ESG and the Road to Serfdom

Well, if that's not a headline grabber, I'm not sure what is. This is probably going to be a controversial article, and I want to make clear at the outset that my views in no way represent those of my firm.

If ESG factors matter to you, by all means invest accordingly. I also care about environmental, social and governance issues. My guess is almost everyone does to varying degrees. Additionally, over the last six years I have invested in companies benefitting from cost declines in renewable power, advised clients to do so and at one point was marketing an energy transition fund to potential institutional investors.

This is a short way of saying that I am neither uninformed nor an anti-environmentalist by any stretch of the imagination. However, my investment work was (and still is) based on fundamental research and compelling valuations rather than an overarching policy preference. And as someone who almost exclusively uses vacation time for remote hiking trips, trust me when I say that I truly care about environmental stewardship.

As I hope I make clear below, my concerns aren’t so much with specific ESG priorities, but rather the top-down and opaque imposition of these factors into the broader investing process. So with that out of the way, let’s begin.

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In 1944, during the height of the Second World War, the Austrian economist and philosopher Friedrich Hayek published The Road to Serfdom. In this classic and influential work of political and economic philosophy, Hayek mounted what many consider to be the definitive case for and defense of classical liberalism.

From the libertarian-leaning Mises Institute:

"This spell-binding book is a classic in the history of liberal ideas. It was singularly responsible for launching an important debate on the relationship between political and economic freedom... It warned of a new form of despotism enacted in the name of liberation. And though it appeared in 1944, it continues to have a remarkable impact...

"What F.A. Hayek saw, and what most all his contemporaries missed, was that every step away from the free market and toward government planning represented a compromise of human freedom generally and a step toward a form of dictatorship--and this is true in all times and places. He demonstrated this against every claim that government control was really only a means of increasing social well-being. Hayek said that government planning would make society less liveable, more brutal, more despotic...

"Capitalism, he wrote, is the only system of economics compatible with human dignity, prosperity, and liberty. To the extent we move away from that system, we empower the worst people in society to manage what they do not understand."

Over the course of this article, I hope to make a compelling case for how ESG investing, as currently implemented by large asset managers, is a threat to our free-market, capitalist system and democracy itself. I am not trying to be overly alarmist or sensational here for the purpose of getting attention. I have given these issues deep thought and am concerned about the road the investment community is leading us down and what I see as its final and inescapable destination if we don't course correct.

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I’m an investor with a contrarian streak. My approach is to figure out where markets may have materially mispriced something and then to take calculated risks that would benefit from catalysts bringing about a return to rationality. Most of the time this is hard because markets are rational and efficient. But as any investor knows, they are also prone to irrational extremes, as well as inefficiencies often driven by technical factors, like liquidity. (See Andrew Lo's Adaptive Markets for a deeper dive on this.)

The reason markets are usually rational and efficient is because the wisdom of the crowd is incorporated in prices. And the crowd is often more accurate and insightful than any one investor – especially over the long-term. That said, the crowd’s collective wisdom sometimes morphs into collective foolishness, especially during periods when seductive narratives and ample liquidity trump fundamentals. (For more on this, see Robert Shiller's Narrative Economics.)

Most bouts of irrationality are harmless and even entertaining (like GameStop and AMC earlier this year), except for those holding when the music stops. Sometimes frenzies result in productive investments though investors end up losing money – such was the case with the investment in fiber optic cables during the 1990s Tech Bubble.

But as we all know, market frenzies can sometimes be destructive – especially when the harm reaches beyond the group of involved companies and investors. The aftermath of the 2007-08 US housing/Financial Crisis is the most recent and perhaps most salient example. Widespread financial misjudgments are bad for society, as they result in malinvestment, the destruction of capital and, unconscionably in the past few crises, socialized losses. When this happens, we often get intense public backlash to the market-based system. "Occupy Wall Street." "Democratic Socialism." This is unsurprising but unfortunate.

Historically, the sensible deployment of capital and socialized gains are trademarks of a functional free-market economy. Promising firms attract investor funds, enabling productive innovations. Yes, in a capitalist system some will succeed more than others, but we all reap the benefits of new products and services.

