Maybe the “G” in “ESG” stands for Guns after all?

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In June 2020, during the height of the Covid Pandemic a colleague and I joked that the “G” in “ESG” stood for guns while talking about how the ESG triumphalism then ascendant might be misplaced, and that firearms stocks, shunned by many ESG funds, were doing quite well. Unfortunately, it seems we were more right than we knew. In the wake of Russia’s invasion of Ukraine Bloomberg is reporting that German arms makers are lobbying to get the weapons industry classified as “sustainable” under the EU’s Platform for Sustainable Finance emerging guidelines on what counts as sustainable finance.

This story is like an onion, a rotten one, where each layer peeled back reveals a rottener one beneath. The surface layer is that the weapons makers are lobbying for a carveout from rules. This is public choice 101, where industry tries to get the rules changed just for them. Yet, while lobbying for carveouts is unseemly, this does seem to be defensive lobbying in more ways than one.

The first way is national defense. The weapons makers are using the not particularly crazy theory that for a society to be sustainable it must be able to protect itself. After all, as Thomas Jefferson almost certainly didn’t say: “Those who hammer their guns into plows will plow for those who do not.”

But it is also defensive for the companies themselves. Apparently, they have been having trouble getting loans due to ESG concerns. Which brings us to the next layer of the onion, the ability of ESG standards to (mis)steer investment. Governmental ESG policies are going to influence investment decisions in some way. It could be very direct, such as additional taxes or penalties. It could be very subtle, such as enhanced reporting requirements, supervision, and social stigma. Either way it will change the economic calculus of whomever is considering investing or lending. To deprive an industry of money you don’t need to make it illegal, or even necessarily unprofitable, you just need to make it less desirable than the preferred alternative. Even if the targeted industry can still access capital, it will be from a less preferred source that is more costly in some way.

Now, if you think we can accurately predict the future and determine which industries, firms, and products are in society’s best interests and which are not, this might not seem so bad. But why on Earth would you think we can do that?! That is a planned economy, and those have a terrible track record. Nobody can predict the future, what people will want or need, and where technology might go. Further, people’s definitions of “the good” differ and there is the risk that those who set ESG standards, by definition elite, will intentionally or inadvertently confuse their moral and aesthetic preferences for “the good”.

Just look in the past couple of years when some people were viewing the cleaner air caused by the covid lockdowns as an inspiration rather than evidence of a tragedy. The extrapolating from a hopefully once-in-a-lifetime pandemic to say carbon intensive stocks were not good investments does not seem to have panned out, at least not yet. Now, to be clear, it is certainly possible that in the long run we will transition away from carbon intensive energies, but if and when that will happen and which companies and technologies will be the winners, is unclear.

Which brings us to the final rotten layer. There is a real argument to be made that ESG can be counterproductive. Discourage domestic firms from doing something currently necessary but arguably undesirable, like say drilling oil? The oil is still going to get drilled, because it is still currently necessary, but it will be drilled by countries with less savory governments. Then they might take the money they make from oil and buy tanks, and they might take the oil they drilled, that you need, and hold it over your head.

There is nothing wrong with moving away from things that have problems to things with fewer problems, but if regulation misjudges what those things are, or forces the transition to occur too soon, or simply shifts the locus of production in a way that creates its own problems society may well be worse off. Regulators, especially specialists like financial regulators, are not in a position to assess all of the possible risks and tradeoffs that might come from an intervention. It’s not clear anyone is, but when regulators make mistakes, they make big mistakes because their mistakes have the force of law. This should give us pause because the consequences can be quite real.