ESG is a shaky framework to guide investment and has no place in compulsory super funds without explicit consent of the beneficiaries, argues IPA Adjunct Senior Fellow Sinclair Davidson.
The use of Environmental, Social, and Governance (ESG) investment strategies within the context of compulsory Australian superannuation raises significant concerns. The concentration of investment funds under the control of the union movement increases the risk of both crony capitalism and crony socialism. This—combined with the regime uncertainty generated by continual government meddling—undermines confidence in the very concept of retirement savings. Policymakers and stakeholders need to take steps to increase transparency and accountability, reduce political influence, increase investor education, improve risk management, and encourage competition. By doing so, Australia can ensure its superannuation system is resilient and robust, sustainable in the broadest sense, and meets the needs of all Australians now and in the future.
There is little evidence to support the efficacy of ESG investment.
This research essay sets out a broad theoretical framework to evaluate the risks by identifying disorder costs and dictatorship costs associated with superannuation. It examines the problems of crony capitalism and crony socialism within the superannuation system. Contrary to various claims, ESG investment strategies do not obviously and comprehensively outperform traditional investment strategies. They do, however, add to the cost of investment funds and these costs are passed on to members. The problems identified need to be addressed, and there are specific recommendations.
Environmental, Social, and Governance investing forms part of a spectrum of investment strategies that ranges from conventional investment strategies aimed at earning (high) financial market returns all the way to traditional philanthropy that only aims to earn a (high) social return.
ESG investing can be differentiated from the very similar notions of ‘social investing’ and ‘impact investing’ as follows:
- Social investing refers to investing in companies or funds that align with the investor’s social or ethical values, while also seeking a financial return.
- Impact investing is a specific form of social investing that seeks to generate positive social or environmental outcomes, in addition to financial returns.
- ESG investing refers to investment in firms that meet certain criteria such as a commitment to minimising a carbon footprint, or meeting high labour practice standards, or board gender composition. The stated aim of ESG investment is to identify those companies that are well-managed, have a positive impact on society and the environment, and offer a high financial return. Embedded within the notion of ESG investing is the belief that companies must make a concerted effort to ‘do good’ beyond simply earning a profit for their shareholders. Unfortunately, also implicit within the idea of ESG investing is the concept of a free lunch: that companies can choose to pursue various options, various business models, or decision-making processes without incurring any additional costs. The ESG mindset is predicated on the idea that inefficiencies exist within the economy and all that is required is that people be sufficiently incentivised to be better. That particular mindset was in 1969 described by economist Harold Demsetz as being the ‘nirvana fallacy’. This fallacy consists of three interrelated ideas:
- There can be a free lunch;
- The grass is greener on the other side; and
- People could be different. The nirvana fallacy usually involves people comparing the actual world to an idealised world and then concluding the real world is somehow deficient and can be improved. All too often, however, such exercises are simply wishful thinking.
The difficulty in departing from traditional investment strategies, such as profit maximisation or maximising portfolio returns subject to risk, is deciding which other investment strategies to pursue. Within the ESG space, there are various indicators and indices that can be deployed when making investment decisions. The Organisation for Economic Co-operation and Development (OECD) in 2020 looked at the ‘Practices, Progress and Challenges’ of ESG investing, and provided a discussion of these indicators, indices, and strategies. It reported high variability between the various information providers who generate these indicators and indices. Consequently, the resulting investment portfolios may be very different too.
The OECD identified six different investment strategies that can be deployed to pursue an ESG investment strategy:
- Avoidance or exclusion of specific stocks or industries (for example, fossil fuels, landmines, and tobacco).
- Inclusionary screening of those stocks that are considered ‘best in class’.
- Portfolio tilt towards those stocks with higher ESG scores.
- A thematic focus on specific ESG issues.
- An impact focus where investors invest in those stocks that make better progress towards ESG goals.
- ESG integration occurs when ESG factors are explicitly and systematically incorporated into all aspects of the investment decision.
