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The problems with "responsible investment", "stakeholder capitalism" and how cooperatives can provide an alternative

Weekly newsletter of Coop Exchange
Weekly newsletter of Coop Exchange
“Environmental, Social and Governance” (ESG) investment is booming across the worlds stock markets. This issue criticizes the ESG approach, stakeholder capitalism and advocates for an alternative based on investing in cooperatives.

What is "ESG"?
Perhaps the most notable trend in the investment industry that seeks to combine social purpose with profits is the Environmental, Social, and Governance (ESG) funds. These funds consist of stocks or bonds that meet environmental, social and governance criteria. There is no shared definition on the requirements, and therefore whether a company is ESG eligible depends on who you ask. For example, one ESG S&P 500 might include 500 largest companies in the US stock market excluding oil companies, while another ESG S&P 500 also excludes weapons manufacturers. 
ESG has faced harsh criticism, including from one of its most influential former champions, Tariq Fancy. Fancy was the first chief financial officer for ESG investment in Blackrock, which manages by far the largest ESG assets. He has bluntly stated that there is “no evidence… of any positive social impact”, describing it as “all optics and marketing” with “the only clear benefit” going to the “asset manager who now has found a way to sell a little bit of a higher-fee product to you.” Despite criticism like this, ESG assets continue to grow at a dramatic pace.
The proponents of ESG base their argument on two mechanisms of influence: divestment (“exit”) and stewardship (“voice”). 
The problem with "exit"
With divestment, the fund sells the shares of undesirable companies it owns to someone else or/and refuses to buy shares from such companies. It might sound intuitive to compare this to a boycott of a product, but that would be a mistake. Whereas a boycott reduces demand and therefore the supply of the product, divestment in the stock market does not reduce the number of shares available. It simply changes who owns them.
Growth of exchange traded funds using environmental, social and governance criteria
Growth of exchange traded funds using environmental, social and governance criteria
To elaborate, let’s imagine a group of horse racing teams are taking part in an auction of horses. Some of the teams refuse to buy horses that have been given steroids, because they deem it against their ESG criteria. Other teams only care about what horse is the fastest. Horses that have been given steroids are not removed from the competition: the impact is only on which team owns the horses. Giving steroids still makes the horses faster: the ESG teams do not make the teams that accept steroid use any less likely to win races. Instead of this type of self-regulation, a much better solution is to change the rules of the racing competitions by banning steroids.
This argument is not just theoretical - a 2021 study from Stanford University concluded that ESG investment has not have the intended impact of increasing the costs of capital for polluting firms. A report from Cambridge university comes to the same conclusion.
A related argument is that ESG funds outperform other firms, or in other words, ESG-eligible firms are undervalued, which is demonstrated by ESG funds tending to outperform benchmark indexes. The proponents of this argument claim that investors have not realized how profitable saving the planet is, which is in contrast to the idea of destroying the planet being too profitable for investors. This claim is somewhat contradictory to other assumptions of ESG funds - if ESG funds are more profitable than other funds, then regardless of whether one cares about shareholder profits or ESG, they should invest in them. Fancy explains how he came across this issue when discussing with a manager in Blackrock, whose view was that the people like him “already focused on performance since it usually determines their compensation, so if ESG information was truly useful they’d use it without being asked.
The case for undervaluation is questionable. An analysis titled “Big Market Delusion: Electric Vehicles“ makes the case that electric vehicle companies are a prime example of stock market overvaluation. Tesla is now worth more than the nine next largest carmakers combined, despite making up less than 1% of global car sales. For the valuation to make sense, Tesla would need to have a dominant market share in the entire auto-industry in the future. However, for that to make sense, the market valuation of its competitors would have to decline as its market share would have to grow at their expense. Instead, car company shares have increased in market valuation overall by 70% in the last three years. In fact, its competitors in the electric vehicle industry are even more dramatically valuable relative to their sales. Nikola Motors, a car company that had never produced a single car, surpassed Ford in valuation in 2020, despite the latter selling 4 million cars during the year. Nikola Motors later collapsed under lawsuits as a federal grand jury charged the company founder with criminal fraud for lying about “nearly all aspects of the business”.
This suggests that at least when it comes to electric vehicles, undervaluation seems unlikely. It’s also worth noting that far from being a success story of self-regulation by private sector actors, Tesla would not be profitable without California state governments carbon credit trading system, where car companies that fail to meet their quotas of electric vehicles have to pay competitors who surpass their quotas.
The problems with "voice"
In addition to divestment, the other mechanism for influence is called “stewardship” or “voice”, where shares are used to vote in annual shareholder meetings for resolutions and candidates that support ESG goals. This approach is especially appealing to large asset managers like Blackrock due to their massive voting power - the three largest asset managers cast around a quarter of all votes in the shareholder meetings of S&P 500 companies.
