What, Really, is ESG?

What, Really, is ESG?

For a couple of reasons, we want to take a little time today to reiterate some of the fundamental differences between the so-called stakeholder model of capitalism and the shareholder model.  These differences are important for any number of reasons, some practical, some philosophical, some metaphysical.  Indeed, the differences between the two models are no mere contrivance or superficiality.  They mirror the major fault line in the West for the last quarter-millennium and, as a result, represent foundational notions for two radically differing worldviews.

Over the past few weeks, we’ve seen a handful of essays suggesting that political conservatives and even market fundamentalists should get over their hangups with ESG and should embrace the strategy as the means to achieve desirable political ends.  For example, if you oppose the rise of China as a superpower, then you should, at the very least, think about how the tactics and strategies of ESG can help you pressure companies to ignore the potential profitability of doing business in China or with CCP-connected corporations (which, in truth, is all or most Chinese corporations).  Doing business with China would be profitable and would, therefore, benefit shareholders and meet the tenets of shareholder capitalism.  So, to oppose it MUST be a stakeholder/ESG position, right?  It must violate the shareholder precepts laid out by Milton Friedman more than fifty years ago.

We understand how one might come to this conclusion, given the widespread confusion about what shareholder capitalism is and what it means.  Nevertheless, this is both a misreading and a misinterpretation of Friedman and the principles he articulated.

In a recent piece for Compact magazine, for example, Julius Krein refers to “Milton Friedman’s dictum that ‘the social responsibility of business is to increase its profits.’”  We’re not sure how many times we have to go through this, but that is NOT what Friedman wrote.  Rather, he wrote that the responsibility of a corporate manager is “to conduct the business in accordance with their desires, which generally will be to make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.” (Emphasis added, for obvious reasons.)

In a narrow sense, this means that it is OK to oppose doing business in China, even if potentially profitable, under the shareholder model.  One needn’t resort to creating or embracing an alternative investment ethos to keep from supporting infanticide, slavery, cultural genocide, and the rest of the PRC’s pathologies.  One need only apply the shareholder model HONESTLY.

In a broader sense, this is possible because the Friedmanite shareholder model is not the “value-neutral” caricature its critics portray it to be.  Rather, it is the opposite, as I note in The Dictatorship of Woke Capital:

For starters, [Friedman’s famous New York Times Magazine essay] is a purely normative document. It is not about proce­dures or actions or techniques or models. It is about the simple ethical proposition that if one agrees to work for a company, one also agrees that the performance of his professional duties will be carried out in the best interests of the company. That interest will generally be to make as much money as possible, but not always, and will only be within “the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

Additionally, because this doctrine is purely prescriptive—i.e., assert­ing and explaining a moral responsibility—it is in no way descriptive, which is to say that Friedman does not presume to tell anyone anywhere how to best go about conducting the business of making money. He does not suggest that managers should screw over their workers. He does not suggest that managers should ignore the environment. He does not suggest that employees should stick it to the customer. He doesn’t even offer a time horizon in which the managers’ responsibilities should be conducted. He doesn’t say they need to meet quarterly guidance or annual goals or any other metric, for that matter. All he says is that the managers of the corporation should do what is in the best interests of the corporation and its shareholders. Whatever that means and however that is accomplished are not Friedman’s concerns (as long as it all follows the “basic rules of the society”).

Moreover, this normative model is perfectly consistent with traditional Greco-Roman/Judeo-Christian ethical and moral principles.  It is, as we have noted before, the Parable of the Talents restated.

If this is the case, however, if shareholder capitalism is, indeed, a morality-based model that not only upholds the moral principles that enable commercial economic activity but also allows for exceptions to the profit-maximization rule to meet community and ethical standards, then that raises some questions.  Why, for example, is stakeholder capitalism necessary in the first place?  Why do we have ESG? And why is ESG definitionally opposed to Friedman’s dictum?

These are good questions, and indeed, they are the questions that form the foundation of the case made by the aforementioned Julius Krein that ESG is really just an outgrowth of the Friedmanite model:

At bottom, ESG isn’t the “opposite” of Friedman’s shareholder primacy; it is an outgrowth of it. ESG, after all, arose well after shareholder primacy became firmly established, and it takes this governance paradigm as its presupposition. That is why an asset manager like BlackRock has become the chief adversary of ESG critics, and why investment criteria and proxy votes are the primary battlegrounds.

Fortunately, these are also questions that I asked myself – and then proceeded to answer in the book (again, emphasis added for obvious reasons):

Since stakeholder theory is derived from the efforts to improve company performance over a longer event horizon, it is quite clear that any conflict between the two is related to new variables added to the equation after the rules were written, meaning that the idea that stakeholders and shareholders are necessarily antago­nistic is a fiction added post hoc to justify the ongoing development of an academic exercise. The normative shareholder model would be perfectly compatible with a literally endless number of descriptive or instrumental stakeholder models. It is only the desire to substitute a different normative system or goal that brings shareholders and stakeholders into conflict. It is a purely exogenous distinction.

