On Climate and Conscience: An Essay and Pamphlet

The original stewardship

One of our challenges in the modern era has been to reconcile the demands of stewardship with the tenets of capitalism, free markets, and the private acquisition of wealth. It has not been easy.

For generations, stewardship and social responsibility were rooted in the ideas of philosophers and theologians – Aristotle, Thomas Aquinas, Locke, the Reverend John Wesley. Stewardship was an obligation and a trust. Wesley sermonized in pre-Revolutionary America that individual and community virtues are interlinked. “When the Possessor of heaven and earth brought you into being, and placed you in this world,” he said, “he placed you here not as a proprietor, but a steward.”

The United States Conference of Catholic Bishops offered a powerful theological definition in its 1992 Pastoral Letter on Stewardship:

What identifies a steward? Safeguarding material and human resources and using them responsibly are one answer; so is generous giving of time, talent, and treasure. But being a Christian steward means more. As Christian stewards, we receive God's gifts gratefully, cultivate them responsibly, share them lovingly in justice with others, and return them with increase to the Lord.

Since the middle of the last century, religious groups and adherents of the New Left have built stewardship into a pillar of conscience in investing. “Socially responsible investing,” or SRI, was not a purely personal choice to avoid perceived harmful assets – the “sin stocks” of pornography, alcohol, tobacco, gambling, and perhaps the instruments of abortion and weapons of war. SRI was also an acknowledgement of group consequences. Individuals drawn to the idea of investing responsibly questioned the ethics of financing instruments of death and ecological destruction. These included nuclear power, nuclear weapons, toxic defoliants, firearms, genetically modified organisms, and fossil fuels.

Two societal themes – human rights and environmental protection – further propelled the concept of stewardship. Startling news provided the fuel: Cambodian mass murder in the mid-1970s, the Three Mile Island nuclear plant accident in 1979, Union Carbide’s deadly chemical leaks from its pesticide plant at the Indian city of Bhopal in 1984, the Soviet Union’s Chernobyl nuclear meltdown in 1986, the Exxon Valdez oil spill off Alaska in 1989, and the Rwandan genocide of 1994. The Sullivan Principles, created in 1977 by the Reverence Leon Sullivan, an African American board member at General Motors, targeted South Africa’s apartheid laws. Sullivan’s call for the fair and humane treatment of all workers at GM and other U.S. factories in South Africa did not lead directly to apartheid’s demise, but it helped define corporate social responsibility.

Sustainability of profit

Today, we face a colossal test of stewardship – the rapid onset of climate change and its threat to humans. Even Jeremy Grantham, who co-founded the Boston investment firm Grantham, Mayo, Van Otterloo and hardly qualifies as a militant, calls the imperative of combating climate change “the moral equivalent of a minor war.” He urges an all-out effort to pressure governments to act: “You need the governments to do the heavy lifting, and if they are not volunteering, you have to influence them as if your lives depended on it.”

Two veterans of the anti-apartheid movement, former U.S. Vice President Al Gore and South Africa’s Bishop Desmond Tutu, both Nobel Peace Prize winners, are urging investors to take a moral stand. “Any organization committed to operating responsibly in this new decade,” they say, “has a moral imperative to stop participating in financing the destruction of human civilization’s future, and to instead invest in renewable sources of energy.”

The investment industry – asset owners like pension funds, plus asset management firms like BlackRock and Vanguard – sidesteps these appeals to conscience. The industry can ignore them in part because it has managed to create its own profit-directed approach to sustainability and is using it as a shield against ethics as a basis for social responsibility and civic duty. This has left to schoolchildren the task of sending an urgent moral message on climate change. The youth movement has no financial leverage. It is little wonder they have chosen to employ one of the few weapons at their disposal: stigmatizing the fossil fuel economy and pressing for a speedy transition to renewable energy.

We have known of climate change’s threat for more than three decades – Exxon knew long before and remained silent. Dr. James Hansen of Columbia University spoke with authority on the subject in congressional testimony in the 1980s. In 1990, the World Meteorological Organization and an arm of the United Nations issued an unequivocal assessment. “We are certain of the following,” it said. “There is a natural greenhouse effect which already keeps the Earth warmer than it would otherwise be. Emissions resulting from human activities are substan­tially increasing the atmospheric concentrations of the greenhouse gases: carbon dioxide, methane, chloro­fluorocarbons (CFCs) and nitrous oxide. These increases will enhance the greenhouse effect, resulting on average in an additional warming of the Earth's surface.” Global conferences ensued in Rio de Janeiro, Kyoto, and Paris.

The United Nations was an early voice warning of ecological threats. In 1987, a UN commission headed by Gro Harlem Brundtland, the former Norwegian prime minister, defined and popularized the term “sustainable development.” The definition was based on the concept of economic justice flowing from one generation to the next. Sustainable development, the commission’s report said, is development that “meets the needs of the present without compromising the ability of future generations to meet their own needs.”

