The Book of ESG

Malt Liquidity 103

I must admit to having something of the “summer blues” when it comes to markets. At least in that industry, this is when everyone takes their block leave or vacation — in New York, the interns get to roam around lower Manhattan, while the desk heads and regular employees steer clear of the shitshow of trying to get into Brother Jimmy’s with a fake and relish in the opportunity to finally use the “do not disturb” functionality on their phone for a brief moment. My recent readings have taken me to a more literary and legal venue while the markets return to a familiar place from the last decade, that of a slow grind up. Nevertheless, the world churns along, and ignoring all the hot-button issues enveloping yet another election cycle, there’s still some ongoing dramatics while everyone’s at the Hamptons.

One thing I don’t talk much about is the rise of ESG investing, which we can define as capital allocation that aligns with the furthering of environmental, social, and corporate governance along with business returns. What sounds like a simple idea that nobody could disagree with, once put through the PR, legal, and consulting grinder, turns into a nebulous sloshing of funds that results in nobody being happy, as businesses like FTX had higher “ESG ratings” than Exxon and Marlboro has a higher rating than Tesla, the largest driver of the clean emissions movement across the globe. This confusing result is entirely predictable when you realize that good intentions lead to bad policy, and good politics is bad finance. Nevertheless, “ethical investing” makes sense! In the long run, environmental goals are good to assess companies by — what point is there investing in a business if the world ends as posited by climate scientists? Shouldn’t a business that’s “inclusive” have a much greater TAM than a business that discriminates, both internally and externally? Doesn’t it make sense to insulate businesses from having significant key-man risk and no recourse over share structures that uniquely hand power over to founders and executives?

The problem is, without a cohesive, logical structure as to what these terms precisely mean and how they are to be implemented without being as hamfisted as NASDAQ’s board member listing requirement, what we get is an arbitrary rating system (if we can’t trust bond ratings, how the hell are we supposed to have more clarity into ESG? Creditworthiness is essentially solved.) and bogus selection criteria that never seem fair to either the beneficiaries or the glossed-over, as the system we have now essentially revolves around unelected power brokers who control whether the capital environment can even be accessed through listing requirements or whether the capital is even allocated to a given company. What we have right now is diversity, sponsored by BlackRock. So here are some thoughts on the flaws with the current system, and perhaps how to reevaluate and restructure these goals to seem more “open” and “logical”, rather than operating at Larry Fink’s whims.

To me, the ESG story begins with the rise of passive investing. Once it was mathematically proven that dampening the volatility of individual company performance by “spreading one’s bets” was optimal for returns, the tsunami of capital flooded so forcefully towards this concept such that the number of ETFs worldwide went from 276 in 2003 to 8754 in 2023. Meanwhile, the number of publicly traded companies has plummeted from over 8000 in 1996 to just 3700 in 2023. The implication is clear — we can still hold individual stocks, but they will be behooved to the baskets that control the distribution of ETF flows to their respective size in said funds. Bucketing isn’t directly the issue here — I will never disagree with the obvious logic that it’s better to have paid professionals at Schwab picking and choosing what stocks to package together — but the proliferation of S&P500, total market, and sector ETFs in particular create a hybrid market-moving mechanism that diverges from “company does good, stock go up.” The original philosophy of the ETF was very simple, in that made sense to spread bets in case one company in the portfolio tanked. You’re much less tethered to individual performance. With mass investment in passive, however, the calculus shifts — since everything is owned by everyone, the path forward becomes a “rising tide lifts all ships” philosophy instead. If I own an airline sector ETF, I don’t want outsized performance by one airline at the expense of others. Instead, I’d prefer to have the pie gradually increase and be meted out to each airline according to their need. Certainly, this is confusing for the management of each company, as a traditional fiduciary responsibility implies that one works for the sake of their shareholders. But should the shareholders that solely hold United be catered to at the expense of the larger institutional holders (such as Vanguard) who hold United, American, and Delta, and would actually suffer losses if United starkly outperformed the rest? This is what the insidiousness of ESG being an enforced framework outside of a company’s own decision-making results in. A company deemed “insufficiently ESG” by BlackRock will be pressured to change management that adapts that philosophy of managing the company “for the greater good” at the expense of the individual owner of shares. There’s too much capital at stake here. This is how we end up with patently ridiculous “scoring” systems that make up ESG ratings:

Sustainalytics, a widely used ESG ratings tool, gives Tesla a worse score than Altria, one of the largest tobacco producers in the world. And the London Stock Exchange gives British American Tobacco an ESG score of 94—the third highest of any company on the exchange's top share index—while Tesla earns a middling 65.

