ESG as a ZIRP artifact

The underlying myths tend to be obscured, and like many other investment trends, the roots of the Environment, Society, and Governance (ESG) philosophy are obscure.

The founding of the World Economic Forum has one origin. Stakeholder theory is another clear precursor to ESG, especially as it was formalized in R. Edward Freeman’s 1984 book. Strategic Management: A Stakeholder Approach. In 2004, the World Bank report “Who Cares, Wins: Connecting Financial Markets to a Changing World” is another contender, providing firms with guidance on integrating ESG practices into their day-to-day operations. And the publication of the United Nations Principles for Responsible Investment Reporting in April 2006 (the most recent version of which can be found here) was different.

Wherever she goes, ESG has clearly been successful over the past five to ten years. These were dizzying times, at least from an economic standpoint, first characterized by zero interest rate policies (ZIRPs) and then, during the pandemic, massive expansionary monetary and fiscal programs. However, the prevailing economic conditions have changed significantly over the past two years. Inflation, at its highest in four decades, is hitting firms, driving up the cost of doing business. It also hurts corporate earnings as consumers cut spending by cutting back.

Nowhere are these effects more evident than in shareholder territory, where the S&P 500 Q4 2022 reporting season is nearly over. “Earnings quality” is an assessment of the reliability of current corporate earnings and therefore how well they can predict future earnings. Over the past year, and certainly over the past quarter, the quality of earnings has been terrible. One particular element – “accruals” or non-cash income – is their highest recorded level ever. according to UBS. In the same report, we find the somewhat shocking discovery that almost one in three Components of the Russell 3000 Index unprofitable.

For these and other reasons, spending cuts have been the subject of many fourth-quarter corporate earnings reports: Disney, NewsCorp, eBay, Boeing, Alphabet, Dell, General MotorsAnd A handful investment banks they are all eliminating jobs and cutting unnecessary spending. While firms regularly write off the value of certain assets and goodwill, this process accelerates during recessions. Firms are also struggling with the highest interest rates they have faced since 2007 and in some cases since 2001. A significant amount of corporate debt, taken on at lower interest rates, is now costing more.

Dividend payments, generally considered inviolable during all but the worst of financial hardships, are aimed at savings. February 24 in Fortuna:

Intel, the world’s largest computer processor maker, cut its dividend this week to its lowest level in 16 years to save cash and help rebuild its business. Hanesbrands Inc., a century-old clothing maker, earlier this month canceled a quarterly dividend it began paying nearly a decade ago. VF Corporation, which owns Vans, The North Face and other brands, has also cut its dividend in recent weeks as it works to reduce its debt burden… In particular, retailers are facing lower profits as persistent inflation also undermines consumer willingness spend. As many as 17 companies in the Dow Jones US Total Stock Index have cut their dividends this year, according to data compiled by Bloomberg.

All this means two things.

First, if large firms do their best to cut unnecessary overheads, feel-good initiatives and other corporate knick-knacks are likely to hit the chopping block, even if it’s subtle. Compliance with ESG is a costly trinket that entails compliance costs, legal fees, measurement costs, and opportunity costs. The reporting requirements associated with complying with ESG standards are high and growing. In 2022, two studies tried to appreciate these costs:

Corporate issuers currently spend an average of more than $675,000 a year on climate-related disclosures, and institutional investors spend nearly $1.4 million on average collecting, analyzing and reporting climate data, according to new research published by the Institute for Sustainable Development. ERM development. … The survey collected data from 39 corporate issuers across multiple US sectors with market caps ranging from less than $1 billion to over $200 billion, as well as 35 institutional investors representing a total of $7.2 trillion AUM… The SEC published its own estimates for under the proposed rules, projecting first-year costs of $640,000 and annual operating costs for issuers of $530,000. The study looked at specific items that are subject to SEC requirements and found that issuers spend an average of $533,000 on them, in line with SEC estimates. Items not included in the SEC requirements included costs related to responding by proxy to climate-related shareholder proposals and operating costs, including the development and reporting of low-carbon transition plans, and stakeholder engagement and relationships. with the government.