Students of business and organizational theory began generating new concepts to help put sustainability into practice. One was advanced in 1994 by John Elkington, a British business consultant and writer. He developed a new accounting method intended to measure not just an organization’s financial profit and loss but also its performance on social and ecological scales. He called it the “triple bottom line,” or TBL. Its aim was to tell a more complete story to the public and investors about corporate costs and benefits and about the long-term impact an organization has on the world outside its walls. True corporate value, said Elkington, could only be assessed over a far longer time horizon than the corporate quarterly calendar.

The Brundtland report, plus mounting concern over environmental and human rights threats, put pressure on political and business leaders. One who felt it acutely was Kofi Annan, an energetic diplomat from Ghana who was elected UN Secretary General in 1997, a time of considerable unsteadiness at the UN. Annan realized many of the problems that landed on the UN’s agenda could not be addressed without the substantial financial resources and political clout of global business and investment leaders. He drew them into his circle and vice versa. Acting, no doubt, with good intentions, Annan would nevertheless play a fateful role in the erosion of the original meaning of socially responsible investing and SRI’s replacement with an industry version based on the profit motive.

Kofi Annan’s compromise

Trained in economics and holding an MBA degree from MIT, Annan set about building alliances in the private sector at venues like the annual business retreat in Davos, Switzerland. At his first World Economic Forum in Davos as UN secretary general, Annan declared that a “creative partnership” between the UN and the private sector could be mutually beneficial. The development work of the UN opened opportunities in underdeveloped countries for economic growth, new markets, and new revenue streams, he said. The concept won support, and the UN drafted a specific partnership plan. In his 1999 Davos speech, Annan proposed a global compact under which corporations and business associations would “embrace, support, and enact a set of core values in the areas of human rights, labor standards, and environmental practices.”

Annan sold the global compact by appealing to the unfettered profit motive of multinational corporations. Too many interest groups, he said, wanted to attach conditions to global trade agreements by insisting on higher standards in the areas of human rights, labor, and environmental protection. “These are legitimate concerns,” Annan said. “But restrictions on trade and investment are not the right means to use when tackling them.” He endorsed the creation of a voluntary guide for corporate behavior on human rights, labor, and the environment and asked business leaders to convince governments to support UN efforts in those three areas.

The global compact was cleverly constructed. It offered corporations the equivalent of a United Nations seal of approval plus consulting help on how to address sustainability, complete with media toolkits for self-promotion. Participating companies would sign the compact and agree to make an annual contribution to the UN based on the company’s gross sales or revenue. It was even tax deductible; the compact was structured as a New York-based foundation. Annan assured the leaders at Davos that they could manage their own progress. “You can uphold human rights and decent labor and environmental standards directly, by your own conduct of your own business,” he told them.

Twenty years later, many who study the effects of globalization believe that trade agreements lacking strict labor and environmental standards exacerbated economic inequality and worker unrest in Europe and the United States. With climate change accelerating, Emmanuel Macron, France’s current president, repeatedly called for the precise opposite approach of the one Annan espoused in creating the global compact. Macron and his European allies will reject new trade agreements with other nations unless the deals include specific commitments to reduce carbon emissions in line with the 2015 Paris Agreement.

By 2020, the UN’s global compact was operating under a sunny brand, “Business as a Force for Good,” and had signed up about 13,000 companies, associations, and non-governmental organizations. Each supports the compact’s 10 principles, including one declaring that businesses should “undertake initiatives to promote greater environmental responsibility.” A company with $5 billion or more in annual gross revenues contributed $20,000 a year to the UN as a full-fledged participant or $10,000 a year as a signatory. The UN later used the same formula to create specialized corporate partnerships, including the Principles for Responsible Banking and the Principles for Sustainable Insurance. In return, the UN provided signatories with a template for setting internal sustainability goals, measuring their progress, and publicly promoting their company’s good deeds.

Annan was motivated two decades ago by a desire to propel the UN’s Sustainable Development Goals, or SDGs. This was his signature priority, and in 2001, the Nobel Committee awarded Annan its Peace Prize “for having revitalized the UN and for having given priority to human rights.” Annan’s work came at a cost. He had given permission to the private sector to voluntarily endorse vague concepts of progress on sustainability, without timelines, and to promote their magnanimous efforts to clients and the public as sanctioned by the UN. Once this gift had been handed to corporate marketing chiefs, they leapt to employ “responsibility” in scores of new ways, depending how they chose to sell “Business as a Force for Good.”

