Society Inc.

ESG—environmental, social, and governance—investing has become one of the fastest growing areas of finance in recent years and increasingly influences capital allocation decisions for investors and firms. But what exactly is ESG, and does its actual impact on a broad group of economic “stakeholders” match its advertising? As ESG funds have grown their assets under management in recent years, ESG invest­ment criteria have, if anything, only become more contested.

Indeed, Bloomberg Businessweek recently revealed that the largest for‑profit accreditation company of corporate environmental and social responsibility, MSCI, does not actually measure a corporation’s impact on society or the environment, but rather assesses how companies are reducing regulatory and brand risks for their shareholders.¹ New York University finance professor Aswath Damodaran recently lamented that the ESG ecosystem is merely a “gravy train” for consultants, ESG fund managers, and investment marketers, leading to little social benefit for stakeholders outside of the self-serving circle of the ESG industry.² Former Facebook executive, SPAC promoter, and Social Capital found­er Chamath Palihapitiya has made an even bolder statement that ESG funds and evaluation agencies like MSCI are fraudulent products.³ He argues that these groups use the veneer of social and environmental responsibility to reduce regulatory oversight for multinational behemoths while allowing them to apply for negative interest rate loans from central banks. From Palihapitiya’s perspective as a venture investor, these “green washed” and “social washed” funds attract investment away from actual businesses that are addressing social and ecological challenges more fundamentally in their business models.

MSCI and other ratings companies have also been criticized for their lack of transparency, divergent approaches to measure­ment, and conflicts of interest. While credit rating agencies’ measures of the credit risks of companies are largely comparable, ESG ratings do not show this same convergence.⁴ Florian Berg of MIT’s Aggregate Confusion Project has shown that often “the firm that is in the top 5% for one [ESG] rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”⁵ Under the current state of affairs, ESG ratings are basically meaningless for comparing investments.

Nevertheless, whether the ESG industry is a gravy train, a fraudulent system of smoke and mirrors, or a mixed bag of confusing options, one thing is clear: the industry is ballooning. By 2025, ESG funds are predicted to grow to $53 trillion.⁶ One in three dollars invested globally is now invested in ESG products.⁷ From 1993 to 2017, ESG reporting grew from 12 percent to 75 percent in the hundred largest corporations in forty-nine countries (4,900 companies).⁸ By some estimates, there are 160 ESG ratings and data products providers worldwide.⁹ Fueling this growth is increasing demand from investors across all demographics. According to a survey conducted by Natixis Investment Managers of 8,550 individual investors across twenty-four countries in April 2021, 77 percent believe it is their responsibility to keep companies accountable for their impact on society and the planet.¹⁰

Yet paradoxically, ESG funds rarely vote in favor of environmentally and socially conscious shareholder resolutions.¹¹ Researchers assessed 593 equity funds with over $265 billion in total net assets that specifically used ESG- and climate-related key words in their marketing. They discovered that 421 of the funds, or 71 percent, have a negative “Port­folio Paris Alignment” score, indicating that the companies within their portfolios are misaligned from global carbon reduction targets.¹² BlackRock’s U.S. Carbon Transition Readiness ETF has holdings in fossil fuel companies and invests in the largest funder of fossil fuel companies, JPMorgan Chase.¹³ Institutional Investor magazine has high­lighted a litany of examples of major brands (Coke, Nestle, etc.) that have been celebrated as ESG stars and yet deplete local water aquifers, generate significant plastic waste, employ child labor in their supply chains, and provide mostly unhealthy beverages to their customers that contribute to obesity, diabetes, and other health problems.¹⁴ Other highly rated ESG investments like Nike, HP, and Salesforce have used accounting tricks to avoid paying U.S. taxes.¹⁵

What about the innovators in Silicon Valley? Scott Galloway, professor of marketing at New York University’s Stern School of Business, has taken aim at Aspiration, a fintech company valued at $2.3 billion that provides debit cards as well as an ESG-focused investment fund, Redwood (redwx), which has been highlighted in B Corporation’s “Best for the World.”¹⁶ Yet like many ESG ratings companies mentioned above, the “AIM” (“Aspiration Impact Measurement”) score it uses to inform customers of positive impact purchases lacks transparency. Even worse, AIM highlights brands based on their climate and diversity slogans regardless of their effect on climate change or other real‑world impacts. Aspiration’s fund, contrary to its marketing slogans, invests in carbon emitting airline and energy companies. In contrast to what the ESG industry may say in their marketing, these funds and companies are not exactly exemplars of high integrity or corporate citizenship.