I’d go further and argue that ever since the inception of market-based economies, the human condition has been improving. You can basically trace a chart back of global progress in living conditions, for which I’ll use GDP as a rough proxy, with the beginning of financial market operations in Belgium and Amsterdam in the 16th and 17th centuries.

Market-based economies excel for many reasons. Three high-level ones worth highlighting:

1) Profit is a motivating factor that leads to hard work and innovation. But funding that work used to be arduous and personally risky. Ever heard of debtor’s prison? The advent of the “joint-stock company” enabled start-up risks and potential profits/losses to be spread across a broad investor base, allowing entrepreneurs to raise capital - via freely tradeable shares - for ventures for which they would have otherwise had to assume personal liability or lacked the means to launch. (For a great discussion on this, see The Ascent of Money by Niall Ferguson).

2) Decentralization: Capital allocation decisions are decentralized in free-market economies. The wisdom of many investors – motivated by profit and prudence – is usually superior to the subjective decisions of state or central planners. This is central to the thesis of Hayek and history has borne it out over the last 100 years. As the baseball announcer Vin Scully succinctly and memorably stated:

3) The market signal: Let’s say a company develops a successful new product or service and gets rewarded by investors. Businesses respond to the positive market signal, iterating and competing. Investors and companies can redeploy profits into further innovations. This create a virtuous cycle of wealth creation, improvements in living standards and economic progress. 

Again, markets aren’t always right. My wife’s claims to the contrary, no one is. But by rewarding success, decentralizing decisions and enabling the input of the masses, free markets have a track record of producing beneficial results for investors and society over time.

My fear is that we are now in the early stages of a detrimental shift: from a dynamic free-market economy to an inefficient, centrally planned one. Where investors’ collective wisdom is being replaced by the imprudent preferences of an elite - and, dare I say, out of touch - few. This brings us to ESG.

Let’s start with a seemingly simple question: what would you think makes more sense to overweight in an ESG fund? (A) Well-governed firms whose products provide basic sustenance to billions the world over? Or (B) firms with dual class share structures, whose services are addictive and eroding public discourse and trust in democracies, and whose employees and management have repeatedly recoiled at the idea of working with Western governments? Surprisingly, or maybe not… B wins.

In the largest ESG EFT, the iShares ESG Aware MSCI USA ETF (ESGU), Facebook and Alphabet make up about 6% of holdings, while Exxon Mobil and Chevron combine for 1%. Apple is close to another 6% of ESGU despite kowtowing to China’s censors and sourcing products from suppliers with potentially suspect labor practices.

In the Vanguard ESG U.S. Stock ETF (ESGV), the total weighting of conventional energy producers is 0%. Likewise in the largest active ESG mutual fund, the $29b Parnassus Core Equity Fund. Similar examples are easy to come by.

Let’s be honest. ESG as practiced today is more like EEESG. But who is to say ESG factors should prioritize environmental considerations over all others? How are ESG factors even balanced? Unfortunately, this is not straightforward.

Below is part of the ESG evaluation rubric from MSCI, which manages the underlying ESG Index tracked by the iShares ESGU ETF. As a former lawyer, I give these charts and the accompanying document an A for obfuscation.

Unlike GAAP accounting, ESG reporting is not standardized. Despite ongoing efforts from groups like the UN-sponsored Principles for Responsible Investment (PRI), my belief is that in finance, once you move outside the realm of numbers, you quickly move into the realm of qualitative and subjective judgments.

I’m not the only one to come to this conclusion. This is what BlackRock’s former CIO for Sustainable Investing – Tariq Fancy – had to say recently in a scathing essay on ESG: "Unfortunately, there’s no clear definition of what [ESG] means — and much of it is believed to be a surface-level, box-ticking compliance activity."

While investing is a serious analytical business, it’s not a hard science where you can quantify things that are subjective by nature. But qualitative judgments are fine. I make them all the time when investing. And if you are choosing to invest in an ESG fund, you are making some qualitative judgment about your priorities. Which is great – you should, it’s your money! One’s personal beliefs should align with their portfolio – you have to be able to sleep well at night.

