A Better Way to Regulate Social Harms than ESG Disclosures
By Joshua Ronen
In March 2023, attorneys general from 21 states sent an open letter to 51 asset managers alleging that their actions to influence climate-related and diversity-related policies at companies where they hold investments were a breach of their fiduciary duties and otherwise violated laws, including state anti-discrimination laws. A similar letter to insurers who are members of the Net-Zero Insurance Alliance followed in May 2023. Also, in 2023, a coalition of 26 states filed a lawsuit against the US government seeking to strike down a rule allowing retirement plans to consider Environmental, Social, and Governance (ESG) factors when selecting investments.
What prompts this opposition to ESG and protestations against ESG-disclosed factors? Greenwashing, non-verifiability, and prevarication lie at the root of the discontent. At best, the ESG framework and related disclosure requirements are an amorphous set of business objectives presumed to guide investors and prompt businesses toward socially and environmentally responsible investments. It is no wonder, therefore, that the obscurity surrounding ESG is raising opposition: If ESG disclosures shame companies into financial-wealth-reducing actions, resistance is understandable. However, based on my research, there is a mechanism that ensures truth-telling and optimal levels of ESG. Briefly stated, instead of disclosures, companies would report to the government acting as a social planner such truthful data as would ensure an optimal level of environmental and social investments. But first, let's unpack the pitfalls of the current ESG framework.
Governance, the "G" of ESG, aligns with the US free enterprise aim of optimizing investor wealth. However, the Environmental and Social aspects (E and S) are contentious. E and S pertain to a firm's reputational value, goodwill, stability, community, labor conflicts, legal and reputational risks, etc.; their disclosed information can inadvertently push companies into E and S endeavors that reduce shareholder value -- If such actions naturally increase shareholder wealth, they'd be rationally adopted.
Is mandatory disclosure of E and S activities desirable if 1) it pressures firms to engage in ES activities and 2) these activities diminish investor wealth? Should firms' activities enhance social well-being while harming investors (e.g., an ESG-focused company overinvesting in renewables becoming less competitive vis-à-vis those using non-renewables, thus decreasing financial returns to its non-ESG-minded investors), or should they harm investors only if they diminish social well-being? Only the latter is justified. The goal shouldn't be solely to drive firms towards E and S endeavors but to deter them from socially harmful practices, a distinction of profound importance.
Consider what might ultimately happen if ES activities decrease financial returns to shareholders without interest in ES. The continued transfer of wealth from shareholders would ultimately diminish their ability to invest in productive firms and decrease investment projects. Such a decline in productivity would inhibit economic growth and reduce social welfare. Eventually, such shareholders would exit the firm engaging in ES activities that diminish their wealth and migrate to firms that refrain from wealth-diminishing ES activities. Reduced demand for the firm's shares will reduce its stock price and increase its cost of raising funds, eventually leading to its disappearance. Disappearance will occur unless investors value ES activities and continue to finance the firm. However, with dwindling financial returns, such ES-loving investors will be impoverished and unable to sustain the firm's continued existence. With the demise of such ES firms, the only firms still in existence will be those conducting only such ES activities as would be consistent with benefiting shareholders. Unfortunately, such an outcome spells a diminution of social welfare.
A Better Way
Historically, armed with taxation, central governments steered resources for E and S betterment. Assuming alignment with citizens' objectives, the nation reaps dividends when governments invest in E and S initiatives. However, businesses might still inflict societal harm even with such governmental intervention. When firms' actions exclusively impact their interests, their decisions benefit both their stakeholders and society. Problems arise when their actions affect others. The solution: a governmental entity (Z) representing those affected by harmful actions, e.g., environmental damages, coupled with a reporting mechanism. For example, if a company (A) emits pollutants, it would outline – truthfully, as induced by the mechanism – its abatement costs to the government. Similarly, Z would report – also truthfully – the benefits of curtailing such emissions. The government would then communicate back to the firm and the Z entity such information as would induce the firm to produce an optimal amount of harmful activity – note that such an optimal amount is above zero.
The proposed system is meant to eliminate the pernicious effects of externalities rather than impose actions — implied under the guise of ES disclosures — on business firms that may harm shareholders even without such entities inflicting external harm. Notably, the solution should be equally applied to beneficial externalities whereby an entity benefits other entities or members of society. One can go further and require the quantum of externalities to become an integral part of the financial reports disseminated by firms. While the S (societal matters like labor rights, wage standards, inclusivity, and lobbying dynamics) is more nebulous than the E, it should still be possible for Z to monetize these social costs, a daunting task yet essential for policy coherence.
Joshua Ronen is a Professor at NYU Stern.