The complexity of measuring costs means the complexity of budgeting them. Another recent report commented:

Although it is difficult to estimate the costs [of ESG], it is fair to expect significant costs for the ambitious goals of ESG. An article in The Economist made a specific cost estimate in relation to offsetting a company’s entire carbon footprint. It is estimated that this cost about 0.4 percent of annual income. This may already be an important component for many companies, but it is only one aspect of just one ESG factor.

However, this comment ends with the kind of confidence that comes from advisors well positioned to frankly make a lot of money from ESG compliance: “There is no real choice, however. The climate definitely can’t wait.” Considering recent backlash against ESG, no matter ideology P Accountingit is clear what is there is a real choice, and this choice is increasingly being used in the commercial world.

Secondly, the recent explosion of ESG adoption may have been in the spirit, if not the epitome of a strictly theoretical manifestation, wrong investment as predicted by the Austrian Business Cycle Theory (ABCT). Without going into a lengthy discussion of ABCT, artificially low interest rates (interest rates set by politicians, not the market) undermine the natural interest rate, generate signals, and mislead entrepreneurs and business managers. Many years of pitifully low interest rates, even negative real rates, have spawned bubble-like companies, projects and, I would say, business concepts. The latter, including but not limited to ESG, appears to be possible and possibly necessary when the money faucets are open. As interest rates normalize and sobriety returns, cost structures reassert themselves. It’s back to business.

Gone are the days of easy money, and with them the sentimental wish lists of niceties that a decade of monetary expansion allowed activists to nonchalantly foist on corporate executives. In the face of rising interest rates, an uncertain inflation path, tight consumer budgets, and rapidly declining corporate earnings, shareholders are likely to be more aware of how and where their money is being spent than ever. While it’s unlikely to go away completely, the ESG fad is probably past the peak of its popularity. It is time for businesses to once again focus entirely and exclusively on the invaluable task of making money.

Peter S. Earl

Peter S. Earl

Peter S. Earl is an economist who joined AIER in 2018. Prior to that, he worked for over 20 years as a trader and analyst for a number of securities and hedge fund firms in the New York metropolitan area. His research focuses on financial markets, monetary policy and economic dimension issues. He has been quoted by the Wall Street Journal, Bloomberg, Reuters, CNBC, Grant’s Interest Rate Observer, NPR, and many other media and publications. Pete holds an M.A. in Applied Economics from American University, an M.B.A. (Finance), and a B.A. in Engineering from the US Military Academy at West Point.

Selected publications

“General Institutional Considerations on Blockchain and New Applications” Co-authored with David M. Waugh at The Emerald Guide to Crypto Assets: Investment Opportunities and Challengesedited by Baker, Benedetti, Nickbakht and Smith (2023)

“Operation Warp Speed” Co-authored with Edvar Escalante in Pandemics and freedomedited by Raymond J. March and Ryan M. Yonk (2022)

“Virtual Weimar: Hyperinflation in Diablo III” V The Invisible Hand in Virtual Worlds: The Economic Order of Video Gamesedited by Matthew McCaffrey (2021)

“The Fickle Science of Locks” Co-authored with Philip W. Magness, Wall Street Magazine (December 2021)

“How does a well-functioning gold standard work?” Co-authored with William J. Luther, SSRN (November 2021)

“Populist Prophets, Public Prophets: Pied Piper Lucre, Then and Now” V financial history (summer 2021)

“Boston’s Forgotten Lockdowns” V American conservative (November 2020)

“Private Governance and the Rules of the Flat World” V Creighton Interdisciplinary Leadership Journal (June 2019)

“The idea of ​​a ‘Federal Job Guarantee’ is expensive, misguided, and increasingly popular with Democrats” V Investor’s Daily Business Journal (December 2018)

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