Unlike many allocators, at least the Parnassus fund I mentioned is more transparent about how they screen companies: The fund excludes stocks “that derive 10% or more of their revenue from alcohol, fossil fuels, gambling, nuclear power, tobacco or weapons.” As “Parnassus believes that these companies … don’t provide a net-positive contribution to society.” I disagree about nuclear and fossil fuels, but no one is forcing me or anyone else to invest in their fund. So if no one is forced to invest in ESG funds, why is any of this problematic?

Well, for one my suspicion is a lot of money flows into ESG products thanks to their marketing appeal, more than a careful consideration of their actual impact. But again, investors should be free to choose how and what they invest in.

Second and far more concerning is the implementation of ESG principles in non-ESG products. Investors managing over $80 trillion in assets have signed up to the Principles for Responsible Investment initiative. This includes BlackRock, Vanguard and State Street, as well as many endowments and pensions.

This is seemingly good, and PRI’s aims are noble. But when we have most of the world’s large asset managers pledging to integrate subjective ESG factors into firmwide investment analysis processes, we – as a society – may get some unintended results.

The most notable unintended results (though I’m sure some would say intended) are in the commodities and heavy industrials sectors, given the almost universal consensus of ESG adherents that carbon emissions are an unforgiveable sin.

At the outset, let’s put aside the question of the fiduciary duty these asset managers have to their clients. Another topic for another day but suffice to say, I’m not sure prioritizing ESG is always consistent with promoting client financial interests. Especially for those invested in non-ESG products.

And let’s also put aside questions of whether major ESG proponents actually lead the kind of low carbon lifestyles it would take to make a serious near-term dent in emissions. My hope is that many do, but my guess is that many don’t. The reality is not many people in developed markets are probably that eager to reduce their consumption habits back to 1950s levels, or pay more for services or goods that use less energy. But that's what it would take to make a meaningful near-term impact.

I’m going to highlight BlackRock here because its CEO Larry Fink is the most vocal and impactful large investor on ESG issues, particularly related to climate. In his 2021 letter to the CEO community Fink wrote at length about “climate risk” and accelerating the path to a “net zero economy.”

Even if well-intentioned and sensible, though, do we really want a handful of senior management at BlackRock and the world’s largest asset allocators pushing for policy-related changes? Isn’t this the role of government?

By virtue of managing tens of trillions of dollars in investor capital, BlackRock and other large PRI signatories have an outsized voice in company affairs. They clearly view environmental risks as a long-term investment risk and are engaging companies accordingly.

In Fink’s words again: “Investors are increasingly reckoning with these questions and recognizing that climate risk is investment risk… Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.”

Just as a quick aside, I think it’s a faulty hindsight narrative to say that climate risks are investment risks. Energy, industrials and other cyclical firms performed poorly in the last decade not because of their climate attributes. Rather, we were in a low growth, low interest rate environment with oversupplied commodity markets. This type of macro backdrop favors growth and duration over value, cyclicals and near-term cash generators. (See my article from July - The S&P 5(00) - for a bit more detail on this.)

And the notion that climate risk equates to investment risk has at least been poor foresight year-to-date. This year, firms with higher carbon profiles have been market leaders and as I’ve covered in prior discussions, I expect their outperformance to continue due to an inflationary macroeconomic regime and demand for commodities outstripping supply. (See my article from September - History 101 - for a deeper dive).

I do wonder if ESG will remain so popular if the holdings are green, but the returns are red.

Anyways, as the ESG voices like Fink’s have become more prominent and impactful, it’s fair to ask some critical questions.

Question: What have we got as a result of the call for curtailing emissions? Answer: A loud signal to energy and materials industry firms to reign in capital expenditures.

Spending on Upstream Oil and Gas Field Development from the IEA's 2021 World Energy Investment Report

Select Mined Commodity Capital Expenditures from the Financial Times

Question: What have we got as a result of large-scale managers either divesting from conventional energy and materials firms or supporting activist board engagement pushing for lower carbon business transformations (as was the case with Engine No. 1's activist campaign at Exxon)? Answer: A higher cost of capital for industry operators.