Misaligned Ends

These revelations undermine the claims of the ESG industry—that their funds will reduce the negative impacts of corporations on the common goods (air, water, livable climate, social trust, etc.) critical for the flourishing of American families and communities. In reality, ESG metrics work from the outside in, assessing the risk from society to the company, not the reverse. While transparency can be effective at chang­ing some corporate behaviors,¹⁷ most market-led ESG measurement accounts for activities or processes and not outcomes, often reporting new ESG programs but not reporting the success or failure of these efforts.¹⁸ Any scrutiny of existing activities begets other activities that may be great for public relations—and reducing oversight—but which do not fundamentally alter the corporation’s negative impact on Ameri­can society or our natural environment. As an example, McDonalds recently reported its commitment to achieving net-zero carbon opera­tions by 2050 but still fails to show how it will practically address its current massive impact on global warming.¹⁹

Such corporate behavior is predictable given the past and current design of financial institutions and modern corporations. Until these designs are reimagined and replaced, ESG will rarely align with social and environmental impact because investors and corporations will be primarily focused on profit and valuations. We should not expect otherwise.

Some in the industry have claimed that markets on their own are moving toward investments in businesses that do good profitably. Some studies have shown better social and ecological performance can lead to better financial returns, especially for those who make wise bets in predicting social shifts, but this research does not conclude that these efforts will lead to corporations actually solving problems for people and the planet.²⁰ More recent, conflicting analysis is showing that positive ESG performance does not always correlate with higher cash flows or profitability.²¹ Other studies have found that while companies with a poor ESG record may face higher costs of capital, the lack of social and ecological limits gives them the competitive advantage to scale globally and increase profits.²² As a proof point, oil stocks actually performed better in 2021 than highly rated ESG funds.²³ It is getting harder to claim that “good behavior” (at least as currently defined by ESG funds) is an effective means to achieve higher profitability and returns for shareholders.

In contrast, while ESG products track the impact of social attitudes and potential government policy on the corporation, the adverse impacts of corporate activity on the nation are becoming clearer. U.S. policymakers, in particular, should note the recent corporate failures that demonstrate how the financial goals of multinational corporations and investors continue to be misaligned with the aims and interests of the American republic. Since the Constitutional Convention, the people of the United States have sought to form a “more perfect union.” Yet when Mark Zuckerberg, CEO of Facebook (now Meta), learned from his staff that platform changes that were aimed at “strengthening bonds between users” were actually making Americans angrier at each other, he resisted proposed fixes because they would lead to lower levels of user engagement and lower ad revenues.²⁴ Our republic is dedicated to “promoting the general welfare.” Yet when Purdue Pharmaceuticals realized that its top-selling pain medicine was causing overdoses, addictions, and com­munity breakdown, it doubled down on its aggressive marketing of opioids.²⁵ Our republic is designed “to secure the blessings of liberty for ourselves and our posterity.” Yet in 2019, the NBA restricted the free speech of American coaches and players who spoke up for the liberty of Hong Kong residents facing oppression from the Chinese Communist Party. The goals of the Constitution and the goals of multinational corporations are often misaligned.

These conflicts of interest all make sense if you understand the design of modern corporate governance. If a corporation’s purpose is to increase shareholder returns, and the salary and stock benefits of CEOs are tied to shareholder returns—and regulators determine that management has a fiduciary responsibility to consider only ESG factors that are “material” to financial returns for shareholders—then why would any company limit its ability to increase valuation and profits?

