ESG: A Dysfunctional Metric

The quality profession already offers solutions to promote environmental and social responsibility

Published: Wednesday, February 22, 2023 - 13:03

Environmental, social, and governance (ESG) is growing in popularity as a metric to guide investment decisions. What does ESG have to do with productivity, quality, or stakeholders, aka relevant interested parties? The answer is—with the exception of generally accepted practices for workplace safety and reduction of all forms of material and energy wastes—almost nothing. ESG underscores instead the well-known principle that measurement of the wrong performance measurements will deliver dysfunctional results.

What is ESG?

Investopedia¹ provides a good overview: “Environmental, social, and governance (ESG) investing refers to a set of standards for a company’s behavior used by socially conscious investors to screen potential investments. Environmental criteria consider how a company safeguards the environment, including corporate policies addressing climate change, for example. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.”

This sounds good, but let’s look at the realities.

Environmental

Take environmental, for example. Following the release of the IPCC’s Sixth Assessment Report on climate change, United Nations Secretary-General António Guterres warned that “This report must sound a death knell for coal and fossil fuels before they destroy our planet.” While I believe in climate science, I also believe that lack of access to inexpensive power delivers nothing but poverty, unemployment, hunger, and cold weather exposure. In the short term, it is far more important to feed and employ people, and keep them warm in winter, than it is to “save the planet.”

Campaigns against fossil fuels including natural gas, along with Russia’s invasion of Ukraine, have resulted in potential natural gas shortages that are likely to result in rolling blackouts in New England if the weather there gets particularly cold.² Like Pennsylvania, New England is, unfortunately, a party to the Regional Greenhouse Gas Initiative (RGGI). The phrase, “You make your igloo and you lie in it,” therefore comes to mind. In addition, when the electricity stops, and the demand is far greater during the work day, factories stop as well. When the factories stop, so do wages. I can’t identify anything socially responsible about idle factories, lost work time, and empty store shelves.

This by no means implies that it’s a good idea to release into the atmosphere hundreds of years of accumulated carbon, or that the issue isn’t important. It’s what President Dwight D. Eisenhower’s priority matrix would call “important but not urgent,” as proven by the behavior of the climate activists themselves. When people fly private airplanes to the 2009 Copenhagen Climate Conference, rent large gasoline-fueled limousines, stay in thousand-dollar (£650 at the time) hotel rooms, and dine on caviar wedges,³ it’s obvious that they don’t regard the issue as urgent. When the European Union requires airlines to fly nearly empty “ghost flights” to keep their landing slots at airports, thus squandering stakeholder money and emitting carbon dioxide for no purpose at all,⁴ it’s clear that the EU doesn’t regard the matter as urgent, either.

On the other hand, curtailing energy waste, including by using ISO 50001:2018 for energy management systems, removes the cost of wasted energy from supply chains. This enables simultaneous lower prices, higher wages, and higher profits, all of which are socially responsible. Even if the wasted energy is from a renewable source, it’s almost certainly fungible via the power grid with fossil fuel energy, so suppressing this waste does something tangible about greenhouse gas emissions.

I put this into practice by installing a heat pump in my house, which works as an air conditioner during summer but an air conditioner in reverse during winter. This means I have to pay less than half for electricity than I would by using baseboard heaters. If we apply this thought process on a larger scale, LEED (Leadership in Energy and Environmental Design) buildings use less water as well as less energy, which reduces costs.

Is corporate giving good stewardship?

The Investopedia reference adds, “Does the company donate a percentage of its profits to the local community or encourage employees to perform volunteer work there? Do workplace conditions reflect a high regard for employees’ health and safety?” While occupational health and safety (OHS) is nonnegotiable by law and also the Code of Ethics of the National Society of Professional Engineers (“Hold paramount the safety, health, and welfare of the public”), profits aren’t management’s to donate. They belong to the investors who entrusted the organization with their money or, in the case of revenues in general, also to customers and employees. Maybe the relevant interested parties don’t want to give money to the causes selected by management and would prefer to give it to somebody else instead. Some major corporations have donated money to extremely controversial organizations that could offend potential customers and also investors.

