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Bill Gates once asked how much carbon ESG investing had removed from the atmosphere. Answering his own question, Gates said, "Probably not one ton."
Terrence Keeley, a former Blackrock executive, shares this anecdote in his book Sustainable: Moving Beyond ESG to Impact Investing (Columbia Business School Publishing, 2022). If Gates is right, then "no further critique of ESG investing is needed," writes Keeley, for it will have "condemned itself." Throughout the book, Keeley does not condemn ESG investing outright, but he is blunt about its limitations. And by his reckoning, there are many.
Limited Jurisdiction
Keeley judges ESG investing against a specific metric that he repeats countless times throughout the book: more inclusive, sustainable growth. In other words, the measure of ESG is whether it supports an economy in which expansion continues, a broader cross-section of Americans prosper, and the worst impacts of climate change are avoided.
Keeley gives several reasons why ESG investing cannot, on its own, create more inclusive, sustainable growth. For one, its jurisdiction is limited. There are 30 million businesses incorporated in the U.S. Of those, only 0.0125% have raised money through the public equity or debt markets. The rest fall outside the influence of ESG investors. Publicly listed companies do account for a disproportionate share of gross domestic product. But all told, they still comprise less than half of all economic activity, Keeley writes.
What's more, these privately-held companies are not just mom-and-pops. They include 60 of the largest 200 food companies, privately-held oil and gas companies, and enormous professional-services firms, to name a few.
"Presumed More Potent Than They Are"
Second, the incentives created by ESG are not powerful enough. The conventional wisdom is that companies with poor ESG scores incur higher costs of capital. Facing this threat, corporate managers will change whatever "bad" behaviors are hurting their scores. Or they will align their corporate strategies to the goal of being included in an ESG index. Such incentives, Keeley writes, "have been presumed by too many to be more potent than they actually are."
"Divestors Don't Change Corporate Behavior"
The same applies to divestment. Keeley is adamant that divestment is a major fallacy of the ESG investment movement. Why? Because it's not a strong enough incentive for a company to change its ways. "Divestment does not stop companies from making unwanted decisions," he writes, even if it leads to higher capital costs. At the end of the day, asset managers who divest are simply transferring equity ownership to others who support the company's strategic direction.
Similarly, pressuring oil companies to abandon their core energy businesses will not result in a net-zero economy, because private oil and gas enterprises are ready and able to snap up those assets and continue operating them with no shareholder oversight. Keely concludes: "Divestors don't change corporate behavior systemically: only regulators, engaged shareholders, and mindful consumers do."
Not for Everyone
Third, high ESG scores do not promise higher returns. At least not yet. For this to happen, writes Keeley, many more companies would need to comply with global reporting frameworks like the Task Force for Climate Related Financial Disclosures (TCFD). Today, too few companies across too few sectors provide fulsome enough disclosure. As a result, the market cannot reward the true corporate "paragons" disproportionately, providing much-needed reinforcement to the incentives upon which ESG operates.
Fourth, ESG investing is not for everyone, Keeley says. Those who should not engage in ESG investing include retirees and central banks. Seniors who are living on fixed income should not pursue concessionary investment strategies that sacrifice returns (and their daily needs) for positive impact. Here, Keeley states that investors who exclude "sin stocks" -- alcohol, tobacco, gambling, and firearms -- from their portfolios have lost money relative to stock indices that include these companies. As for central banks, they must manage their trillions of dollars in reserves for "liquidity and safety first, not return and certainly not impact."
The Way Forward
Keeley's prescription for more inclusive, sustainable growth is a cocktail of finance and policy solutions. On the finance side, he states that society has more than enough capital to solve its most pressing problems. The most efficient way to do this is for the world's largest asset owners -- sovereign wealth funds, pension plans, insurance companies and central banks -- to allocate 1.6% of their assets annually toward measurable and verifiable impact investing strategies over the next decade. This would generate $3.5 trillion in investment capital per year. That amount more than covers the estimated cost of meeting the UN's 2040 Agenda for Sustainable Development.
The Tax Code
Keeley views the tax code as a critical tool in achieving inclusive, sustainable growth. He is not alone in this view. Tariq Fancy, a more strenuous critic of ESG investing, says we need to rely less on voluntary, non-binding pledges and more on taxation and regulation.
Keeley's tax proposals include a tax on carbon and a tax on excessive consumption. He does not outline how either tax would work and he does not say how "excessive" consumption would be defined. He also calls for capping marginal tax rates on regular income at 50 percent, raising taxes on short-term financial speculation, and gradually lowering taxes on long-term investment and capital formation. Capital gains taxes would be "phased out to zero after five years." The point of all this is to create incentives for long-term-oriented investment.
1.6% Solution; Impact versus Net-Zero; ESG's Legacy
Keeley pairs these tax proposals with a 1% wealth tax (to replace the estate tax),
universal basic income, universal pre-K-through-twelfth-grade education, and basic universal health protections. Circling back to the investment world, he calls on university endowments to prioritize explicit impact investment objectives over net-zero investment commitments.
Sustainable's biggest contribution is in forcing the reader to consider the extent to which the ESG movement is providing the illusion of progress rather than the real thing. According to Keeley, this is the case with divestment and the "shaming" of publicly listed energy companies upon which our energy security depends. As it happens, these activities are closely associated with modern environmental activism, and they attract a lot of press attention.
What are we to make of ESG investing, then? According to Keeley, its most constructive legacy may be that it has supported more "mindful" corporate leadership and drawn attention to the potential for companies and corporate managers to improve society. However, ESG "may be doing more harm than good" if the public believes that it will solve our most pressing problems while generating superior returns.
Questions to Consider as You Read and Discuss this Book
Do you agree that endowments should prioritize impact investment objectives over net-zero commitments? Why or why not?
Is the U.S. tax code an underappreciated mechanism for achieving sustainable, inclusive growth? Is a carbon tax in the United States plausible? What does it mean to tax excessive consumption?
Should endowments abandon net-zero commitments in favor of impact investments?
is Keeley's "1.6% Solution" achievable?
Keeley says that regulators, engaged shareholders, and mindful consumers, rather than divestors, change corporate behavior. What are some examples of mindful consumers influencing corporate strategies?
Keeley writes that the rise of populism in the United States "has been precipitated by multiple negative externalities caused by free markets that were left unchecked." As examples, he attributes the opioid crisis to "the gutting" of communities by free trade on the one hand and to "unscrupulous pharmaceutical companies" on the other. He also points to the decimation of North Carolina's furniture industry by "unfettered free trade". Are there other examples?
What are the differences between active ESG equity strategies, indexed ESG equity strategies, ESG impact strategies, ESG fixed income strategies, and impact investing? Which are most successful at generating measurable impact and superior returns?
Keeley writes that "business and finance need regulators, public policies, private corporations, civil society, and individuals to play specific, complementary roles." What are some recent examples of civil society playing specific and complementary roles alongside business leaders and policy makers to achieve constructive outcomes?