Incommensurate Goods in ESG
When values conflict, how do you choose what to prioritize?
ESG (Environmental, Social, Governance) investing is an investment thesis that goes something like this: in the long-run, companies that score well on measurements of environmental, social, and corporate governance factors will outperform peer companies that score poorly. In practice, this thesis means avoiding investments in, say, landmine companies or coal mines while instead seeking investments in solar companies or inclusion-focused fintech services.
Counterintuitively and perhaps counterproductively, ESG investing makes returns higher for those without qualms investing in non-ESG industries (at least in the short term). If the majority of investors care about ESG and are unwilling to provide capital to firms engaged in, say, drilling oil or manufacturing guns, these ‘bad’ firms will indeed have a harder time financing their operations. ‘Bad’ firms, then, will have to go to the capital markets and accept worse terms—say, higher interest rates on their loans—to attract the ‘unscrupulous’ investors since the available world of capital is smaller.
This situation is bad for the ‘bad’ firms, but great for the ‘unscrupulous’ investors; the ‘unscrupulous’ investors get to collect a premium for simply being willing to do business with unsavory industries and companies.
The especially interesting thing about ESG is that it is context dependent. As pointed out by Matt Levine in ESG Goes to War, when Russia initially began its invasion of Ukraine, there were curious pressures from the international community to support the defense industry or increase oil drilling to aid Ukraine’s defense and reduce the impact of sanctions on Russian oil, respectively.
This got me thinking about incommensurate goods: just like there can be tradeoffs at the margin between liberty and equality, two incommensurable values, how do you make a decision when, for example, environmental sustainability and economic hardship come head-to-head? Many families around the world will be subject to harsh economic decisions due to skyrocketing energy prices. These price hikes would be dampened by increases in oil production, but at the cost of environmental damage from increased extraction activities. Which course of action should you pursue? Or in the context of the defense industry issue. Levine notes:
If you are an ESG investor you need to have a theory of international relations that tells you whether it is a net good or bad for human flourishing for democracies to procure powerful weapons to deter and/or conduct wars.
This dilemma doesn’t just face ESG investors, though: every philanthropist faces it when they make a donation; every politician faces it when choosing between policy options; every citizen faces it when they go to vote.
My own industry of solar is rife with wicked problems that I’m not sure I have a position on, much less an answer, due to the incommensurability problem. For example:
Do I think that it’s good for workers to have the opportunity to unionize? Absolutely. But every time a state passes a prevailing wage law or law requiring union labor on solar projects, it becomes harder to deploy solar in that state because installation costs go up. We face a choice: do we care more about providing people better wages or about deploying clean energy and accelerating the transition away from fossil fuels? Every time a state proposes such a law, clean energy groups predictably come out against it (see CT, IL).
Another example from solar is that of net metering. Net metering is policy that allows solar installed behind the meter of customers to be compensated for the energy they produce. Net metering traditionally worked by compensating systems with 1:1 full retail credits for energy produced and sent to the grid. For every kilowatt hour produced by the system, the generator receives the same value on their account as the kilowatt would have cost at the time of production.
While this policy is second only to the investment tax credit in driving solar deployment around the country, utilities insist around the country that net metering has created a “cost shift” from solar adopters (mostly wealthy) to everyone else. As noted in an anti-net metering op-ed in the LA Times:
The difference between the wholesale and retail prices is what pays for the system’s fixed costs, including most transmission and distribution costs, wildfire mitigation (think cutting trees and bushes around power lines), compensation for past victims of wildfires, subsidizing energy-efficiency programs and low-income customers, and making investments in new renewable technologies. As solar households consume less utility-provided power or export more power to the grid, those fixed costs don’t decline much if at all.
Based on data from the CPUC, the Energy Information Administration and other sources, my colleagues and I calculated the result: Utility customers who install solar save 20 to 30 cents for every kilowatt-hour their system produces, but the utility’s costs go down by only 7 to 9 cents. That leaves 10 to 20 cents in costs that still must be covered, so electricity rates go up, which hits people without solar panels.
In effect, opponents claim net metering to be a regressive tax on energy against people who can’t afford to adopt solar or who can’t (e.g., renters). So when the California Public Utilities Commission proposed a revision to the state’s net metering law last year that gutted the value of energy sent to the grid in a way that experts predict would shrink the CA residential solar market by half by 2024, I felt conflicted. On one hand, the actual policy they proposed was clearly onerous, punitive, and intended to destroy the distributed solar market, but on the other hand, the state’s net metering policy, and especially the residential net metering policy, is inarguably overcompensating generators relative to the real value they’re providing to the grid.
Do I want more solar installed around the United States? Absolutely. Do I want non-adopters to have to pay more for energy in what effectively amounts to a regressive income tax? Absolutely not. Incommensurability strikes again. What is the well-being generated by 2.4 gigawatts of clean energy compared to the cost shift of $3 billion to non-solar adopters?
I’ve been calling these things incommensurate, but I think that characterization is a bit inaccurate. Incommensurability’s difficulty lies in a lack of ability to measure two outcomes against each other—what is better, a more free society or a more equal society? But in truth, the “E” and “S” and “G” of ESG can be compared. After all, the fundamental thesis of ESG is that human flourishing and business flourishing should align in the long term. What is missing to make the comparison of these values is a common dimension of measurement. For example, those who work in global public health have created the concept of a quality-adjusted life year to compare the efficacy of different health interventions.
The problem, then, becomes one of calculation. We can calculate the net benefit of the gigawatts of energy versus the billions of dollars of cost shift, but the calculated output will be so assumption-laden that it is unlikely to be conclusive in any single direction (I know this because people do calculate the net benefits, and they often disagree).
In truth, though, I imagine that these value conflicts will really expose the duplicity of many of the funds engaged in ESG investing. Many analyses suggest that ESG funds are only marginally better than standard funds along environmental dimensions; for instance, a study from late 2021 found that “many ESG ETFs were still more carbon-intense than a hypothetical fund that precisely tracked the S&P but excluded the five dirtiest companies in each sector.” If an ESG fund hardly does better than the S&P 500 minus the biggest oil companies, that isn’t socially conscious investing; it’s greenwashing. As noted by other ESG critics, and as illustrated by the defense industry example at the beginning of this post, ESG seems to be quite sensitive to updating its methodology based on the whims of current events and political winds rather than based on real impact.
As ESG formalizes itself and governments continue to encourage and even mandate public discussion of ESG-related factors, such as the SEC’s March 21, 2022 proposed set of rules on climate-related disclosures, companies and investors will be forced to confront these issues. My hope is that widespread adoption will bring improvements and more resources to the cost-benefit analyses surrounding these important issues similar to how the effective altruism movement promotes a more quantitative way of looking at the efficacy of doing good.
Until we’ve got ESG funds that are truly engaging in unmotivated cost-benefit analyses of human well being from different courses of action, I’m not touching these funds. As noted by a friend, in their current state these funds serve as little more than virtue signaling for the investment class.
Thanks to Shreyas for his thoughts, as always.