Cigarettes, quite literally, actively cause the death of members of society. Doesn’t seem to fit our ESG ethos of “all stocks rise when society is bettered”, eh? Let’s dig deeper:

Some scores, including S&P Global's, say in fine print that they are sector-specific, which means companies are held to different standards depending on their industry. An unusually green tobacco giant could score better than an electric carmaker with an all-male board, and corporations can earn points merely by setting water reduction targets or using "diverse" suppliers.

That may be why Philip Morris International, in its 2022 ESG report, bragged about "empowering" female tobacco farmers. "Women involved in tobacco farming often face structural and cultural barriers," the report explained. "Globally, less than 15 percent of agricultural land is owned by women."

This sort of rhetoric permeates Big Tobacco's ESG reports, documents aimed at investors seeking an ethical portfolio. Imperial Brands touts its trainings on "microaggressions" and a board that is 40 percent women. Philip Morris International and British American Tobacco promote their scores on Bloomberg’s Gender Equality Index—Tesla doesn't doesn't participate—which uses self-reported data to track companies' progress toward "equitable inclusion." Altria advertises a granular list of diversity targets, including for "AAPI women." And in 2020, the company's "Corporate Responsibility" report addressed the "pandemic within the pandemic" caused by "systemic racism." It did not mention that smoking, like COVID-19, disproportionately kills black Americans.

The crux of the issue is highlighted here. There’s no philosophical coherence on what “ESG” actually means. One could logically note that the movement to shift away from big oil goes hand-in-hand with the movement to end smoking, perhaps the most easily preventable cause of death in the US (depending on whether you think it’s easier to quit smoking or go on a serious diet/exercise regimen.) What’s absurdly hilarious is that choosing to market in a diverse fashion scores you a ton of ESG points, even if what you are marketing directly kills who uses your product:

Some rating systems even encourage cigarette makers to market their products to marginalized groups. Altria has a perfect score on the Human Rights Campaign's Corporate Equality Index—a metric rumored to be behind the disastrous LGBT marketing campaigns at Target and Bud Light—which lets companies earn points by "advertising to LGBTQ consumers."

In California, tobacco kills almost as many gay and bisexual men as AIDS. LGBT youth nationwide are over twice as likely to smoke as their straight counterparts, and transgender adults smoke at three times the rate of the general public.

The reason I focus on ratings is because that is inevitably what is hand-waved when pitching and allocating to ESG funds. There’s no way to assign a “points” system as to what is worth more than another; it’s going to be unique case by case. I’m reminded of the Silicon Valley “woman engineer” sketch: “we want to hire the best engineer, but it would be better if she’s a woman, even though that’s totally irrelevant to the hiring process.” ESG is not created equally across all fields — in fact I do agree with sector-specific ESG rankings! — but if it’s using the same scaling system, it’s totally pointless. This logical incoherence to the points system is highlighted again and again in totally absurd circumstances:

The crypto exchange, which moved its headquarters from Hong Kong to the Bahamas last year, was given a score of 50 for governance out of 100 by Truvalue, despite having just two directors on its board, one of whom was founder Bankman-Fried.

It scored 12 points higher for governance than Exxon Mobil, which has an 11-strong board and has been operating for more than 135 years.

America, for whatever reason, loves points systems. Our college systems use category rankings to provide a sense of scale, movies are out of 10, product reviews are out of 5, and ESG scores are out of 100. What do any of these numbers actually mean? Even in a relative sense, I could not tell you the difference between a restaurant that gets 4 out of 4 stars in the New York Times food review vs 3 out of 4. Intuitively these scales only make sense at the tails, if that — and if a ranking system puts Phillip Morris at the 90s and Tesla at the 30s, something is clearly wrong. At best, you could say the system was gamed — at worst, you could say that the capital allocators are enforcing their ideology and the ratings agencies play along as the regulatory framework entrenches them in. I wonder when government-ran funds, e.g. California pensions, are banned from investing in “low ESG” companies.

There is a simple fix to this, but it’s philosophical, not mathematical. Simple, intuitive changes in how we “ethically invest” could be broadly applicable and relieve a lot of strain and end a lot of the grift that comes with arbitrary ratings systems. Stay tuned, they might take a familiar shape.