Eugene Fama—the 2013 economics Nobel Laureate (joint with Lars Peter Hansen and Robert Shiller)—is most famous for his exposition of the ‘efficient markets hypothesis’. What this suggests is that investors should not be able to outperform the stock market on a risk-adjusted basis by following an investment strategy that relies on publicly available information.
The Australian superannuation system suffers from high levels of regime uncertainty.
This is an important consideration because ESG investment strategies rely explicitly on publicly available information. In addition, formulating investment portfolios on the basis of ESG information is itself costly. If Fama’s ‘efficient markets hypothesis’ is correct, ESG portfolio returns should be lower than market returns after adjusting for risk and transactions costs. On the other hand, it may well be the case that markets have not accurately incorporated information relating to ESG considerations and, consequently, it could be possible that ESG investment criteria add value to investment decision-making processes. This is very clearly an empirical question.
The 2020 OECD report into ESG investing summarised the research on this topic:
The existing literature reveals a largely mixed and somewhat inconsistent empirical evidence, in which the researchers point out the difficulty of quantifying the real impact of ESG rating on the performances of portfolios. The inconclusiveness may depend on problems regarding different providers, methodologies, investment strategies, geographical selection, sample selection and timeframes.
That is a technocratic way of saying there is little evidence to support the efficacy of ESG investment. That ESG investing delivers superior returns to investors is neither clear nor obvious. The OECD then performed its own empirical analysis of ESG investment strategies:
The first main finding related to the correlation between high ESG scores and higher financial returns, based on backtesting of various portfolios over the past ten years. What we find is a very different result, mainly due to different providers’ methodology, investment strategies, regions and time frames. This does not mean that all ESG portfolios underperformed the traditional market: however, many high-scoring ESG portfolios did underperform, and a number of low-scoring ESG portfolios outperformed the markets.
The second key finding looks at absolute and risk-adjusted return measures. We find that there is a wide range of performances depending on the provider used. Moreover, we found that high scoring ESG portfolios, even when using a best-in class approach that limits the concentration from reducing exposure to lower ESG scores, do not seem to outperform traditional indices.
To be clear: these results are damning. The OECD found ESG investing did not add value to the investment strategies being pursued. What would have happened, however, is ESG consultants adding to the cost of pursuing those investment strategies. The academic literature reports similar results. A 2020 article by Bradford Cornell titled ‘ESG Preferences, Risk, and Return’ in the European Financial Management journal concludes:
The jury is still out on whether there is an ESG risk factor. There are no noncontroversial ESG ratings and the available sample period over which ESG data are available is short. However, even if ESG ratings are related to an underlying risk factor that does not mean they can be used to identify superior investments. The existence of superior investments requires that ESG risks are mispriced. Given the intense focus on ESG investing in today’s market such mispricing seems unlikely. Putting aside mispricing, if there is an ESG risk factor, then stocks with high ESG ratings that are less exposed to that risk, should provide lower, not higher, expected returns for hedging reasons.
Results such as that are problematic. Investors want to earn high returns on their investments. But academic studies routinely report things such as in a 2019 paper in the Journal of Financial Economics by Dyck et al which stated, “Whether E&S performance is beneficial to the average shareholder remains controversial.” What is not controversial, however, is that ESG investing is associated with institutional investment. That, however, is also problematic. The same paper states (emphasis added), “We specifically investigate institutional investors because these shareholders own and vote the bulk of the world’s equity capital.” In particular, Dyck and others report that pension funds (or in Australian terminology superannuation funds) “consistently influence firms to strengthen [their] E&S performance”. Yet a 2022 article by Sanjai Bhagat in Harvard Business Review observed:
The conclusion to be drawn from this evidence seems pretty clear: funds investing in companies that publicly embrace ESG sacrifice financial returns without gaining much, if anything, in terms of actually furthering ESG interests.
To the extent that ESG investment imposes a cost on institutional investors—such as superannuation funds—but does not result in higher returns, those costs are in effect a tax on investors in those funds. In the Australian context, this is particularly onerous given that superannuation is compulsory.