Reimagining Corporate Purpose and Performance

In 2019, facing this dilemma of profit maximization versus corporate citizenship, the Business Roundtable, a powerful collection of over 180 American CEOs, made a public statement ending the organization’s decades of support for economist Milton Friedman’s idea that the social purpose of business is to maximize shareholder value for investors. They provided a new vision called “stakeholder capitalism,” which includes the full range of stakeholders (workers, investors, suppliers, communities, etc.) that should experience the benefits of growth and prosperity. Although the announcement made a splash in the financial and business press, two years on the dominant ESG investment players still promote Friedman’s shareholder-first model, albeit with a socially varnished covering. Unfortunately, the Business Roundtable lacked a rigorous plan to turn its grand visions into reality and to overcome the conflicts between genuine ESG and profit maximization highlighted above. In 2021, researchers from the Harvard Law School Program on Corporate Governance²⁶ found that “about 85% of the signatory companies didn’t even mention joining the ‘historic’ statement in their proxy statements sent to shareholders the following year. Among the 19 companies that did mention it, none indicated that joining the statement would cause any changes to how they treat stakeholders.”²⁷ Their analysis of the signatory companies revealed that two years later corporate governance is still tied to shareholder value maximization with no substantive link to performance for other stakeholders.

While in the last decade, many companies have begun to incorporate ESG approaches into their strategic conversations, annual reports, and public branding, most have lacked any formal management and incen­tive structures to systematically utilize capital and talent to achieve positive ESG impacts.²⁸ Even more difficult, federal and state policy still upholds the “shareholder first” paradigm. But for ESG to become some­thing more than a gravy train, it will require, as Harvard Business School professor George Serafaim has advised, both market forces and public policy: “Contrary to the opinions of some, neither is likely to be sufficient in making progress and both are necessary.”²⁹

From the market side, in the wake of the financial crisis, a positive step occurred when the CEO of Mars Corporation asked his board, “What is the right level of profit for a company?” This provocative question sparked a movement called “economics of mutuality,” led by Mars’s then chief economist Bruno Roche and Oxford Saïd Business School professor of finance Colin Mayer.³⁰ In their proposed new paradigm, mutuality is “the creation of shared and lasting positive benefits across stakeholders through an organization’s activities.” In the context of corporate governance, “every corporation has a purpose to produce profitable solutions to the problems of people and planet; while at the same time not profiting from producing problems for people and planet.”

In Roche and Mayer’s new conception, “Ownership is not just a bundle of [property] rights but also a set of obligations [to stakeholders] to put their purpose into practice. Firms in this context are not just nexuses of contracts but a nexus of relations of trust based on principles and values upheld by the boards, directors, and companies.”³¹

The economics of mutuality squarely opposes the theories of “finan­cial capitalism” inspired by Milton Friedman. Mutuality claims that the theory of shareholder value maximization has little to no regard for our human ecology, the reality that people and businesses exist inside a web of ecological and social relationships, and that this human ecology is built on a foundation of common goods necessary for human and planetary flourishing.

In Completing Capitalism, Roche and his coauthor, Mars’s Catalyst think tank director Jay Jakub, observe that while financial capital is abundant under the regime of low interest rates and cheap money, scarce natural resources are being used at an alarmingly unsustainable rate, overshooting our global capacity to renew what they term “natural capital” (clean freshwater, clean oceans, energy, topsoil, biodiversity, etc.), the resources needed to support human life and economic activity over the long term. We are taking more from Earth than the planet can now sustainably provide.³² With Mayer, they outline additional com­mon goods (human talent, social trust, and more) undergirding success­ful businesses in an economics of mutuality.

