A dangerous distraction

Companies are creating a misleading narrative that they can change the world through ESG initiatives – governments must make systemic change, writes Tariq Fancy

By Tariq Fancy

October 31, 2021

“Society is demanding that companies, both public and private, serve a social purpose.” My former boss, Larry Fink, the CEO of BlackRock, wrote that line in 2018 in his annual letter to the CEOs of the world’s largest corporations. It wasn’t the first time someone had said it, but it was the first time that someone whose firm managed over $6 trillion in assets had said it.

Financial institutions like BlackRock wield 75% of the world’s shareholder voting power, on behalf of investors large and small, and BlackRock leads the pack. It owns seven percent of the companies on the S&P 500. As the firm’s Chief Investment Officer for Sustainable Investing, I led the effort to incorporate Environment, Social and Governance (ESG) activities across all the firm’s investment activities. This was exactly where I wanted to focus: if we were successful in showing how we could invest trillions of dollars across different strategies and geographies in a way that achieved strong profits while also creating better environmental and social outcomes, the rest of the industry would follow — reforming capitalism in the process.

Given the boundaries of fiduciary duty, however, in most jurisdictions the concept of social purpose can only be applied to business operations if it helps, or at least doesn’t hurt, investment profits — meaning you can’t forego profits with someone else’s money, even if you think it’s for a good cause. As Nell Minow writes in the Harvard Law Forum for Corporate Governance, the foundation of capitalism is strict adherence to fiduciary obligation, because it “gives credibility to capitalism by addressing the agency cost risk of entrusting money to others.”

So in most major economies, companies are legally obligated to deliver shareholder value as their primary role. As a group, they have met their obligations brilliantly. From top to bottom, from CEO compensation to divisional budgeting and P&L to managerial targets, structures, and incentives, we’ve built private firms from the ground up to do one thing really well: extract profits. Though many companies deliver great things for society, from low-cost food to groundbreaking medicines to a supercomputer in every pocket, the fundamental measure of corporate success is still profit.

In the face of this unfortunate reality, we led the way in popularizing a new and optimistic view: that companies with better performance on environmental and social issues would enjoy larger profits in the long-term, as there was no disconnect between ‘purpose’ and profits. It was kind of like saying that good sportsmanship in basketball is not at odds with scoring points.

But it was more than that: we argued that companies that embrace sustainability early create more profit for shareholders over the longer-term, which is a bit like saying that good sportsmanship on the court is linked with eventually scoring more points as a result. And therein lies today the glowing promise of “ESG integration” in the industry: it offers better ways to pick out those companies considered to be ‘doing good’, which we argued to be the same as ‘doing well’.

I travelled the world to promote this notion, and our green investment products, which helped BlackRock to stay at the cutting edge of a quickly expanding – and highly lucrative – part of the financial sector. I sincerely believed that while sustainable investing was not perfect, it was a step in the right direction in the critical question of how business and society should intersect in the 21st century.

Unfortunately, I now realize that I was wrong. The narrative that has built around ESG investing is, in fact, a dangerous distraction from the need for governments to make systemic changes. Our current situation is like leaving it to individual sports players to behave with admirable sportsmanship, even if they have been trained and incentivized first and foremost to score points at all costs. Some will, many will not. The real solution is to change the rules of the game and the incentives of those who play it.

Sustainable investing

Sustainable investing is a confusing area of finance that often means different things to different people. Most of the time it means building investment portfolios that exclude objectionable categories, such as ‘divesting’ of fossil fuel producers in an apparent attempt to fight climate change. Unfortunately, there’s a difference between excusing yourself from something you do not wish to partake in and actively fighting against something you think needs to stop for everyone’s sake. Divestment, which often seems to get confused with boycotts, has no clear real-world impact since 10% of the market not buying your stock is not the same as 10% of your customers not buying your product. (The first likely makes no difference at all since others will happily own it and will bid it up to fair value in the process, whereas the second always matters, especially for a company with slim profit margins and high fixed costs.)