Henry Ford didn’t donate any money to charity despite his enormous wealth. This doesn’t mean he kept all the gains for himself. He shared the money with customers in the form of lower prices, his workers as higher wages, and his suppliers as fair compensation. He wouldn’t pay for a supplier’s waste—and this might include a supplier’s ESG efforts today—but he did recognize their need to profit and pay their workers high wages as well. The result was that his industries abolished poverty wherever they appeared because workers spent their disposable income in their communities, creating more wealth and more opportunities for everybody.

When DEI training becomes sexual harassment

Some ESG principles are already generally accepted common sense and even required by law. In its ESG definition, Investopedia adds the criterion of “...accurate and transparent accounting methods,” for which there are (for example) generally accepted accounting practices (GAAP), and also the requirements of the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS). The social definition includes “Supports LGBTQ+ rights and encourages all forms of diversity.” Gender identity and sexual orientation are protected characteristics according to the Equal Employment Opportunity Commission (EEOC), so discrimination against LGBTQ+ people is unlawful and socially unacceptable. Period.

Diversity, equity, and inclusion (DEI) initiatives can, on the other hand, often cause the very problem they purport to solve. A case in point was the sexual harassment lawsuit filed against the Federal Aviation Administration (FAA). According to court records, during a mandatory FAA sexual harassment training event, women participants in the exercise “would make comments to men who proceeded through a line of women while the women may have touched the men on the arm or may have given the man a `little slap on the butt.’”⁵

When I last checked, the purpose of sexual harassment training is to show people how to avoid it rather than have a literal hands-on exercise in which they do it. Although the court threw out the plaintiff’s claims for racial and religious harassment, it didn’t throw out the sexual harassment claim. The defendant ended up paying a settlement.

The takeaway here is that certain activities that look good from an ESG standpoint can actually be unlawful. If the employer does what the EEOC says it needs to do, and ensures that nobody is treated better or worse than anybody else because of his or her race, ethnicity, religion, gender, age, sexual orientation, or other protected characteristic, there won’t be any problems.

Governance

When ESG investments constitute breach of fiduciary duty

We’ve seen so far that certain ESG activities that relate to DEI can do the opposite of what they are intended to do, and even violate EEOC regulations and create hostile work environments. If we return to the proposition that a company has a fiduciary duty to maximize profits for its investors via all lawful and ethical means available—and this includes workplace safety in accordance with OSHA regulations, compliance with environmental laws, a square day’s pay for a square day’s work, and not cutting corners on value or quality—then ESG initiatives could easily constitute a breach of fiduciary duty.

Even though we would expect companies with good ESG ratings to outperform those with poor ones—after all, we expect good performance from good governance and bad performance from bad governance—Bhagat (2022) states, “To begin with, ESG funds certainly perform poorly in financial terms.... Although the highest rated funds in terms of sustainability certainly attracted more capital than the lowest rated funds, none of the high sustainability funds outperformed any of the lowest rated funds.”⁶

If one has a fiduciary duty to investors, as pension funds and mutual fund managers do, then investment based on ESG criteria rather than actual performance (e.g., as measured by price/earnings ratios and forecasts of growth and income) constitutes a breach of fiduciary duty. This is, in fact, the legal opinion of the attorneys general of 19 states as expressed to investment management firm BlackRock. This letter reads in part (emphasis is mine):⁷

“While couched in language about long-term value, BlackRock’s alignment of engagement priorities with environmental and social goals, such as the U.N.’s Sustainable Development Goals, suggests at a minimum a mixed motive. Blanket statements regarding investing in particular asset classes without referencing price is not consistent with fiduciary and legal obligations. Nor are blanket commitments to vote for directors based upon protected characteristics, such as gender. Rather, BlackRock appears to be acting for a social purpose that may have a financial benefit if certain improbable assumptions occur. If BlackRock were focused solely on financial returns, its conduct would likely be different.