Rationale for ESG

Corporations adhering to Annan’s global compact represented one side of the private sector’s sustainability equation. The other comprised investors, the buyers and sellers of billions of shares that are the lifeblood of global capital markets. The investment industry held enormous financial leverage. It included asset owners like pension funds, insurance companies, sovereign wealth funds, university endowments, and big foundations. The other pillar was comprised of asset managers, firms that invest capital belonging to others. These include banks like J.P. Morgan and BNY Mellon, plus money management specialists like BlackRock, Vanguard, Schwab, State Street, and Fidelity.

Alongside the UN’s drive to advance corporate responsibility, the investment industry and its consultants were conceptualizing and crafting a market-based process for addressing sustainability. They recommended a complex, indirect strategy under the banner ESG – “e” for environment, “s” for social, and “g” for governance. The shorthand rationale was this: Under ESG, investors assessing the value of a company and its stock would measure how well or how poorly companies were performing on issues of environmental protection, labor standards, and corporate governance. This would result in ratings that would serve to encourage companies to behave better. The investment world itself was not proposing to directly confront climate change or any other sustainability issue, but it would be glad to act as a catalyst for shaming corporations into action.

The ESG framework was another enterprise backed by Kofi Annan. Senior executives of global investment banks and insurance companies supporting the global compact had lobbied for the adoption of ESG, and Annan accommodated them with a UN endorsement. ESG was inaugurated in 2004 with the publication of a report by 20 financial and investment firms. They included ABN Amro, Banco do Brasil, BNP Paribas, Calvert Group, Credit Suisse Group, Deutsche Bank, Goldman Sachs, Mitsui Sumitomo Insurance, and Morgan Stanley. The name of the report carried little subtlety. It was titled Who Cares Wins, and it sketched out a grand vision of the role of global capital and the investment industry in advancing the UN’s human rights and environmental goals – albeit on terms the private sector would control.

The Who Cares Wins manifesto invited investment analysts to use an ESG lens to rate companies on their sustainability efforts, and it urged investment industry directors and executives to commit to ESG analysis. It urged companies being rated to disclose to investors, in a standard format, any material risks to the company arising from ESG factors. For example, a company’s large or growing carbon footprint could pose a financial risk if a carbon tax were imposed. The manifesto urged regulators to require companies to provide “a minimum degree of disclosure and accountability” on ESG issues. It urged stock exchanges, rating agencies, accounting-standards boards, stock index providers, and industry self-regulatory bodies to “establish consistent standards” for the use of ESG.

As ESG gained acceptance, and as the investment industry polished its ESG pitch to clients and the public, it became clear that firms marketing ESG could gloss over the specifics and define ESG in any way that suited them. Confusing and contradictory assertions emerged across the investment landscape. Was ESG an umbrella term that included socially responsible investing and impact investing such as green bonds? Yes. Was it separate and apart from socially responsible investing? Yes. Did it fully embody responsible investing? Yes. Did it allow clients to express their values? Yes. Was it divorced from ethical considerations? Yes. Was socially responsible investing an umbrella term that incorporated ESG? Yes. ESG was a nicely malleable concept.

On the climate issue, what most mattered was that ESG allowed investment firms to hold high the banner of environmentalism, whatever that might mean in practice. When asset management marketing departments were unleashed, the industry found to its delight that clients were eager to buy a central ESG theme – “good” companies with high ESG ratings can be more profitable over the long run than “bad” companies with poor ratings. ESG was presented as a smart path to profit that had the salutary effect of improving life on Earth. The investment industry cast itself as a corps of agnostic yet responsible investors letting market forces work.

A ‘win-win’ theory

The ESG process was based on assumptions that have not been proven over any meaningful time period. In theory, if smart investors incorporated ESG factors into their stock analysis and began rating companies on sustainability in Darwinian fashion, management teams would be forced to make their company “better.” In theory, companies trying to be “good” would be more profitable than those not trying hard enough. The resulting improvement in corporate profits would funnel more winnings to shareholders of the “good” companies. And in theory, if investors pushed for disclosure by companies of any material risks to the company’s continued good behavior, those holding the shares would be seen as “responsible investors.” This was ESG’s circle of virtue, springing from capitalism’s DNA: The profit motive and competitive self-interest would enhance the UN’s sustainability goals, including climate stability.

At ESG’s birth, the investment banks and insurers standing behind the strategy cast the future as a “win-win.” Employing ESG, they wrote, “will contribute to better investment markets as well as to the sustainable development of the planet.” Notably, no ESG metric focused on outcomes, the actual results for society and the global environment. The industry was far more eager to show it was pulling hard on its oar than determining whether the ship was on course or nearing its destination. Investment firms managed over the years to convince clients and beneficiaries that the industry was already acting responsibly on clients’ behalf and on the planet’s behalf. SRI in its original form was now redundant.