ESG IS MAKING SOMEONE MONEY
There is a massive conflict of interest at the heart of ESG investment. To the extent that institutional investors drive the demand for ESG type activities at the firm level—but those activities do not result in higher investment returns to the institutional investor—a cost is being imposed on the underlying beneficial owners of the funds. It may well be true that institutional investors ‘vote the bulk of the world’s equity capital’, but the fact of the matter is that they cannot be said to ‘own’ that equity in an economic sense. These institutional investors are in fact imposing their own preferences on their clients. This conflict of interest was very nicely summed up in a 2023 article in Compact Magazine by Julius Krein:
Ironically, it was a Reagan-era regulatory change that empowered the likes of BlackRock, granting fund managers outsized influence over corporate governance. In the 1980s, a failed Republican Senate candidate named Robert Monks became administrator of the Office of Pension and Welfare Benefit Programs at the Department of Labor. Monks worked to change proxy-voting rules to allow fund managers, instead of the underlying beneficial owners, to vote the shares they held on behalf of investors. Notably, Monks then left the government to found Institutional Shareholder Services, or ISS, one of the leading proxy advisers making recommendations on how institutional managers should vote their shares.
While it might not be entirely fair to ascribe bad motives to Robert Monks, it is clear that he created his post-government business opportunity while employed by the government, and he directly benefitted from a policy change he proposed and championed while in government employment. There are many such conflicts of interest and perverse incentives in the institutional investment industry.
ESG AND COMPULSORY SUPERANNUATION
Compulsory superannuation was introduced in Australia in 1992. At present working Australians are required to contribute 10.5 per cent of their income to a superannuation fund. That amount, the so-called Superannuation Guarantee Rate, is set to increase in incremental steps to 12 per cent by June 2026. The payment is described as an ‘employer contribution’, yet it is clear the economic incidence of the payment falls upon the employee. (It does not matter who writes the cheque, the effect is just as if the full amount had been paid to the employee who was then forced to deposit it in a superannuation account.)
Dictatorship costs are the risks posed by the State and its agents behaving badly.
Many of the arguments and debates relating to compulsory superannuation are tactical, and do not address the core issues. For example, there are debates as to whether it should be compulsory or voluntary, or whether the Guarantee Rate should be higher or lower, or how much people should be allowed to accumulate in their superannuation funds, or how it should be taxed … if at all.
To avoid this trap, I am going to introduce a conceptual model which provides a framework for evaluating those arguments and debates, and then use this to examine ESG and related considerations.
In a 2003 paper in the Journal of Comparative Economics, Harvard economist Andrei Shleifer (and co-authors) introduced the idea of an ‘institutional possibilities frontier’ that traded off private ‘disorder costs’ against public ‘dictatorship costs’. In this model, disorder costs relate to the risks to individuals and their property posed by other individuals behaving badly. Bribery and theft, for example, would be individuals behaving badly. In contrast, creating a superior product and outperforming a competitor would not constitute a disorder cost. Within this definition, the private subversion of public institutions also constitutes disorder costs. In contrast, dictatorship costs are the risks posed to individuals and their property by the State and its agents behaving badly.
ASIC is investigating whether some superannuation funds are ‘greenwashing’.
It is possible to augment this model with other ideas. For example, one form of dictatorship cost is Robert Higgs’ notion of ‘regime uncertainty’ which he defined as:
… a pervasive fear that existing private property rights in one’s property and the income the property yields will be attenuated or destroyed by unpredictable changes in government taxation, regulation, or other action.
It is quite clear the Australian superannuation system suffers from high levels of regime uncertainty—and these can be considered ‘dictatorship costs’. For example, efforts to increase taxation on superannuation balances while in the so-called accumulation phase, or placing caps on how much can be accumulated within superannuation accounts constitute dictatorship costs. More recently, the Australian government has suggested superannuation funds should engage in ‘impact investing’ or ‘social investing’.
The Australian Treasurer Jim Chalmers penned an essay in the February 2023 edition of The Monthly (a left-wing current affairs magazine) setting out the idea of “redesigning markets… for social purposes”, as if markets were not already highly social constructs:
There are ways to protect essential public goods and direct investment to areas where there are financial and social returns available. [Michael] Traill has pioneered this idea of investing with purpose in Australia by using the discipline of market-based activity to transform the availability of capital, and by directing investment to organisations that are delivering genuine, measurable outcomes … If we could redesign markets for investment in social purposes, based on common metrics of performance, many more well-run ‘for purpose’ organisations could get much more of the growth capital they need.