In order to believe that ESG is innocuous or that it is derived purely from the desire to maximize profits or even that it can be applied, without consequence, to achieving “conservative” political ends, one must ignore, in their entirety, the developments of the last 35 years and must pretend that the growth of stakeholder capitalism ended with the instrumental model.

It did not end there, however, and a handful of academics, led by R. Edward Freeman, pushed the envelope, insisting that there was a better, more ethical way to understand and apply capitalist mechanisms to man’s condition.

In 1984, Freeman published the foundational document in ethical or normative strategic planning, Strategic Management: A Stakeholder Approach.  In this initial book, Freeman’s recourse to normative appeals was relatively mild but was nevertheless incredibly significant.  Not only did he identify the shortcomings in the more traditional stakeholder models, but he also established the normative model as a focus for future research in the fields of planning and management.  With this relatively modest foray into the normative theories of business, Freeman launched an entire genre of research and, in so doing, laid the groundwork for an entirely new subfield in business management, “applied business ethics.”  In turn, he also laid the groundwork for the practical application of stakeholder principles, i.e. ESG.

While it would be an exaggeration to suggest that Freeman did all of this singlehandedly, it would be only a slight exaggeration.  What Freeman did is considerably more substantive than merely offering a different perspective on stakeholders.  He created an entirely new model of stakeholder behavior.  Whereas the empirical and instrumental models were based in reality – who are the stakeholders, what do they want, and how do we best satisfy those wants? – Freeman’s model took the analysis one step further, into the theoretical and the judgmental/subjective – what should stakeholders want, and how should we ensure that they get what they need, regardless of what they say they want?

Unfortunately, when he did so, he did a few other things as well.  Notably, he sowed a great deal of confusion.  Stakeholder theory had been established as the means by which effective and successful managers planned and administered their business operations.  And then, suddenly, a new component was added to the analysis, one that necessitated the application and enforcement of “values” external from the narrow function and focus of the business.  In their 1995 examination of the developments in stakeholder theory, Thomas Donaldson and Lee Preston argued that “A striking characteristic of the stakeholder literature is that diverse theoretical approaches are often combined without acknowledgment.”  This led, in turn, to poor analysis, both at the academic and business level, making a mess of the whole idea of stakeholder analysis.  “The muddling of theoretical bases and objectives, although often understandable, has led to less rigorous thinking and analysis than the stakeholder concept requires.” Finally, all of this created an environment in which stakeholder analysis was discussed and undertaken with rote repetition of “values,” many of which were inapplicable or counter-indicated by circumstances.  “Much of the stakeholder literature, including the contributions of both proponents and critics, is clearly normative, although the fundamental normative principles involved are often unexamined.”

Or to put it another way, the creation of the normative model of stakeholder theory only served to compound the moral chaos that already existed.

In their original joint analysis of capitalism and its stakeholder deficiencies, Freeman and William Evan, a UPenn sociology professor, determined that the value that mattered most was “democratization” or “individual rights,” or as Donaldson and Preston put it, “They asserted that the theory of the firm must be reconceptualized ‘along essentially Kantian lines.’ This means each stakeholder group has a right to be treated as an end in itself, and not as means to some other end, ‘and therefore must participate in determining the future direction of the firm in which [it has] a stake.’”

In this, you can see the not-so-subtle shifting of the ground away from the “instrumental” version of the stakeholder model and the suggestion that corporate managers should assess stakeholders in terms of the broader societal goals.  What this means is that almost immediately upon introducing a normative component to the discussion, Freeman moved explicitly and irreversibly away from the idea that any of this was about a corporation and its success and toward the idea that society’s ends were more important, and that businesses exist, in part, to serve societal needs.

The normative model of stakeholder capitalism, NOT the Friedmanite shareholder model, provides the justification for ESG.  To believe otherwise requires both the suspension of disbelief and uncritical acceptance of ESG practitioners’ convoluted rationalizations for their attempt to weaponize capital to achieve their preferred political ends.

ESG is FUNDAMENTALLY inimical not just to Friedman’s model but to all traditional conceptions of capital markets, the commercial economy, etc., including those developed and honed throughout the 4000 years of Western Civilization, encouraged by John Calvin, and explained by Adam Smith.  It is based on a moral foundation that preferences the rights of business stakeholders over those of shareholders.  It is not a mere outgrowth of shareholder capitalism or an effective means to political ends.  It is reliant upon a transformative model of corporate moral obligations.

Given this, “conservatives” are certainly welcome to employ ESG principles in the efforts to achieve what they consider to be proper social and political ends, but if they do, they will be contributing to the moral confusion surrounding and the degradation of capitalism as we know it.

Stephen Soukup
Stephen Soukup
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Steve Soukup is the Vice President and Publisher of The Political Forum, an “independent research provider” that delivers research and consulting services to the institutional investment community, with an emphasis on economic, social, political, and geopolitical events that are likely to have an impact on the financial markets in the United States and abroad.