Filling a non-need

In one sense, ESG was deceptively simple. Existing U.S. law already mandated most of its tenets. In the United States, public companies must not withhold from investors any material fact that a reasonable investor would need to determine a course of action related to the stock. This is true for any risk, whether financial, environmental, social, or governance related. By creating ESG, the financial sector merely focused a spotlight on one specific set of material risks that public opinion was beginning to comprehend. Investment firms that took pride in their rigorous research of a company’s value should have been evaluating environmental, social, and governance risks all along, whether they were labeled ESG or not. And corporations should have been disclosing such risks all along. As a standalone, segregated approach to material corporate disclosures, ESG is not necessary. Ultimately, it is packaging. ESG only became necessary when the investment industry realized it could construct a new research process anchored in financial risk assessment, then market the process as a UN-approved path to social and environmental progress.

The ESG process depends at all levels on an intangible: good faith. It depends on the good faith of corporations to be better citizens, it depends on investment firms applying ESG analysis in good faith to pressure corporations, and it depends on the good faith of corporations to disclose material risks to investors. Further, ESG also depends on the good faith of investment managers to help retail investors make smart choices: to offer products such as mutual funds that meaningfully disfavor or eliminate low-scoring companies, to make it easy for clients to see a fund’s true holdings, and to steer clients to ESG funds because they ostensibly perform better.

All of this good faith occurs through a process proudly free of ethical considerations. Unlike Elkington’s “triple bottom line,” ESG evaluates companies based on how their behavior impacts corporate value, not on how their behavior impacts sustainable human value. If the actual impact on social stability were the measuring stick, ESG might show incremental gains in corporate governance and perhaps in the treatment of workers. On climate change, however, it is not lowering global emission levels. ESG is simply failing as a weapon against climate change.

Absence of standards

ESG has been exceedingly complicated to implement. Who Cares Wins called for consistent standards 15 years ago, but there are none. Many users of ESG are buying corporate sustainability metrics from third-party research firms. Today, this industry has more than 100 data providers, including MSCI, Sustainalytics, S&P, Bloomberg, FTSE, Thomson Reuters, and Institutional Shareholder Services (ISS), each selling exclusive analytical tools to investment firms. The metrics for assessing a company are far from consistent. The Wall Street Journal noted in 2018 that MSCI ranked Tesla No. 1 on its ESG scale for automakers because its electric cars do not produce carbon emissions. At the same time, FTSE gave Tesla its worst rating because of carbon production by its factories.

The ESG framework also envisioned clear ways for companies to disclose their material risks. But a standardized reporting framework in the U.S. still does not exist. The Securities and Exchange Commission, with a majority appointed by President Donald Trump, is deeply skeptical of ESG – not because of its marketing-heavy approach but because, in the majority’s view, it is a mechanism to ruthlessly stymie private enterprise.

Several U.S. and international organizations and standards bodies are wrestling to bring coherence to the sustainability reporting process. They include organizations bearing the abbreviations SASB (Sustainability Accounting Standards Board), TCFD (Taskforce on Climate-related Financial Disclosures), CDSB (Climate Disclosure Standards Board), GRI (Global Reporting Initiative), and IIRC (International Integrated Reporting Council). More localized reporting bodies exist in Europe, China, Japan, Hong Kong, and Singapore. Only in Europe have regulators taken the first steps toward standardized ESG reporting by companies; full implementation will take years.

Principles to sell by

Kofi Annan advocated yet another private sector partnership, beginning in early 2005, the UN Principles for Responsible Investing, or UN PRI. Launched formally in 2006 at the New York Stock Exchange, the PRI was created to sell ESG. It provided a public platform for institutional investors to declare their support for ESG and align themselves with the aspirations of the United Nations. The PRI was created by and for investors and is financed by its signatories. It is not an arm of the UN but rather a “partner” of the global compact and the UN Environment Programme Finance Initiative. The PRI’s most powerful attraction was that it handed the investment industry an implicit license to market ESG as a UN-approved process. The PRI assured prospective signers that its six principles were “voluntary and aspirational.” The group asked member firms to report each year, in broad strokes, on their efforts to carry out the PRI’s goals. As the sustainability movement mushroomed, the PRI grew quickly. By 2019, it had roughly 2,300 signatory companies managing assets of about $80 trillion.

From the outset, the PRI marketed itself according to the unusual idea embedded in ESG that the pursuit of self-interest can lead to a better world. The PRI crafted a new definition of “responsible” that left ethical considerations at the curb. It declared:

The PRI defines responsible investment as a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership. We note that responsible investment is not the same as ethical investment, socially responsible investment or impact investing. While these approaches seek to combine financial return with moral or ethical considerations, responsible investment can and should be pursued even by the investor whose sole purpose is financial return.

For the PRI, any investment management firm that examined ESG factors in its investment process was, by definition, “responsible.” If the world’s glaciers were receding at an alarming pace, if Greenland’s blanket of frost was shrinking faster than expected, if the polar ice caps were breaking apart, if flooding and forest fires and storms were occurring more frequently or with greater intensity, then the “responsible” answer was to improve and accelerate ESG.