Since the early 2000s, many investors have moved past divestment to faster growing areas of sustainable investing, such as a newer focus on impact and ESG products, all with a general goal of leaning toward or even creating positive and often measurable social impact alongside strong financial returns. Green bonds, where companies raise debt for environmentally friendly uses, is one of the largest and fastest-growing categories in sustainable investing, with a market size that has now passed $1 trillion. In practice, it’s not totally clear if they create much positive environmental impact that would not have occurred otherwise, since most companies have a few qualifying green initiatives that they can raise green bonds to specifically fund while not increasing or altering their overall plans. And nothing stops them from pursuing decidedly non-green activities with their other sources of funding. If the economy is growing, it’s quite feasible that you can increase your impact investments while also increasing your stake in fossil fuels.

Another red-hot area in sustainable investing allows investors to own baskets of more “responsible” stocks, as Larry pointed out in his January 2021 letter: “From January through November 2020, investors in mutual funds and ETFs invested $288 billion globally in sustainable assets, a 96% increase over the whole of 2019.” Since ESG products generally carry higher fees than non-ESG products, this represents a highly profitable and fast-growing business line for BlackRock and other financial institutions.

Since such products own some percentage less of polluters and low-ESG shares than the relevant market benchmark, the underlying ‘theory of change’ behind these tilts is the same as divestment: trillions of ETFs that adhere to this form of ‘soft divestment’ just aggregate into some fraction’s worth of de facto market divestment. But because they collect baskets of shares already traded in public markets, investing in such a fund does not provide additional capital to more sustainable companies or causes.

A series of other sustainable products across the spectrum of financial assets — from debt to equity, public to private — have all grown in recent years, all with similar promises to also satisfy societal needs in the pursuit of profit, often even measuring a second “social bottom line.”

Despite the popularity of these products, it became clear to me that the degree of overlap between purpose and profit in my own firm’s investment activities was less than I had expected, or could possibly justify the widespread hype. As I moved through meetings with senior managers across the firm to explore how ESG data could improve their investment processes, I saw firsthand that for most investment strategies only a few ESG issues concretely mattered. It sometimes depended on the location: having an animal rights controversy is worse if you’re based in California than if you’re based in China.

Some things are only important when public attention is squarely focused on them: think of how the #MeToo and #BlackLivesMatter movements have elicited hurried responses from companies acknowledging shortcomings in their diversity and inclusion efforts. (And a number of promises that have not been met yet.) The idea of fickle public attention to preserve society’s long-term interests is a prospect that should alarm us all. Senior managers know that the shareholders’ AGM will happen every year with the same reporting and profit expectations, but the media spotlight on any given social topic will keep moving.

It isn’t just the fickleness that causes damage; these business-led initiatives actively undermine societal pressure for more meaningful interventions. Working with Ryerson University and the Strategic Council, a polling firm, we conducted a study in 2020 to better understand public attitudes on building a more sustainable society. The poll included three thousand people of all ages in the US and Canada.

We showed respondents a headline related to Larry’s 2018 letter on purpose and seven other similar headlines around new sustainability initiatives — mostly to do with businesses voluntarily taking the lead and other headlines in the sustainable finance space — and asked them to indicate whether they thought each was helpful in driving social change or not. All eight headlines were generally believed to be helpful. This is even though a number of them were decoys that I asked the polling firm to include in the study, knowing full well that they were window dressing with little to no real-world impact. Most people, it appears from our research, do not know what works in climate change mitigation and what doesn’t, leaving them vulnerable to ‘greenwash’ marketing.

More worryingly, we used a control group to gauge respondents’ views in the absence of such headlines. In our American sample in particular, exposure to headlines about businesses’ ESG initiatives made people 17% more likely to say that business, not government, will lead the way in building a more sustainable economy. In effect, ESG-related headlines are giving people a false sense that the problem is being addressed, even when those headlines refer to ineffective measures. The ESG marketing is not just ineffective greenwash – it is actively reducing democratic demands for more impactful policies. It is a deadly distraction.

It turns out that a large, multinational profit-making machine that’s built to do one thing really well operates exactly as we should expect it to. If we expect companies to ‘do the right thing’ but the expectation is not enshrined in law in a very specific way, then we should not expect different results.

