The ‘free market’

Jennifer J. Schulp

After years of headlines about the growing environmental, social, and governance—or ESG—movement in investing and corporate governance, it’s no surprise to see headlines about the burgeoning anti-ESG backlash. While criticism of ESG isn’t ne-w, its opponents have rec-ently begun to focus on le-gislative action aimed at stopping ESG in its tracks.
A recent Reuters analysis identified 44 bills and new laws in 17 conservative-led states seeking to penalize financial institutions that have taken what they view as ESG-motivated stances on issues such as gun control, climate change, and diversity that they argue deprive legitimate businesses of capital. Conservative groups, like the American Legislative Exchange Cou-ncil and Heritage Action for America, have supported these efforts with model legislation to protect beneficiaries of state pensions from “politically driven in-vestment strategies” and en-sure that states “only do bu-siness with companies that share an interest in the state’s profit, not the demise of it.”
While these types of legislative measures may have intuitive appeal for anyone who believes like Milton Friedman that the social responsibility of a business is to maximize shareholder profits—or, as Samuel Gregg puts it in his essay, “Why Business Should Dispense With ESG,” that “the central telos of business” is to generate a profit for its owners—these anti-ESG measures often conflate multiple understandings of ESG and have the potential to undermine the same free markets that they purport to protect.
ESG has long been an umbrella term applied to a variety of management and investment decisions. But it is important to differentiate between what professors Robert Eccles and Jill Fisch describe as a value-based ESG strategy and a values-based ESG strategy, or, in other words, to distinguish ESG as a process from ESG as a product.
Value-based or process ESG refers to integrating financially material ESG factors when evaluating a company’s economic prospects. As one investment manager described it:
If you look at General Motors, you’d be irresponsible if you didn’t consider their strategy in electric vehicles. You just considered an “E” factor, okay? You’d be irresponsible if you didn’t understand what their relationship is with their labor unions. That’s an “S” factor. There, you just had ESG-integrated investment decision-making.
There is little new about this type of ESG. That, of course, doesn’t mean that integrating ESG factors into financial valuation is cut and dried. But the proc-ess—i.e., determining whe-ther a factor is financially material—does not lend itself to one-size-fits-all pronouncements about the relevance of ESG factors.
Values-based or product ESG, however, seeks to enshrine particular values into investment decisions to achieve a particular outcome. While many of these outcomes align with “what would be conventionally c-alled progressive priorities,” as Gregg writes, ESG can be viewed as a modern variation of purpose-driven investing, which over the years has supported both progressive and conservative causes. (One scholar has even characterized such harnessing of private investment to seek solutions for broad societal problems as a “significant libertarian turn.”) Regardless of political stripe, this type of ESG is comfortable with sacrificing investment returns in exchange for a values-based end goal. Understanding this divide in ESG helps when analyzing anti-ESG actions because the devil is in the details when it comes to whether such state actions are worthwhile.
Starting with state pensions, many conservative state actions look to limit the consideration of ESG by plan fiduciaries. State laws mandate fiduciaries to act in the best financial interest of the plan’s beneficiaries. Without a precise definition, a plan fiduciary may simultaneously believe that fiduciary duty both requires and prohibits the consideration of ESG. Indeed, the fe-deral Department of Labor has appeared to straddle these conclusions in its own fiduciary guidance, with the Obama and Biden administrations permitting consideration of ESG and the Trump administration prohibiting it. Both extremes, though, are more similar than different because they both recognize that plan fiduciaries must consider factors that materially affect an investment’s risk/return profile. This supports the use of ESG as a process—and rejects the use of ESG as a product—in retirement investing, which makes sense because fiduciaries must act “with an eye single to the interests” of the plan’s beneficiaries.
State pension guidance that elaborates on this basic fiduciary duty puts ESG on the same footing as other m-ethods of evaluating investments, and allows the market—subject to a pension fi-duciary’s standards—to sort out the best means of figuring out investment risk. Be-cause funds that advertise themselves as ESG tend to have higher expenses, a fid-uciary must find that an ESG fund will have a higher expected return to justify such an investment. Fiduc-iaries should exclude funds that are aimed at a particular values-driven outcome that does not redound to the pecuniary interests of the plan’s beneficiaries. It’s no surprise, then, that strong stances against ESG investing by some Republican state attorneys generals have changed nothing at all for state pensions that were already focused on beneficiaries’ interests.
But some state pension guidance has gone further by viewing all ESG as a values-based strategy and requiring divestment of state pension funds from investments with managers that “boycott” fuel companies. These directives can c-onflict with a fiduciary’s d-uties, harming pension beneficiaries by artificially res-tricting investment options to those that may have lower returns. This is no less of a problem when states seek to divest their pension funds from fossil fuel companies or gun producers.
Several states also have required divestment from or have blacklisted investment firms in connection with other state business, limiting the pool of investment firms that can service the state, for example, by underwriting municipal bonds. This not only can raise costs for taxpayers by limiting competition, it also improperly imposes the state’s own values-based investment philosophy. These measures aren’t anti-ESG; rather they’re just ESG by a different name.
While the details of each state action vary, the general justification for divestment was set out by 19 state attorneys general in a November 2021 letter:
the overarching objective of our actions will be the same—to protect our states’ economies, jobs, and energy independence from these unwarranted attacks on our critical industries…we will each take concrete steps within our respective authority to select financial institutions that support a free market and are not engaged in harmful fossil fuel industry boycotts for our states’ financial services contracts.
Put somewhat more pointedly, Louisiana’s State Treasurer described divestment from BlackRock as “necessary to protect Louisiana from actions and policies that would actively seek to hamstring our fossil fuel sector.”
Invocations of the “free market” under these circumstances are red herrings. Wholesale divestment orders, motivated by the same values-driven inquiry that those issuing the orders object to, constrain the free market by imposing a state-sponsored ideological screen on financial institutions. This results in less competition, thus harming taxpayers, and creates an environment where each state feels empowered—or compelled—to add an increasing number of ideological or protectionist demands on financial institutions that wish to serve them.
Take, for example, Texas, which prohibits local jurisdictions from contracting with banks that have adopted ESG policies against oil and gas and firearms industries. A recent study estimates that as a result of the law—after which the five largest underwriters left the market—Texas cities will pay an additional $303 million to $532 million in interest on $32 billion in bonds. Higher costs will not be unique to the municipal bond market; prohibitions may raise costs for a range of state business, from managing state funds to providing depository accounts and government credit cards.
That’s not to diminish a state’s right to make contracting decisions; where a financial firm is engaging in a values-based strategy or selling ESG as a product, the state may choose not to buy what the company is selling. But states should support competition, allowing the market to provide solutions. States can also hold investment managers accountable, such as by ensuring that the investment manager fairly represents investors’ interests when voting proxies. The state’s contracting decisions, though, should be motivated primarily by investment performance and pecuniary interests, rather than exogenous policy or ideological concerns.
While Gregg may be right that “at some point, market signals are likely to crowd out virtue-signaling,” those market signals will be blunted if state policy has distorted them. This is why state action that enshrines ESG or anti-ESG principles into investment decision-making is so dangerous.
Gregg writes that ESG’s weakening of the profit motive of companies “damages society’s wider capacity to recognize that when business achieves its proper ends, the wider, albeit indirect benefits for others are enormous.” This principle holds true regardless of the political or ideological cause being advanced by the particular flavor of values-based ESG—be it pro-ESG progressivism or anti-ESG reaction. It’s a misuse to wield the principle to stand in the way of individuals or investment entities examining the financial health of a business through an assessment—by ESG as process or through other factors—of any and all material financial risks.