Nothing in the PRI describes a desired outcome, including a stable, healthy planet free of the climate change menace or environmental degradation. No “principle” of the PRI declares that climate change is a threat to human life. Indeed, its “principles” are a set of vaguely worded actions. Once in its preamble and again in its conclusion, the PRI document discloses a revealing lawyerly caveat: the actions of signatory companies will occur “where consistent with our fiduciary responsibilities.”

To prospective signatories, the PRI promoted “A Prosperous World for All.” In its 2018 Annual Report, it employed the headline “Protecting Investments, Protecting the Planet,” which crystallized a soothing rationalization for avoiding direct climate action. Unsurprisingly, the PRI described itself as “the world’s leading proponent of responsible investment.” In 2017, Martin Skancke, the PRI chair and former head of asset management at Norway’s finance ministry, took the PRI’s self-congratulation to new heights in his introduction to the PRI’s 10-year “Blueprint for Responsible Investment.” Skancke wrote:

Our challenge is to focus ever more deeply on what it truly means to be a responsible investor – and to then embed that so fundamentally and comprehensively in how all investors work that responsible investment as a standalone concept melts away.

The PRI’s signatories proudly wear the label “responsible” and pursue profit with a clear conscience. Their definition of responsible is not to avoid harming the social fabric or to actively repair the social fabric. It is only to pay closer attention to the social fabric and trust that others will effect change.

Standing behind incrementalism

We now know that the PRI vastly oversold the potential impact of ESG on climate change. In late 2018, the UN itself concluded that ESG “remains in its relative infancy” and that institutional investors are “rarely adjusting their models based on ESG data.” In translation, this means many firms conduct ESG research but few act on it. The UN has also found that the dominant ESG concern for U.S. companies was not environmental issues but governance. In 2019, Royal Bank of Canada surveyed nearly 800 institutional investors globally. Companies in Europe and the UK, combined, ranked climate change as the most concerning ESG issue. In the U.S., however, the top-ranked issue was governance, and within the governance category the top concern was maintaining the privacy of client data.

As climate change relentlessly exhibited its power in the form of unusual melts, storms, and fires in the period from 2015 to 2020, the PRI occasionally rang alarms. In 2016, it declared that climate change was “the highest priority ESG issue facing investors,” and it said, “there is no time to waste.” Yet in 2018, the PRI reported that roughly two-thirds of its signatories had not reduced portfolio exposure to emissions-intensive or fossil fuel holdings.

Despite its statement that urgent action was needed on climate change, the PRI and its member companies failed to use their financial leverage to move governments toward meaningful action. They did not lobby for an end to massive government subsidies for fossil fuel extraction. They did not coordinate to establish a national green bank. They did not demand that the U.S. government launch a 10-year crash effort to hasten the transition to economical energy alternatives. They did not create a lobbying arm to press the government to enact mandatory carbon pricing regimes or strong tax incentives. Any of these would have constituted a direct effort to blunt climate change. Instead, the PRI stood squarely behind its indirect and incremental effort. It called for more and better ESG.

Adhering to failure

The UN Emissions Gap Report of November 2019 landed with a thunderclap. It underscored how little ESG had accomplished on climate change. The report said greenhouse gas emissions need to be cut 7.6% a year for the next decade to reach a goal set by the 2015 Paris accord but that global emissions were in fact rising. The totality of government and market-based private efforts to curb greenhouse gas emissions was delivering negative results.

While the PRI’s core efforts have failed to turn the tide against climate change, the organization has helped convene a small group of asset owners – pension funds and insurance companies – willing to publicly commit to reaching “net zero” greenhouse gas emissions in their investment portfolios by mid-century. These would be concrete actions. By 2050, these firms say they will press companies held in their portfolios to reach the same net-zero goal, thereby allowing the total portfolio to reach the goal. Net-zero means that any remaining carbon emissions will be offset by the removal of equal levels of carbon from the atmosphere through reforestation or future technologies to capture carbon from the air and store it. The asset owners are organized under the banner of the UN-convened Net-Zero Asset Owner Alliance. Unfortunately, the alliance has just 18 members. Only one is based in the United States, California’s $400 billion public employee pension fund, CalPERS.

In 2019, the PRI realized that ESG needed a marketing facelift. It launched Stewardship 2.0. The PRI’s CEO, Fiona Reynolds, said Stewardship 2.0 would try to “move stewardship from box ticking and compliance to outcomes.” She said that, for the first time, the PRI would remove signatories “who do not meet our minimum requirements.” Together, the statements were an admission that too many PRI signatories had been going through the motions on ESG, just as the UN’s own surveys had confirmed. Predictably though, the new PRI effort merely offered interested signatories an opportunity to advance from standard PRI membership to something akin to platinum level – if they were willing to collaborate with other members on ways to achieve broad societal outcomes. For now, enhancing ESG remains the PRI’s core goal.