Unlike the Business Roundtable, Mayer and Roche’s proposals to address these new scarcities in common goods have actual substance and depth. From the lofty reimagining of corporate purpose, they have drilled down to the mundane challenges of accounting for societal and ecological impact, creating a way to measure responsible stewardship for multiple common goods. To aid CFOs in the challenge of responsible oversight, Mayer, Roche, and their colleagues have even reimagined a “mutual” profit and loss statement to track a company’s performance in creating mutual value for all stakeholders. At Oxford, they are training both MBA students and current business leaders in a methodology of purpose-driven leadership and the management of mutuality within corporations, providing case studies of real companies that put purpose into practice. One of their case studies demonstrates how SAP, a company with over 95,000 employees and $24 billion in revenues, is implementing Integrated Reporting, a process of assessing, measuring, and quantifying forms of pre-financial capital throughout its business.³³ Examples of metrics include retention and development of talent, employee well-being, and the reduction of carbon emissions, energy usage, and water usage across the global company. With 77 percent of the world’s business revenues touching their systems, SAP has an opportunity to influence “pre-financial” reporting at a global scale.

Increasing Risks

Economics of mutuality is a noble, well-designed effort, but what if we are too late in the game? Take the example of climate change. Over a decade ago, the Pentagon recognized climate change as an “accelerant of instability or conflict, placing a burden to respond on civilian institutions and militaries around the world.”³⁴ Recent studies have documented the impacts of climate change on over twenty strategic U.S. military sites around the world.³⁵ In the next twenty years, these impacts will grow in scale and complexity, as global temperatures are expected to warm 1.5 degrees due to increasing human emissions of carbon dioxide³⁶ and other greenhouse gases caused by economic and population growth. On the current trajectory, climate change will have devastating effects on water and food systems both at home and abroad. In more fragile areas of the Global South, the prevalence of famines, droughts, and environmental degradation will continue to intensify conflicts over scarce resources and push millions of people to migrate to developed countries like the United States, risking political stability in all regions.

In 2021, these realities became hard to ignore. Due to a mix of climate change, poor forest management practices, and overdevelopment, global wildfires were larger than ever. The effects of climate change and natural resource depletion are starting to hit home for Americans, where 75 percent of the American West faced drought in the last year. And yet, even with widespread public outcry about impending effects of climate change, global emissions of greenhouse gases (GHGs) continue to rise.³⁷ Part of the challenge is that emissions are actually going down in the United States, but in Asia, where most of our supply chains have been outsourced, emissions are still growing at an alarming rate (as well as emissions generated by the transportation of goods back from Asia). From an American perspective, should we be allowing multi­national corporations and financial institutions to devour these re­sources and profit from regulatory arbitrage without concern for the impacts on the national security of our country and the general welfare of our citizens?

On the social side, corporate disinvestment in the American workforce and the decimation of American communities due to mass outsourcing of manufacturing and offshoring of tax liabilities has contributed to destabilizing distrust among our fellow citizens.³⁸ This distrust, combined with the fracturing effects of corporate social media, has rotted away the foundations of legitimate democratic governance and sparked a rise in domestic political violence culminating in the 2021 riots in the Capitol building. Social distrust, climate change, and the effects of forced mass migration on our politics are already beginning to feed into each other, making each problem harder and harder to solve and our nation increasingly vulnerable to outside threats from geopolitical rivals like Russia and China. The windows for change are closing quickly and a fraudulent ESG system will only redirect public attention away from strategic investments in solutions to our country’s most pressing problems. BlackRock’s former chief investment officer for sustainable investing honestly reflected on this reality in a tell-all essay: “What if the work I had been doing at BlackRock was actively harming society, by misleading the public and delaying overdue government reforms?”³⁹

While a market-led “economics of mutuality” movement is a brilliant long-term, “soup-to-nuts” approach to transforming our social and economic systems, we do not have time for corporations to slowly develop a social conscience. Globally, the modern corporation took centuries to evolve culturally and politically into its current form. In the United States, our political system has helped centralize corporate power, given private corporations many of the liberties and rights of individual persons, and enshrined in law corporate managers’ fiduciary responsibility to increase shareholder value as their primary purpose. To implement Roche and Mayer’s reforms in an American context will require decades of complex cultural change in both our political economy and financial institutions. Further complicating these efforts, our federal system decentralizes state authority over corporate governance. To change the nature of the American corporation would require changes in fifty different states.