Unfortunately, by raising these industries’ cost of capital and decreasing their willingness to invest in new production (Exxon's new Engine No. 1-supported directors are now pushing to curtail large oil and gas projects), ESG-minded asset managers are indirectly increasing the cost of living for many in society who can least afford it. An "ESG consumption tax" on those least able to pay.

Yes, I am aware that lower commodity prices and investors pushing for greater capital discipline have contributed to the emerging commodities deficit, but ESG priorities have surely also helped get us here.

Based on ESG portfolio constructs and asset manager comments/actions, it sure seems like the movement is prioritizing environmental considerations at the expense of societal and governance ones. Yet, who is to say that emissions reductions to benefit future generations are a more important priority than improving the quality of life for current ones? I have a son and care deeply about his future, but I can’t truly put myself in the shoes of someone in poverty.

According to the World Bank, 43% of the global population lives on less than $5.50 a day and 9.3% on less than $1.90.

As reported a few days ago in The Wall Street Journal, 40% of Americans are experiencing financial distress, and 19% of households have lost all savings since the Covid outbreak.

Per the World Bank and BP, 13% of the world population (some 940m people) lacks electricity access. As seen in the below charts, the differences in energy and electricity consumption between people living in developed market countries vs emerging market ones are orders of magnitude.

Again, who is to say that access to affordable energy and poverty alleviation aren’t basic human rights that also warrant ESG consideration? Is it ideal that ESG priorities have contributed to the rise in daily living costs and a potential future energy shortfall?

Both BP and the IEA in their widely followed energy outlook reports predict that even in a rapid clean energy transition scenario, the world will be short on conventional energy supplies if we do not ramp up investment in oil and gas production. Especially over the next decade.

From BP's Energy Outlook (2020)

From the IEA's World Energy Outlook 2021

I think there’s a compelling argument that the environmental benefits of ESG shareholder activism are negated by the societal costs of declining resources affordability. But I also don’t know how any one investor or firm can truly weigh these factors.

Perhaps the climate-at-all-costs course is worth embarking on. But should it be the BlackRocks of the world moving us in this direction? Such impactful policy decisions involving complicated tradeoffs are traditionally the responsibilities and moral burdens of global governments.

And what if BlackRock’s and its peers’ approach is wrong? In their view, fiduciary duty and ESG priorities are one in the same, under the logic that what’s good for all stakeholders per the ESG framework is good for business and thus long-term profitability.

In Larry Fink’s 2021 letter to clients, he wrote: “Investment stewardship plays a key role in how we fulfill our fiduciary duty to our clients. We engage with companies regarding governance and sustainable business practices that we believe promote durable, long-term profitability.”

Again, how do we know if BlackRock is weighing these factors right or wrong? If striving to achieve climate goals results in higher energy and materials costs, which hits consumers and businesses, how is that net better for society, let alone the economy or long-term profitability?

I think it's notable that prior to the ESG rhetoric shifting into its current high gear, U.S. emissions were actually falling drastically thanks to free-market dynamics. Largely due to cheap natural gas supplanting coal in the power sector.

Charts from the U.S. Energy Information Administration.

And there were geopolitical benefits as well to the U.S. shale revolution (though I’m not sure where national security falls in the ESG framework...).

The free market was also working with wind, solar and battery storage cost declines. See, for instance, the below chart from Lazard’s widely followed Levelized Cost of Energy Report.

For those truly concerned about the climate, nuclear power has been viable for over half a century, producing reliable, reasonably priced, emissions free baseload power. You’d think environmentally conscious investors would be flocking to support it…

Rather than asset managers imposing restraints on business operations, I think we should be focusing on free-market technology solutions. Over time, the most reliable and cheapest sources of energy will ultimately prevail. And if trends continue, there’s no reason to believe renewables and nuclear won’t play a major role in emissions reductions.

But we talk about the “energy transition” because we can’t have a top-down, investor-mandated rapid “energy replacement” without resulting in some major, disruptive setbacks of the like we are experiencing today.

If free markets are ultimately considered to be an insufficient means to achieve carbon reduction, then governments should perhaps focus on implementing policies such as carbon taxes and/or more thoughtful and politically viable energy market reforms. The fact that they mostly haven't shows there is much more difficulty in balancing competing priorities than ESG investors let-on.