“BlackRock’s actions on a variety of governance objectives may violate multiple state laws.... Our states will not idly stand for our pensioners’ retirements to be sacrificed for BlackRock’s climate agenda. The time has come for BlackRock to come clean on whether it actually values our states’ most valuable stakeholders, our current and future retirees, or risk losses even more significant than those caused by BlackRock’s quixotic climate agenda.”

If we summarize this letter in a single sentence, it might read as follows. “If you want to invest in environmental or social activism, do it with your own money and not that of investors, including pension funds.” To put this in perspective, the FTX cryptocurrency firm had a better governance rating than Exxon-Mobil. Wongnatthakan (2022) elaborates, “FTX used ESG as a cover to avoid scrutiny after Alameda Research used FTX client funds to speculate on cryptocurrency tokens, and political donations may have slowed any scrutiny.”⁸ The SEC press release, “SEC Charges Samuel Bankman-Fried with Defrauding Investors in Crypto Asset Trading Platform FTX,” shows just how much that governance rating was worth.⁹

The dysfunctional nature of ESG ratings is underscored by the fact that cryptocurrency funds have them at all, because cryptocurrency is nothing more than a pyramid or Ponzi scheme similar to the Dutch tulip mania of the 17th century and the dot-com stock frenzy at the beginning of the 21st century. Cryptocurrency is valuable only because people think it is. Hern (2018) reports that it took 19 megajoules (5.2 kWh) to “mine” a dollar’s worth of Bitcoin, 9 MJ for a dollar’s worth of rare earths that have useful industrial applications, and 5 MJ for a dollar’s worth of gold.¹⁰ Even if the electrical power squandered on cryptocurrency production comes from renewable sources, it’s fungible via the power grid with fossil fuels. That tells us everything we need to know about the “environmental” part of cryptocurrency’s ESG.

The U.S. Department of Labor adds,¹¹ “At this early stage in the history of cryptocurrencies, the Department has serious concerns about the prudence of a fiduciary’s decision to expose a 401(k) plan’s participants to direct investments in cryptocurrencies, or other products whose value is tied to cryptocurrencies. These investments present significant risks and challenges to participants’ retirement accounts, including significant risks of fraud, theft, and loss....” It’s no more prudent to invest in cryptocurrencies than it is to invest in collectibles or trading cards, or even to gamble in a casino.

There is an excellent Biblical parable that relates to fiduciary duty, found in Matthew 25. A man who had to go on a journey entrusted three servants with some money. Two servants invested the money responsibly. “And so he that had received five talents came and brought other five talents, saying, Lord, thou deliveredst unto me five talents: behold, I have gained beside them five talents more.” One servant, however, hid the money away and did nothing.¹²

“Then he which had received the one talent came and said, Lord, I knew thee that thou art an hard man, reaping where thou hast not sown, and gathering where thou hast not strawed. And I was afraid, and went and hid thy talent in the earth: lo, there thou hast that is thine. His lord answered and said unto him, Thou wicked and slothful servant, thou knewest that I reap where I sowed not, and gather where I have not strawed: Thou oughtest therefore to have put my money to the exchangers, and then at my coming I should have received mine own with usury.”

If this servant had told his master honestly instead, “I looked into the possibility of putting your talent into the exchanges and saw an opportunity to return two for one, but also a chance of losing all. I therefore thought it best to invest thy talent in Treasury bonds that are backed by the full faith and credit of the United States and return it with only the four percent interest it hath gained,” that would have been good stewardship. Investors can in fact specify preservation of capital as a principal objective, and although the mutual funds in question deliver lower returns than those that take some risks, the investor is at least sure of keeping his or her principal. If, on the other hand, the servant had said, “Alas, master, I invested thy talent in FTX because of its ESG rating, and now it’s gone,” that would have been poor stewardship and a breach of fiduciary duty.

What should we do instead?

It should now be abundantly clear that ESG has almost nothing to do with quality, productivity, or bottom-line performance. It should never become part of the quality profession; the quality profession already offers well-established and off-the-shelf solutions to promote environmental performance and social responsibility. These are relatively easy to measure, and unlike ESG, they all support the needs and expectations of stakeholders, aka relevant interested parties.