The libertarian culture of America, even for some on the corporate left, will likely consider any such reimagination of corporate purpose and social accountability as a limit on individual freedom, even though better corporate investments in common goods could actually increase individual freedoms through better pay and benefits, better long-term investments in human talent, and increased social trust due to shared value creation for local communities. Some corporate leaders will fight this tooth and nail and redirect public attention solely to individual rights issues like racial and gender diversity. Of course, a reasonable pursuit of equitable pay based on performance and ability is essential for civil rights and the constitutional goal of “establishing justice.” But adding diversity to boards and executive teams, while important, is not likely to lead to a family wage for working-class Americans, many of whom are women, immigrants, and people of color. Luckily for investors, most Diversity, Equity, and Inclusion (DEI) efforts deal with more subjective issues like sensitivity in communications and marketing, and often do not restrict the corporation’s ability to focus almost purely on profitability and valuation at the expense of workers and local communities. More rigorous requirements for cor­porate stewardship will be much harder to justify in service of the bottom line.

We see this resistance to real accountability playing out in the recent efforts by the U.S. Securities and Exchange Commission (SEC) to regulate corporate reporting on nonfinancial performance. The SEC, under chairman Gary Gensler, has signaled an intention to create base­line standards for sustainability reporting but faces substantial opposition from some in the financial industry who defend a narrow definition of materiality.⁴⁰ He has also faced fierce opposition from some politicians, and SEC Commissioner Hester Pierce has claimed, “Many ESG issues lack a clear tie to financial materiality and therefore do not warrant inclusion in SEC-mandated disclosure. And if not materiality, what would an alternative limiting principle be.”⁴¹ In other words, if it doesn’t help the bottom line, it shouldn’t matter.

Transparency Now: Impact Weighted Accounts

Again, this ultimate emphasis on financial performance is to be expected. We need to realize that corporations, especially publicly traded multi­national corporations, are not designed for social outcomes and likely will not be any time soon. But our republic under the Constitution is. We need to strategically focus on corporate transparency efforts that match the goals of the Constitution (e.g., national security, domestic tranquility, the general welfare of our citizens). Particularly for Ameri­can companies that provide ESG products, the government should be able to know that firms are not negatively impacting the United States. Otherwise, any ESG product is fraudulent. Unfortunately, this is all too similar to some other corporate marketing labels like “made in America” and “organic” foods.

Even within the constraints of our current political economy, the U.S. government has the appropriate role, power, and resources to provide information on stewardship of national common goods without unduly limiting the economic liberty of Americans, especially if the investment products in question label themselves as socially and ecologically responsible. There is precedent for this in American history as well. In the wake of the financial crisis that caused the Great Depression, the Roosevelt administration rightly standardized financial report­ing to increase transparency and protect the integrity of markets for the good of the national economy. This transparency effort ultimately led to growth in capital markets.⁴² Given the risks we face as a nation from corporate impacts to community flourishing and freedom, we need a similar effort to increase the transparency of ESG reporting that address­es the multiple crises outlined above.

Professor George Serafeim of Harvard Business School and impact investor Sir Ronald Cohen have created one potential near-term solution that provides a credible and objective methodology for assessing corporate impact on our society and environment. In this accounting methodology, called Impact Weighted Accounts, “line items on a financial statement, such as an income statement or a balance sheet, are added to supplement the statement of financial health and performance by reflecting a company’s positive and negative impacts on employees, customers, the environment, and the broader society.” The Impact Weighted Accounts augment traditional valuation methods⁴³ and calculate negative social and ecological impacts in terms that businesspeople can understand: value creation and value destruction for society in dollars (or other currency terms). The approach provides “precise, comparable figures about the impacts of corporate operations, employment, and products, and [reflects] them in financial accounts.”⁴⁴

Serafeim and his team have analyzed the total environmental cost created by 1,800 companies. As an example, they found that Sasol and Solvay, two chemical companies with comparable revenues of around $12 billion each, created environmental damage of $17 billion and $4 billion a year, respectively, while another, BASF, with $70 billion of sales, created $7 billion.⁴⁵ His team has revealed that 250 businesses “create more environmental damage a year than profit, that 600 create damage equal to 25% or more of profit, and that together the 1,800 companies create $3 trillion of damage annually.” Serafeim and his team have shown that you do not necessarily need a regulatory authority to create transparency.