The fiction of the free market

At the time of the COVID-19 lockdowns in my home country of Canada, the government did not rely on individuals to choose to ‘do the right thing’ to control the virus. While some of the decisions were ham-handed and seemingly arbitrary, one thing was clear: the experts who were advising our government did not think it wise to leave adherence up to the voluntary good graces of our better selves alone. So rather than relying on voluntary compliance to flatten the COVID-19 curve, our government actively ensured that lockdown measures were mandatory through forced closures and penalties. Those who didn’t adhere to the rules endangered us all, so we were generally fine with stiff penalties that applied to anyone caught flouting the guidelines.

The alternative to mandatory lockdowns was relying on individuals to be responsible, which would have left us at the mercy of the least socially responsible people in our communities. How we fare in the face of such systemic, societal problems is not defined by the best behaved, but the worst.

If voluntary and individual measures are clearly not good enough to bend our society’s COVID-19 infections curve downward, then why do the experts think that such measures will bend our society’s greenhouse gas emissions curve downward? And there’s the rub. On climate change, just as with COVID-19, the experts are not advising us to leave it to individual, voluntary action. They know that it won’t work. The issue is that we’re not listening to them.

Taking climate change as an example, every serious voice in the elite now claims to believe the science; but few are listening to the policy experts on how we must enact the changes the scientists are telling us we need immediately.

This is William Nordhaus, the American Nobel Prize-winning economist, in a lecture at Stockholm University:

“Economics points to one inconvenient truth about climate change policy. And that is that in order to be effective, the policies have to raise the price of carbon, or CO2, and in doing that correct the externality of the marketplace… I think one of the insights of economics… one that I feel very strongly about… is that if you’re going to be effective, you have to raise the price. Because putting a price on our activities is the only way…”

“We have to get billions of people, now and in the future. Millions of firms. Thousands of governments… to take steps to move in the direction we want. And the only way you’re going to do that effectively is to increase the price of carbon.”

What Nordhaus is effectively saying is that we must change the rules of the game. These are the rules by which every player must abide, or face serious criminal consequences. Carbon pricing is a simple and elegant solution that changes the incentives of all companies in a clear and fair way. Elon Musk has said an internationally effective carbon price would solve the problem of climate change “almost over night”. The reality is of course more nuanced, requiring a broader set of sweeping policy measures, but Musk and Nordhaus are not far off.

What Nordhaus is emphatically not saying is that companies will solve the problem on their own, out of good intentions and a sense of social duty. If you want to change the behavior of all of the players in the game, you have to change the rules of the game for everyone. Instead, on sustainability issues we’re currently being told that our hope lies in standing back and relying on some players sometimes deciding to pursue good sportsmanship, purely voluntarily, even if playing dirty helps them fulfill their legal duty to score maximum points.

I knew for sure that Goldman Sachs CEO David Solomon knew all of this after reading an op-ed he published in the Financial Times in December 2019. After long passages that proudly list various new Goldman initiatives to be greener, he included a curious near-caveat toward the end: “To give us the best chance of combating climate change, governments must put a price on the cost of carbon, whether through a cap and trade system, a carbon tax or other means.”

At this point in the discussion, we’re all brainwashed to say the same thing: Gasp, but wouldn’t that mean that the government is intervening in the free market? Fixing the rules of this system so that it produces better societal outcomes is not “intervening in the free market” — especially as there is no such thing as a ‘free market’ in the first place. A market economy is at its core a collection of rules. No rules, no market. Just as every competitive sport has clear rules, competitive markets need rules: no rules, no game. Nor is there one set of preordained rules: every rule, ranging from the number of years a new idea gets patent protection to the corporate tax rate, is a deliberate decision that has implications for the outcomes of the system. If we change the rules of the game, we’ll get different outcomes, all of which can be described as market outcomes.

The capital allocation processes that Wall Street and the City manage connect our savings with the most productive uses of that capital in our economy. If you were to tell a portfolio manager to lower the carbon footprint of their portfolio, most will nod their heads and agree it’s important, but then return to allocating capital to the most profitable endeavors. If, on the other hand, a negative externality is “internalized” by the government through, say, a pollution tax, thus lowering the profitability of heavy greenhouse gas emitters, capital allocators will automatically react as fast as they can, allocating less capital to these now less profitable opportunities.