I worry about the consequences of unaccountable asset managers imposing societal-wide changes. At least governments can be voted out if their policies fail or are unpopular. To whom are these asset managers accountable if their policies result in any harm?

If the push by BlackRock and peers for climate goals ends up creating higher costs for consumers and businesses without discernable benefits, the blowback may undermine the initial energy transition goals and our political-economy itself.

As an aside regarding benefits, any reductions in emissions by the U.S. and other developed market countries in the near-term are likely negated (and then some) by China ramping up its coal production and consumption again. Despite this and well-documented human rights violations (as well as unreliable corporate governance), ESG-minded BlackRock is recommending clients increase their allocation to China by up to 3x. It sure does seem like the ESG motivations end as soon as they conflict with the business development ones.

Tying this to the beginning. Recall the three main tenets and benefits of a free-market economy: 1) profit motivation; 2) decentralized decision making; and 3) the market signal. The ESG movement as currently undertaken threatens all three.

1) ESG goals supplant profit;

2) Decision making is becoming ever-more centralized across large asset managers who apply the same ESG-motivated pressures to the boards and management teams of their holdings; and

3) The market signal is getting muddied by considerations outside business fundamentals.

Now, as a contrarian investor, this has made the market rife with new opportunities over the past few years, as it just has increased the overall level of inefficiency and irrationality (particularly within the commodities complex). But I’m not that excited about the broader implications.

If the ESG movement ultimately results in bad outcomes for society (like sharply rising energy and commodities costs, supply chain mayhem and stagnating economic growth) it will further erode confidence in our market-based system. As someone who strongly believes in the benefits of a free-market economy and has an appreciation for history, I’m worried about the potential for the ESG movement to undermine the viability of both our form of markets and government.

I’m of the view that economics explains much of history. People who are content don't become rebels. Countries at a sufficient level of wellbeing rarely go on to start wars. If the ESG movement contributes to key resource shortages, it is creating a less stable world.

If the free-market system is thought to have morphed into a ESG-driven market system that leads to a decline in living standards, the next big blowback won’t be like “Occupy Wall Street” or the “Democratic Socialism” movements, it will populism. Some would probably argue the U.S. is already dangerously close to going over this cliff's edge.

Pick up a history book. Declining living standards and instability almost always lead to a rise in populism. Modern instances of communist, socialist and fascist movements almost all started off as populist responses to dire economic circumstances, matured into totalitarian rule and ended in disaster. If Europe wasn’t immune to this in the 20th century, why should anyone think the U.S. will be in the 21st? This history is only a lifetime ago.

In turn, populism inevitably leads to worse conditions than its leaders and supporters sought to fix in the first place. Populist leaders tend to be long on rhetoric but short on actual policy solutions. With populism also comes free market interference, as populist leaders claim to know what's best and enough people have become desperate enough in their living circumstances so as to believe them. Yet, whatever is to be gained in the short term by centrally planned policies quickly erodes, leaving everyone worse off over the long-term.

And in the ways I have outlined, the current ESG movement - as implemented by the investment community - is leading us down the first footsteps of Hayek's road to serfdom.

It turns out that governing and balancing competing interests is hard. Much harder than just a three-letter acronym. While progress can be bumpy, free markets and liberal democracies have an excellent track record of getting things right over time. It would be a shame if ESG plays a role in our deviation from a proven but difficult path for the empty promises of a populist one.

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If you’re still reading... one, you have a lot of time and, two, you can probably gather I’m worried about the convergence of trends I’ve covered above. So I wanted to throw out one potential solution. One I never thought I’d be advocating for.

Antitrust was not my favorite law school course. The topic is dry and as a free-market oriented guy, it’s just not something that I’m naturally all that excited about. My antitrust law professor was Einer Elhauge – a great teacher, all around nice person and brilliant mind – who at least for me, brought some life to the otherwise dull antitrust party.

In the 10-ish years since I’ve graduated, Professor Elhauge has become a leader in scholarship critically examining the anticompetitive impact of horizontal share ownership by the likes of BlackRock, Vanguard and State Street. With the rise of ETFs and passive indexing, their combined and arguably anticompetitive influence over large swaths of the economy has become a growing issue.