1. You shall have no other Gods before me

Put more simply, collective ownership above a certain threshold in large, sector-defining companies must be prevented. When the largest shareholders, both regular and custodial, hold common ownership across every major competitor in a sector, the fiduciary responsibilities of an executive become far too vexing and inevitably they lead to incorrect prioritization. In the long run, a single company that outperforms and leaves the sector behind is likely to lead to the best outcome for that sector, rather than forcing them to maintain a balancing act to not disrupt the market share and functioning of competitors. Even if you believe that shareholder prioritization leads to exploitation of labor, this doesn’t change with a collective ownership framework — only the manner with which the labor operates shifts.

2. You shall not make idols

Even the best founders of public companies should not have unfettered control of the apparatus. How many companies went public with a dual class structure that gave unlimited voting power to the founder such that they could do whatever they want? This necessarily bypasses any sort of accountability to any shareholder, whether it’s an ETF provider or an individual. Indeed, it’s kind of terrifying that Vanguard is obligated to allocate to these companies — your 401k is at the whims of whatever Mark Zuckerberg decides. All you can do is hope that someone attempts to reason — please Zuck, stop setting cash on fire to build this nonsensical Metaverse! — because you have no recourse. This should not stand going forward.

3. You shall not kill

Look, this is self-explanatory. Big Fucking Tobacco is not ESG. There is absolutely nothing beneficial in the long run for society to have a stake in tobacco companies going forward. They are a vice, and I have no problem with people’s right to smoke, but it is clear that if we are operating on a “greater good of society” model, we want the healthiest possible outcome for everyone and the least strain on the medical system going forward. Cancer sticks, no matter if they come in rainbow wrappings, need to be prevented from gaming the system. It’s nakedly obvious that selling cigarettes violates basically any form of ethics. Much more arguable is investing in big oil — I firmly maintain that any “green” innovation probably comes from Exxon, because they need to insulate against a future with scarce oil. They’re probably the biggest investor in “green” technology! Assessing the “green” investments from this point of view provides a much simpler framework than whatever “point” system exists nowadays. If the future investments work out ideally, would it help humanity or hurt it? Is the lack of investment ignoring that harm will directly result from it? If so, this violates our “new” ESG.

4. You shall not commit adultery

Especially in corporate America, which emphasizes time spent “at work” to a very high degree, it’s not unreasonable for two people to romantically meet at work. In a large company, with many divisions, where you’re spending 50 plus hours a week in a location, is it so ridiculous to think that exposure might result in something beyond just work?

That being said, I’m a bit liberal with “adultery” here. Beyond execs cheating on their significant others with their secretaries, I would define it here as “inappropriate contact” that would invite scrutiny or lawsuits as to how “relationships” work in a company — unwanted approaches, harassment, abuse of the corporate ladder power structure, or basically anything that Uber did, for example. The flawed idea of “diversity” that current ESG operates with — that you get points for “showing diversity” at the board level or the hiring level — ignores that what probably matters more is cohesion at the day-to-day level where the majority of interactions in a company occur. If there is a recurring problem with those interactions, then our “new ESG” looks upon investing in this company with a skeptical eye.

5. Honor your Father and Mother

Or, in other words, lend weight to a continuance of governing philosophy (if the company had a cohesive one prior.) For well-run large companies, the transition of power takes a form similar to that of a decently sized nation. Jobs to Cook was a resounding success; Gates to Ballmer not so much. A mature business need not radically reinvent itself upon every iteration of management. The goal of maintaining a hyper-scaled system is to reduce as much volatility as possible. I don’t think I’d be able to point to specific metrics to “score” this point, but it’s nakedly obvious when the “son” or “daughter” leverages the prior CEO’s work to even greater heights (Apple, Pepsi) versus when the “father” does not want to give up his creation (Disney). The reason this is important to me as an investment philosophy ties in to the whole “generational wealth” scenario that everyone is familiar with: the first generation makes the money, the second generation maintains it, and the third squanders it. When there is a successful transition of control and the well-oiled machine runs even cleaner, this “generational pathway” resets. Cook is once again the “first” generation that made the money, giving investors another 30-40 years of a properly managed company.

While the “new ESG” is a bit of a gag, it emphasizes my philosophy that while I do understand the core principle of “bettering society betters returns”, the way that it’s being handled is beyond terrible. Railing against “woke BlackRock”, though, is counterproductive. The reactionary creation of “anti-woke ETFs” and purposely investing in archaic companies to “stick it to the libs” misses the point in that there is a way to remove this insidious influence across publicly traded companies, but it lies in reworking how passive investment works entirely, not adding to it.