the taxpayers significantly because they make the municipal bonds market less competitive, requiring states to pay higher interest on the bonds.

In conclusion, anti-ESG legislations want to protect companies with poor ESG performance from being discriminated against by investors - all in the name of protecting clients’ best interests. Now to what extent this makes sense to you, is perhaps dependent on where you lie on the political compass.