A foremost principle is that any form of waste (muda) is inconsistent with social responsibility because it comes out of the pockets of customers, workers, and investors. It may also be inconsistent with environmental goals because wasted energy is almost certainly, regardless of its source, fungible with fossil fuels through the power grid. Wasted materials may be environmental aspects, but even if they aren’t, they constitute wasted money.

Even though attention to wastes that aren’t environmental aspects isn’t required by ISO 14001:2015, I recommend that users of this standard apply its consideration to all forms of material waste. Henry Ford made an enormous amount of money by finding ways to either not create the material waste in the first place, or repurpose it, even though he could have legally thrown whatever wouldn’t go up his smokestacks into the nearest river. Waste wood was distilled into saleable chemicals and also Kingsford charcoal, while slag from blast furnaces was converted into cement and paving materials. Coking of coal extracted all the valuable chemicals including the sulfur, which would have otherwise become acid rain. Ford converted it into ammonium sulfate and sold it as fertilizer instead.

Social responsibility also requires a fair day’s pay for a fair day’s work. One can’t look for ways to pay people as little as possible and expect them to do their best. Ford pointed out that when a share of productivity gains shows up in people’s pay envelopes, they will look for ways to improve productivity even further. Occupational health and safety (OH&S) is nonnegotiable by both law and the Code of Ethics of the National Society of Professional Engineers. While people don’t ordinarily think of OH&S as part of the quality profession, and quality professionals should indeed defer to OH&S professionals in technical matters, safety is a consideration in process failure mode effects analysis (PFMEA), which is part of the quality profession.

Mark Twain wrote in A Connecticut Yankee in King Arthur’s Court, “Somehow, every time the magic of folderol tried conclusions with the magic of science, the magic of folderol got left.” ESG is the magic of folderol: It seems to serve no purpose other than to divert attention from value creation and even promote deployment of dysfunctional performance metrics. Prudent and ethical business practices that deliver fair returns to all stakeholders are the magic of science. That is all we need to know.

References
1. Investopedia Team. “What Is Environmental, Social, and Governance (ESG) Investing?” Investopedia, Sept. 27, 2022.
2. Hoplamazian, Mara. “New England’s grid is expected to be reliable this winter, but a cold snap could cause issues.” WBUR, Dec. 6, 2022.
3. Gilligan, Andrew. “Copenhagen climate summit: 1,200 limos, 140 private planes and caviar wedges.” The Telegraph, Dec. 5, 2009.
4. Neslen, Arthur. “Airlines flying near-empty ‘ghost flights’ to retain EU airport slots.” The Guardian, Jan. 26, 2022.
5. Hartman v. Pena, 914 F. Supp. 225 (N.D. Ill. 1995)
6. Bhagat, Sanjai. “An Inconvenient Truth About ESG Investing.” Harvard Business Review, March 31, 2022.
7. Arizona Attorney General Kris Mayes. “AG Brnovich Letter to BlackRock, Inc. RE: ESG Concerns.” Aug. 4, 2022.
8. Navellier, Louis. “2022 Will Be Remembered For The Collapse Of ESG... And FTX.” Seeking Alpha, Nov. 29, 2022.
9. “SEC Charges Samuel Bankman-Fried with Defrauding Investors in Crypto Asset Trading Platform FTX.” U.S. Securities and Exchange Commission, Dec. 13, 2022.
10. Hern, Alex. “Bitcoin’s energy usage is huge—we can’t afford to ignore it.” The Guardian, Jan. 17, 2018.
11. “401(k) Plan Investments in ‘Cryptocurrencies’.” U.S. Department of Labor.
12. Matthew 25:14-30. King James Bible.

About The Author

William A. Levinson

William A. Levinson, P.E., FASQ, CQE, CMQOE, is the principal of Levinson Productivity Systems P.C. and the author of the book The Expanded and Annotated My Life and Work: Henry Ford’s Universal Code for World-Class Success (Productivity Press, 2013).