Triumph of arketing

The ESG project represents a triumph of marketing. Today, even the SRI acronym, which once described “socially responsible investing,” has been altered on the pages of many investment firms’ websites and brochures. It now stands for “Sustainable, Responsible, and Impact” investing. The word “social” has been shown the exit. Two ESG experts at Harvard Business School now refer to socially responsible investing as the “predecessor” to sustainable investing – in effect, an artifact.

The investment industry understands that if a firm considers ESG metrics in the process of picking securities – or simply says it does – it will be viewed as eco-friendly and can drop text onto its website promising to “invest with values in mind” or offer clients a chance to “do well by doing good.” The Web pages of one name-brand investment firm drew attention to its investor surveys that found “75% of retirement plan participants say it's important to make the world a better place while growing their personal assets.” Another declared: “Responsible Investing Is Good Investing.”

Vanguard Group tells clients that ESG investing is “where your money reflects what matters to you.” Vanguard also blurs the distinction between social ethics and ESG by noting, without explanation, “you may hear the term [ESG] used interchangeably with ‘socially responsible investing.’” At least Vanguard steps beyond many of its peers and discloses that some of its “ESG”-labeled funds exclude companies with oil, gas, or coal holdings while others might include an energy company that is “thoughtfully navigating” a transition to sustainability.

For example, one ESG-labeled Vanguard fund holds no fossil fuels-related companies while another ESG-labeled Vanguard fund holds Total S.A., the French energy company. Total reported that in the third quarter of 2019, its oil and gas production rose 8% from the year-earlier period to the equivalent of 3 million barrels of oil due to the ramp-up of projects in Russia, Australia, Nigeria, Angola and the UK. The company apparently lands in the portfolio of an ESG-labeled Vanguard fund because its expanding fossil fuel extraction represents a “thoughtful” transition.

The marketing power of ESG is now so strong that even smaller asset managers that reject stocks based on ethical considerations – the original SRI – are promoting ESG. Instead of using ESG to screen out holdings, these firms employ the rating system to “screen in” high-scoring companies in various sectors. In investing parlance, these are “best in class” companies. This is not a benign endeavor. It needlessly validates ESG, a form of analysis that purports to represent “responsible investing” while serving as an impediment to action on climate change.

Portfolio shell game

The financial industry knows it must make some sense of the jungle of terms surrounding “sustainability” and “ESG”-labeled products. Recent U.S. and international surveys of individual investors and investment professionals alike show serious levels of confusion. Without clear terminology, individual investors lured by “invest your values” marketing can easily stumble when choosing “ESG” or “sustainable” funds.

One of State Street’s exchange-traded funds, the SPDR MSCI ACWI Low Carbon Target ETF, bearing the fetching ticker LOWC, holds fossil fuels exposure totaling 6.3%, according to the fund tracking tool of the non-profit As You Sow. That’s only slightly lower than the fossil fuel component of the broad stock market. LOWC earns a sustainability grade of “C” from As You Sow. The fund includes shares of Phillips 66, Valero Energy, Halliburton, Marathon Petroleum, and China Oilfield Services.

On the website home page of BlackRock, the world’s largest fund manager in assets under management, we learn that “sustainable investing is simply smart investing.” Inside, BlackRock offers an exchange-traded fund based on an index of U.S. stocks, the iShares ESG MSCI USA ETF (ticker: ESGU). BlackRock says the fund is a good way to gain access to “companies with favorable ESG characteristics.” At year-end 2019, the fund held shares of the energy giants Exxon Mobil and Chevron. It is not fossil-fuel free because Exxon Mobil and Chevron enjoy “favorable” ESG ratings – not in any absolute sense but in comparison to their peers. When companies are graded on a curve, rated against one another in the absence of any standard criteria for a “flunking” grade, ESG delivers Exxon Mobil and Chevron to your portfolio.

In a celebrated January 2020 letter to clients, BlackRock promised to eliminate coal-heavy investments from products where it can exercise discretion (all but index funds). It also vowed to create more fossil fuel-free fund options for investors. The principle behind the company’s shift carefully avoided any considerations of social ethics and did not target outcomes. This follows a predictable ESG script. BlackRock’s CEO explained that when climate change forces governments to finally take action, requiring a significant reallocation of capital, investors will need to be prepared to react. The company is not pushing governments to act. It is not proposing to be a direct catalyst for capital reallocation. It is not urging clients to invest in fossil fuel-free funds and products that help capitalize energy alternatives. It is not calling an investment industry summit to speed decarbonization. All of that might violate its self-definition of fiduciary duty. Instead, BlackRock will do nothing that might drain profits until the federal government requires, for example, a carbon pricing regime.