What if an independent organization had the resources, mandate, and bipartisan oversight to use Serafeim’s methodology to assess the social and environmental impact of all U.S.-based firms in ESG funds?⁴⁶ Without any additional regulation, American citizens and investors would have access to public data that accounts for social and ecological impact. Similar work could be done to assess other national interests or constitutional goals. This would bypass the need to show connections to materiality as outlined in SEC regulations and would require no changes to corporate governance law at the state level. A company could still pursue shareholder value maximization at the expense of other stakeholders, but if it chose that strategy, it would have to address the public outcry for the social value destruction caused by its products, services, and activities.

A Window of National Sovereignty

If the U.S. government does not act, other stakeholders will. Global finance is moving to standardize ESG reporting. The United States has a window of opportunity to make sure we measure corporate impact on American society, not the other way around. Different models and regional approaches (United States versus Europe versus Asia) to ESG standards make efficiency and scale difficult for global banks, asset managers, multinational corporations, ratings agencies, and accountants. These players have every incentive to align ESG standards around the ends of the financial industry, not society.

To address the demand for clearer ESG criteria, the IFRS Foundation Trustees announced in November 2021 the creation of a new standard-setting board, the International Sustainability Standards Board (ISSB), to house these efforts. Some have questioned the independence of IFRS to create standards for the industry, however, when a large percentage of the organization’s funds comes from financial services and accounting firms.⁴⁷ Outside the industry, IFRS receives funds from the Chinese Ministry of Finance.⁴⁸ Their work towards standardization and trans­parency in sustainability reporting is rational and in principle a good practice for corporate responsibility at a global level, especially for climate change. And accounting standards for financial reporting are not likely to need variation across societies. Accounting for social impact is different, however. What is socially good in Vietnam or Belgium may not be socially good in the United States. Americans should be determining what is good for their own society.

While it is not an individual nation, the European Union as a governing body has moved further in regulating its ESG industry. The European Commission has led a multi-stakeholder process to align the meaning and use of ESG terms and metrics (or “taxonomy”). Like any collaborative effort at the level of the EU, the process was messy, the final content is dense and complex—which will likely add further fuel to the ESG consulting and accounting gravy train—and not every country is happy about the outcomes. The German Green Party objected, in particular, to the inclusion of nuclear energy and natural gas in the ESG taxonomy. Defenders of nuclear, especially the French, point to the efficacy of nuclear in reducing carbon emissions. Gas was included because of the social impact that the loss of natural gas could have for many poorer European countries. But to the Commission’s credit, it has driven a process that is citizen-centric, not finance-centric. Starting in 2022, asset managers in the EU will be required to integrate social and environmental impact considerations into their fiduciary duties.⁴⁹

The United States has different interests and priorities than the EU, but it shares common primary stakeholders—citizens, not shareholders. We likely will not create a complex taxonomy of social and ecological responsibility and regulate the use of that taxonomy. But we can hold the financial industry accountable with stronger, federally funded assess­ments of corporate impacts on our nation.

Regardless of the current hype, ESG will rarely fully align with the stewardship of common goods because investors and corporations will always be primarily focused on profit and valuation even when they say otherwise. This should be expected based on the centuries-old design of corporate incentives. Without government-led accountability for power­ful multinationals, corporate managers will continue to pursue shareholder value maximization at the expense of national interests and the flourishing of future generations.

We have a choice. America can either lead or outsource responsibility for what is “good” for our society to corporate managers and unelected global organizations, ones getting funding from the Chinese government. If America wants to be more than a “servile state” to unelected global interests and instead have corporations serve the nation and the common good of our society, American policymakers need to create transparency in social and ecological impact that works for our national goals as outlined in the Constitution. The time for America to act is now, while we still have the agency to lead and influence the process for our national security and general welfare.

This article originally appeared in American Affairs Volume VI, Number 1 (Spring 2022): 3–17.

Notes