Friedman and societal needs

The voice of the late economist Milton Friedman has dominated the question of social value and capitalism for the last half-century. In his seminal 1970 essay entitled “The Social Responsibility of Business is to Increase its Profits,” he argued that “a corporate executive is an employee of the owners” and that their primary responsibility is to maximize shareholders’ profits. The Friedman doctrine has come to dominate and define Western shareholder capitalism.

What’s most galling about the entire debate is how Friedman’s own message has been mangled. Yes, he said that the sole purpose of a business is to generate profits for shareholders. But that didn’t mean that he thought no one should look out for the public interest: in the very same paper he argued that the responsibility for protecting society fell to civil servants, whose authority business executives should not usurp as such roles “must be elected through a political process.” In fact, he called the idea of business executives taking on this role to be “intolerable” on grounds of political principle.

We are currently seeing this ‘intolerable’ situation play out. A large group of leading CEOs in 2019 signed the US Business Roundtable’s (BRT) statement on stakeholder value, declaring that profit was not the sole purpose of a company and shareholders only one of its many important stakeholder groups. “There were times that I felt like Thomas Jefferson,” said Johnson & Johnson CEO Alex Gorsky, who led the drafting of the BRT’s statement. It’s easy to understand why he felt that way, given the weight of such lofty words. But not enough people have asked a simple question: does it make sense that a CEO should feel like a famous US President? Only one of them is elected by the people. In vital questions about the direction of society, democratic representatives are ceding ground to unelected CEOs.

Perhaps unsurprisingly, the BRT’s social aspirations seem rather far off reality. As Aneesh Raghunandan and Shiva Rajgopal point out in the paper “Do the Socially Responsible Walk the Talk?”, relative to their peers, publicly-listed BRT signatories report higher rates of environmental and labor-related compliance violations, pay more penalties as a result, and have been lobbying actively in recent years against a price on carbon, the elimination of tax loopholes, and a number of other initiatives designed to fight climate change and rising inequality. And a new report last September confirmed that since the global pandemic began, BRT signatories have proven no better than anyone else in protecting jobs, workplace safety, and labor rights, or doing anything to redress racial inequalities.

Fix the rules

I left BlackRock in part to help with very real family business issues. Unofficially, I had also privately concluded that there was no point continuing in that role: trying to create real-world social impact through sustainable investing felt like pushing on a string.

Unfortunately, I now realize that it’s worse than I originally thought: the evidence around the deadly distraction made it clear that we weren’t just selling the public a wheatgrass placebo as a solution to the onset of cancer. Worse, our lofty and misleading marketing messages were also delaying the patient from undergoing chemotherapy. And all the while, the cancer continues to spread.

Between now and 2030, the stakes are so high that we should grant ourselves the right to be skeptical, even downright cynical, since we have to make this work. In light of that, the lazy prevailing attitude — that ongoing discussions around “stakeholder value” are automatically steps in the right direction — seems unwise.

I decided to speak out about it because somewhere out there, a kid in Bangladesh is going to bear the consequences of our inaction. Increasing cyclones, floods, and extreme weather conditions will cause her and her family to lose their livelihood and turn into economic migrants – even though they have next to no carbon footprint themselves. I thought that in returning to the finance industry with BlackRock I would have been helping to change that.

Instead, I was contributing to a giant societal placebo that was actually lowering the likelihood that we’d ever implement the kinds of concrete reforms that she and billions around the world need right now, and then working to protect wealthier people’s investment portfolios from the carnage that would unfold as a result. And somehow this was being sold to the public under the guise of responsible business. In sounding the alarm, my hope is to expose this illusion for what it is: a dangerous fantasy.

Every year, companies invest more and more in sustainability initiatives. The tools, such as ESG data and reporting standards, can be useful since they help us to start measuring the side effects we need to manage better, and the people, who bring sustainability expertise, are also critically needed. But the overarching narrative that these alone will matter without rule changes risks rendering all of these efforts meaningless or even counterproductive. Having coaches who teach clean play doesn’t do much if cheating and dirty play still wins games. Should we wait for profits and purpose to magically overlap on their own, or does an outside and rather visible hand need to enforce new rules of the game to make it happen faster?