BlackRock remains a climate bystander. It will prepare its clients for the inevitable demise of fossil fuels by more carefully examining companies and industrial sectors “exposed to a reallocation of capital.” This is little more than an accounting exercise and a classic example of what Al Gore calls “the pernicious orthodoxy of short-termism.” It is also an abdication of social responsibility.

The allure of cost-free ethics

Why does the investment industry avoid social ethics? What is it afraid of? It fears losing money. Specifically, it fears any strategy, such as divestment, that narrows the available set of investment opportunities. The prospect of multiple activist interest groups demanding that one class of stocks or another be eliminated from a portfolio to achieve a social end is a profit killer, according to modern investing precepts. Agreeing to constrain a portfolio for extraneous reasons is especially risky in a highly competitive industry like investing, where the fees clients pay are being driven down by index funds and exchange-traded funds.

The benefits of a broadly diversified portfolio spring from Modern Portfolio Theory, which is anchored in the Nobel Prize-winning work in the 1950s of Harry Markowitz. He argued that the logical method of analyzing a single security or stock to understand its true value was flawed. By applying statistical analysis to a broad set of assets, an investor could create an optimal portfolio of many stocks. The analysis would examine diversification, risk, and expected return for the whole combination of stocks. Eliminating a class of stocks based on ethics would undermine the benefits of diversification and lower expected return for the portfolio. This is one reason – perhaps the most important – that university endowments and many other portfolio managers resist eliminating fossil fuel investments. They fear a persistent erosion of diversification driven by the endless whims of pressure campaigns.

Lost in all of these considerations is a simple truth. Neither true diversification nor ESG analytics matter at all if an individual or institution focused on the long term decides to apply principles of social ethics – the consideration of right and wrong. Yes, this investor might forgo some profit, or might not. This is the heart of socially responsible investing. You risk lowering returns. But you make a choice. The buyer of an electric vehicle, knowing it costs more than a gasoline model, makes the same choice. If we know as a society that our continued burning of fossil fuels is dragging us into a climate calamity, how can it be right to continue to finance the extraction of oil, gas, or coal? How can it be right to pretend that combating climate change through investments will not involve costs?

The ethical argument drives campus activists who stigmatize the fossil fuels sector and encourage a swift capital shift to alternatives. We know that financing or capitalizing corporations that extract, refine, transport, or burn a resource whose use contributes meaningfully to climate change is a pursuit manifestly harmful to society. As such, it is wrong – not just economically fruitless in the long run but morally barren today. The activists, along with faculty supporters, maintain that it is unjust and intolerable for a university, which exists to pursue public good and not private profit, to maintain investments in oil, gas, and coal. Whether carried out by a university endowment, a pension fund, a church, or a multinational bank, ethical choices are perfectly valid in their own right and may or may not reduce portfolio returns. If stakeholders or shareholders demand that maximizing portfolio returns outweighs all other considerations, so be it. They have made the decision to ignore social conscience and will be judged accordingly. They cannot, however, claim to be acting responsibly under any definition of the word. Companies usually do not think this way, however. For asset owners and managers, ESG is a sales mechanism too good to pass up. And it keeps social activists at bay.

Fiduciary desires

Investment professionals adhering to Modern Portfolio Theory have declared for decades that placing extraneous ethical restrictions on a portfolio could not be in a client’s best interest and would be a violation of the firm’s fiduciary duty. It is conceivable that even the ESG process of considering a stock’s exposure to environmental, social, and governance risks might run afoul of this legal duty. This fear never materialized.

In 2005, just as Kofi Annan’s various partnership projects were getting off the ground, the UN sponsored a deep look at fiduciary responsibility around the globe. The law firm Freshfields Bruckhaus Deringer conducted the research. In a book-length report , the firm concluded that the legal canons and precedents of the world’s major economies either did not require firms acting as fiduciaries to maximize returns or prescribed no particular level of required profitability. Unless a client set a specific investment mandate for a portfolio, what mattered was that the fiduciary followed “the correct process” of decision-making, as Freshfields put it. It took only a small leap of logic for Freshfields to conclude that the consideration of environmental, social, and governance factors in weighing the value of a holding and its future performance was “clearly permissible and is arguably required” of fiduciaries. Investors are required to weigh the value of such intangibles as a company’s brand or its patents, which fall under the standard accounting concept of “business goodwill.” Weighing the value of material ESG factors in the investment process is no different, Freshfields said.

Two conclusions flow from the Freshfields report. If it is arguably a requirement that fiduciaries consider every material risk, why are ESG risks packaged in a special research process of their own? Again, the answer is that ESG, as a standalone process, is unnecessary. Only because it serves an important marketing end does ESG become a business necessity. Secondly, is a fiduciary who sees the looming demise of the fossil fuel industry over the horizon serving a client’s best interests by ridding a portfolio of fossil fuels stocks? If the process for reaching that conclusion is sound, fiduciary duty has been satisfied.