Subsequently, writing in The Australian, the aforementioned Michael Traill, who is the Executive Director at For Purpose Investment Partners, argued:
Executed well, there is a real opportunity to mobilise large-scale capital from traditional institutional sources including superannuation funds for the kind of investments that meet reasonable risk-weighted financial hurdles and drive social impact. There is equal scope for sensitive use of the kind of market disciplines business is used to applying in meeting customer needs to drive better outcomes and significant cost savings and welfare reform.
This notion of ‘social impact investing’ is an example of what Harold Demsetz labelled ‘nirvana economics’. In particular, it assumes ‘that people could be different’, that there are relatively easy and low-costs changes that can be made to public policy that will result in huge improvements in the ‘human condition’.
These ideas are also a modern manifestation of the ‘socialist calculation debate’ conducted from the early to mid-20th century. In that debate Ludwig von Mises and Friedrich Hayek engaged with several socialist-inclined neo-classical economists on the relative merits of capitalism and socialism. In short, the case made by the socialists included the notion that market performance could be replicated and improved upon by socialist planning. This is the same argument we hear today from advocates of impact investing and social investing.
The real challenge now is to proclaim the currently unfashionable reality that value can be measured by money and profit is a signal of social worth. Social problems very often exist because of information shortfalls and missing markets. Wishful thinking cannot substitute for those missing markets, nor create the incentives to discover information.
The profit motive, however, can and does create those very incentives. This is a very important difference between ‘impact investing’, ‘social investing’, and ESG investing. The latter promises (incorrectly) that ESG investment can be as profitable as traditional investment. Impact investing and social investing makes no such promise. Consequently, if individuals wish to engage in such investment practices they should do so with their own money and governments should not mandate such practices without explicitly conceding this constitutes a de facto tax on investors.
In short, government mandated investment criteria that deviate from traditional investment metrics constitute a tax on investors, contribute to regime uncertainty, and should be labelled a dictatorship cost. Similarly, the ‘voluntary’ adoption of ESG investment criteria by superannuation funds (in the absence of specific products that investors can select) constitutes a disorder cost. While reasonable people can reasonably disagree as to the utility of compulsory superannuation, forcing individuals to involuntarily contribute to a superannuation fund and then have that fund not attempt to maximise their returns subject to the traditional definitions of risk and traditional metrics would constitute the exploitation of investors.
The widespread adoption of ESG investment practices within the Australian superannuation industry would exacerbate existing problems related to union domination of the industry. This lack of diversity can result in inappropriate political influence (see, for example, the IPA’s 2017 Research Paper, ‘Rivers Of Gold: How The Trade Union Movement Is Funded By Industry Super’).
This is problematic because it can give rise to both crony capitalism and crony socialism. Both problems can undermine the general performance of superannuation funds and result in distortions in the Australian economy and economic policy more generally.
Crony capitalism occurs when business and politicians collude to advance their own private interests at the expense of broader public interests. A lesser appreciated problem is crony socialism. Here political elites make use of socialist (or in modern-day terms ‘egalitarian’) rhetoric to justify policies that, again, advance their private interests rather than broader public interests. Ironically, arguments for ESG-type investment practices are a blend of both forms of cronyism: the deployment of private investment activities through markets that advance non-market values and principles.