In a 2019 article in the University of Chicago Booth School of Business ProMarket publication - titled: The Greatest Anticompetitive Threat of Our Time: Fixing the Horizontal Shareholding Problem - Elhauge wrote: "Horizontal shareholding poses the greatest anticompetitive threat of our time, mainly because it is the one anticompetitive problem we are doing nothing about...

"The leading shareholders of large competing firms often comprise the same set of institutional investors. Common sense and economic theory indicates that firms with the same leading shareholders are less likely to compete vigorously against each other...

"What can antitrust law do about horizontal shareholding? Quite a lot, in fact. The Clayton Act bans any stock acquisition that may substantially lessen competition, and Supreme Court case law makes clear that continuing to hold stock is an "acquisition." Even critics acknowledge that the plain meaning of the Clayton Act would ban horizontal shareholding—if they were convinced that it empirically had anticompetitive effects."

For a far more detailed analysis on the problems with horizontal shareholding and enforcement remedies under antitrust law, see Elhauge’s 2020 Harvard Business Law Review Article: How Horizontal Shareholding Harms Our Economy - And Why Antitrust Law Can Fix It.

In short, per FTC guidance, rising prices are an empirical sign of anticompetitive practices: "It is illegal for businesses to act together in ways that can limit competition, lead to higher prices, or hinder other businesses from entering the market."

If BlackRock and other large asset managers are imposing ESG priorities onto energy and materials companies, which leads to lower output and investment in future production, and in turn higher prices, this would seemingly call for antitrust review.

As mentioned above, this is already playing out. ESG-minded hedge fund Engine No. 1 succeeded earlier this year in its activist campaign to elect three new directors to Exxon's board with the support of BlackRock, Vanguard and State Street, who combined own over 20% of the stock.

From The New York Times article about Engine No. 1's victory:

"Last week, an activist investor successfully waged a battle to install three directors on the board of Exxon with the goal of pushing the energy giant to reduce its carbon footprint. The investor, a hedge fund called Engine No. 1, was virtually unknown before the fight.

"The tiny firm wouldn’t have had a chance were it not for an unusual twist: the support of some of Exxon’s biggest institutional investors. BlackRock, Vanguard and State Street voted against Exxon’s leadership and gave Engine No. 1 powerful support. These huge investment companies rarely side with activists on such issues.

"The stunning result turned the sleepy world of boardroom elections into front-page news as climate activists declared a major triumph, and a blindsided Exxon was left to ponder its defeat."

Well, I guess you reap what you sow. Today, during a time of commodity shortages and rising energy prices, we are seeing the results of Engine No. 1's institutional investor-backed victory (from the Wall Street Journal below). From a business and economic perspective curtailing production right now makes no sense.

The global oil and gas market is large, with many players. But it's not a stretch of the imagination to think that Exxon holding back on the development of large-scale, promising assets due to ESG-imposed pressure, brought on by its leading index fund shareholders, won't have some harmful impact on consumer prices. This seems like a clear, ESG-flavored example of the anticompetitive risks of horizontal share ownership.

For what it’s worth (per Bloomberg data as of Oct. 21), BlackRock, Vanguard and State Street together own over 20% of Exxon and Chevron. The three own equal or more amounts of shale firms like Pioneer Natural Resources, Diamondback Energy and EOG Resources.

Perhaps further scrutiny of the effects of overlapping/horizontal share ownership are worthy of an antitrust challenge by aggrieved consumers. Courts might be receptive to examining such a novel legal argument.

All I can say is it’s a lot more interesting and compelling of an antitrust theory to me than the so-called "Hipster Antitrust Movement," which is seeking to punish popular technology companies that have helped improve consumer welfare, in part by lowering prices!

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In sum: if you care about ESG issues, I sincerely hope you invest and live your life accordingly. I mean it when I say that I think that's great. Many ESG issues matter to me as well.

But if you care about free-markets and their viability, the implementation of ESG in its current form should be a concern.

If you made it through all this, thanks for your time and interest. I really appreciate it. Now, have a field day with the comments and critiques!

Disclosures:

This letter is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

Investing involves risks, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results. Consult your investment advisor before considering transacting in any security.