But this idea is inconvenient. When it serves the interests of money managers to avoid removing fossil fuel holdings from portfolios, they cite fiduciary duty. It is equally logical that fiduciary duty requires money managers to remove client capital from the certain risks of climate change, including holding oil and gas assets that will ultimately be worthless. Yes, it will take years to transition from fossil fuels to renewables, and the value of today’s fuel reserves is debatable. There is little debate, however, about the urgent need for accelerated U.S. investment in renewables. We trail both China and Europe on that measure. So, the question arises: which is more socially responsible, shifting capital now from fossil fuels to renewables to spur and accelerate the transition, or standing on the sideline promoting the self-fulfilling prophecy that the transition will take a generation? Responding to climate change can certainly be both morally sound and economically justified.

Beyond fiduciary duty, asset owners and managers argue that fossil fuel divestment will cause them to lose their voice as voting shareholders of companies that need to evolve during an energy transition. This process of “engagement” may be useful at the margins and over long time horizons, but it can occur without ESG. CalPERS, having enormous financial leverage, is one of the most active participants in the process of urging companies to cut their carbon footprints. The pension fund has a fiduciary duty to retirees and at some point, that duty will demand the sale of fossil fuel stocks. But CalPERS, to our knowledge, is not threatening to divest, which would provide the greatest leverage. Many other asset managers frequently cite engagement as a means of persuading companies to disclose more to investors about their embedded climate risks. This is an accounting exercise. The investment industry’s claims of benefit from engagement fit neatly with its cult-like devotion to ESG. But as harmful emissions continue to rise, where is the evidence that pushing companies for more risk disclosure is shielding us from climate change? According to the Emissions Gap report, there is none.

‘Alibi for inaction’

This is essentially the conclusion that John Elkington, creator of the “triple bottom line” accounting method, reached in 2018. In a powerful essay in Harvard Business Review, he announced a “recall” of his TBL framework. Elkington noted the growing investment opportunities that the sustainability movement was expected to deliver, then added: “But success or failure on sustainability goals cannot be measured only in terms of profit and loss. It must also be measured in terms of the wellbeing of billions of people and the health of our planet, and the sustainability sector’s record in moving the needle on those goals has been decidedly mixed. While there have been successes, our climate, water resources, oceans, forests, soils and biodiversity are all increasingly threatened. It is time to either step up – or to get out of the way.”

In sobering fashion, Elkington concluded that ESG and similar metrics “can provide business with an alibi for inaction” and that such sustainability frameworks will not be enough to make an impact “as long as they lack the suitable pace and scale – the necessary radical intent – needed to stop us all overshooting our planetary boundaries.”

Conclusion

It is difficult to escape the conclusion that the United Nations collaboration provided the global finance and investment industry with either a self-delusional approach to thwarting climate change or exquisite cover – what Elkington called an “alibi for inaction.” ESG and the UN PRI have served as an immense distraction that may be locking billions of dollars of capital into investments that will serve only to delay an energy transition. Boards and CEOs are absolved of responsibility for this distraction, because they operate under a new definition of responsibility, one not based on outcomes but on business process.

The only meaningful way to define socially responsible investing is as a trusteeship and stewardship of the very things that profitable commerce requires: peace and stability, sustainable sources of food and water, an educated and thriving middle class, effective fire and flood control, reliable transportation and communications networks, and sustainable energy sources. Stewardship is the ultimate fiduciary duty. We cannot pretend that ethical investing comes without costs or is a natural outcome of unfettered commercial forces. This defies all common sense. Resisting climate change will be costly. The burden will fall more justly only if institutions and individuals become true stewards, operating from the dictates of conscience, not corporate Newspeak. Social responsibility might even take, as Elkington put it, “radical intent.”

Our need for moral leadership on climate change from the investment community in the United States has not diminished. The greater the investment industry’s urge to recede to the haven of self-satisfaction, the more urgent it becomes for its clients, customers, and beneficiaries to see through the gauzy marketing. The boards and officers of the nation’s biggest banks, investment firms, universities, and corporations understand the threat of climate change. But they have locked themselves into the position that climate challenges will be addressed in due course by a process that they and the United Nations have deemed to be “responsible.” In the meantime, the investment industry is selling the concept of “doing well by doing good” for all it is worth.

This is why BlackRock declares in bold type that “sustainability, and climate change in particular, are poised to transform investing.” What we urgently need is the reverse. We need investing to transform climate change.

E.A. Blair worked in the asset management industry for more than a decade. See www.eablairessay.com.

Copyright 2020 © E.A. Blair All rights reserved. No portion of this work may be reprinted without the written permission of the author.

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