POLICY RESPONSE TO ESG INVESTMENT
The Australian Securities and Investments Commission (ASIC) is currently investigating whether (some) superannuation funds are engaged in ‘greenwashing’. This is the notion that funds are marketing their environmental credentials to attract investors while not actually delivering on those claims. At face value this certainly appears to be misleading conduct. Yet ASIC appears to be focussed on a very narrow interpretation of ESG investing. As set out earlier, investment exclusion is only one of six ESG investment strategies identified by the OECD. Indeed, the situation is far more complicated, as Julius Krein identified (in the same article referred to earlier):
ESG ratings, which function like credit ratings for ESG issues, are often highly inconsistent across providers. Some companies ranking near the top in one rating system are near the bottom in others. Furthermore, ESG funds often fall far short of the promises made in their marketing materials, investing in companies with disastrous environmental and social records. The crypto exchange FTX, now bankrupt and known to have permitted massive governance failures, scored higher than ExxonMobil in ratings by Truvalue Labs, a division of Connecticut-based financial-data firm FactSet.More fundamentally, the purpose of ESG itself isn’t entirely clear. Although it is often described in
the media as a means to promote a political agenda or certain kinds of business behaviour, ESG frameworks generally define their purpose as simply helping companies avoid various reputational, political, and indeed financial risks.
Cynics might describe a situation like that as being all care and no responsibility. Yet, it appears that unless a fund is pursuing a strictly exclusionary investment strategy, ESG investment can be consistent with almost any investment behaviour or practice. That, however, might not be ASIC’s view, as reported by Hannah Wootton in The Australian Financial Review in March 2023:
Some funds such as UniSuper argue that their investments in fossil-fuel companies still align with sustainability goals as the sheer
size of their holdings gives them influence over how these entities drive the energy transition. But Ms Press said any funds making such claims needed to be able to back that up with evidence of how they were wielding that influence and whether it was effective.
It is difficult to see how a government could enforce such a requirement. All the fund need demonstrate is that it had a meeting with management who declined to accept their advice. Shareholders do not, and should not, directly manage the companies they own. Quite rightly it is the board of directors that controls companies. Ultimately, ASIC is suggesting that companies, boards of directors, and shareholders engage in poor corporate governance practices.
There is a role for policy measures to address the challenges and risks associated with ESG investment.
- Reduce political interference: To mitigate the risks of crony capitalism and crony socialism, there should be strict limits on political influence at superannuation funds. Super funds should be prohibited from making donations of any kind—especially political donations—and there should be restrictions on the appointment of former politicians, public servants, or trade unionists to the boards of superannuation funds.
- Improve investor education: There is a need for greater investor education to help Australians better understand the risks associated with investing in funds that are heavily influenced by political and ideological considerations.
- Increase accountability and transparency: There needs to be increased transparency and accountability in the management of superannuation funds. This involves greater disclosure of investment decisions, fund performance, and conflicts of interest. Funds should be required to disclose their voting records, the rationale for voting—including advice from, and payments to, professional proxy advisors—and any conflicts of interest that may have influenced the decision.
- Improve risk management: Superannuation funds must improve their risk management practices and reporting, particularly around ESG investing. This includes the impact of political and social factors on investment decisions. Superannuation funds undertaking ESG-type investment should be required to report the performance of their funds relative to an ‘ESG-efficient frontier’, using for example the methodology set out by Lasse Heje Pedersen et al in their 2021 paper, ‘Responsible investing: The ESG-efficient frontier’ in the Journal of Financial Economics.
ESG investing has become increasingly popular around the world. In many senses it appears to provide a free lunch: investors are able to align their financial interests with their ethical and social values. The evidence strongly indicates, however, that this is too good to be true.
Nevertheless, it appears to have been widely adopted by superannuation funds in Australia, with many funds claiming to integrate ESG considerations into their investment processes. But this is particularly problematic in Australia, where superannuation is compulsory. Individuals should not be forced to adopt, and effectively subsidise, ethical and social views to which they may not subscribe.
In addition to the existing problems of regime uncertainty that bedevil superannuation, ESG investing poses further risks. These include the potential for crony capitalism and crony socialism.
If individuals wish to pursue non-traditional investment objectives, they should be able to do so. But for the many millions of Australians who are involuntarily invested in superannuation funds, those funds should be maximising returns subject to traditional risk metrics and allowing those fund members to make their own ethical choices.
Sinclair Davidson is an Adjunct Fellow at the Institute of Public Affairs and Professor of Institutional Economics at RMIT University. He is a member of the UniSuper defined benefit scheme. This research essay was commissioned by the IPA.