Here the problem is the legally binding fiduciary duty, which requires one to put shareholder returns first. As Fancy states “a CEO may decide to reduce her company’s carbon footprint, but she can’t do so because it’s “fair” or the “right thing to do”; it has to be justified in terms of shareholder interests.” (Fancy, 2021) Stewardship is therefore limited to addressing situations where a company would become more profitable for shareholders if they become more sustainable. However, it does not make sustainable behaviour any more profitable - or destroying the planet any less profitable. There might be situations where companies are endangering their shareholder profits by engaging in environmentally harmful behaviour - but more often the problem is companies endangering the environment to improve shareholder profits. Prioritising shareholder gains over harm caused to others is exactly what the fiduciary duty of shareholder-owned companies requires. These problems cannot be solved in the shareholder meetings, but through structural change derived by rearranging regulatory incentives.
However, it should be stated that the theoretical basis for using “voice” is stronger than that of “exit” in secondary markets. The approach should not be seen as entirely useless, but rather as much weaker than what its proponents like to claim.
The problems with "stakeholder capitalism"
The problem of prioritising shareholder interests at the expense of other stakeholders has been acknowledged publicly by many CEOs of large businesses. In 2019, Business Roundtable, a lobbying organisation for major US businesses, overturned its 22 year-old statement that the purpose of the corporation is maximising shareholder returns. Spearheaded by Blackrock’s CEO Larry Fink, they announced commitment towards an idea described as “stakeholder capitalism”, where the interests of the suppliers, employees, customers and the wider society are taken into account alongside shareholders. However, recent research suggests that the signatories have actually performed worse than their peers when it comes to treatment of their stakeholders, such as employees, during the pandemic.
The popularity of this concept can be seen with Google Ngram, which reveals that new books published have started to use the word “stakeholder” more than “shareholder” for the first time.
The word "stakeholder" has surpassed "shareholder" in popularity recently
The word "stakeholder" has surpassed "shareholder" in popularity recently
Fancy remains skeptical of these sort of initiatives, describing them as “private sector initiatives that arguably only serve to delay overdue rule changes by encouraging a dangerous illusion; that the changes we need will be led voluntarily by businesses, all acting of their own accord based on a vague promise to be responsible and focused on a broader set of stakeholders.”
This claim is not just based on opinion. Fancy worked with Ryerson University to conduct polling on the topic, asking a representative sample of 3,000 people in the US and Canada about their attitudes towards sustainability. He explains some of the key findings as follows:
“…In one key section, we showed respondents a headline related to Larry’s 2018 letter on purpose and seven other similar headlines around new sustainability initiatives — mostly to do with businesses voluntarily taking the lead and other headlines in the sustainable finance space — and asked them to indicate whether they thought each was helpful in driving social change or not. All eight headlines were generally believed to be helpful. This is even though a number of them were decoys that I asked the polling firm to include in the study, knowing full well that they were window dressing with little to no real-world impact…Unsurprisingly, most didn’t know that fossil fuel divestment campaigns have little real-world impact…
Unfortunately, it gets even worse… For half the respondents we removed the headlines entirely, and then compared the views of both groups — those who had seen the headlines and those who hadn’t — on who should lead the way in building a sustainable society. In Canada, it didn’t make that much difference… But there was a large and statistically significant difference in the US. Exposure to the headlines made people 17% more likely to say that business, not government, will lead the way in building a more sustainable economy.
Think of it this way: the more they saw isolated anecdotes of a few players playing clean (many of whom actually weren’t), the more they wrongly believed that good sportsmanship, not effective refereeing, is the large-scale solution to the dirty play we’ve seen in the game recently.
However, in fairness towards the Business Roundtable, the organisation did change its earlier opinion of government regulations by explicitly supporting pricing carbon - which effectively means the government either setting a carbon tax or cap-and-trade. Although some BRT signatories have lobbied actively against measures to price carbon, support for regulatory restrictions should be considered as a move towards the right direction even if one accepts Fancy’s criticism. 
Fancy also mentions that there is an argument to be made for the positive sustainability impact of, for example, “a climate tech venture capital fund or some breakthrough ventures fund. Because if you didn’t invest in it, that fund wouldn’t exist, depriving innovators of the direct, primary funding they need to build the solutions that society needs right now.” There are numerous large corporations that have engaged in funding like this - not least Blackrock with its $100 million grant to Breakthrough Energy’s Catalyst Program. While $100 million is a lot of money, it is equivalent to only 0.01% of Blackrocks overall assets under management.
The companies who signed the Business Roundtable statement supporting pricing carbon could simply obligate politicians to support pricing carbon if they want to receive campaign donations. This would likely have a much greater impact than individual corporations taking voluntary measures to tackle climate change, because it would incentivise or force everyone to take such measures.
That being said, there is a lot that private entities and individuals can do, and are doing - in some instances they might be better equipped than governments. For example, private businesses can have greater freedom in procuring goods and services from suppliers by taking into account social impact, whereas the public sector often has stricter procurement requirements in favouring one firm over the other to prevent those spending public money from engaging in corrupt favouritism.
Nevertheless, there are good reasons to be skeptical of the current approach towards the ESG boom in the stock market and the Business Roundtable statement on stakeholder capitalism. Instead of embracing it, cooperatives and mutuals should seek to challenge it - and make the case that instead of voluntary actions, we need structural change of economic incentives to change behaviour.
For example, Vanguard has not moved towards ESG ETFs anywhere near to the extent as Blackrock. Instead of competing with Blackrock on ESG ETFs, perhaps it could consider a marketing campaign where it warns its customers about dubious claims of ESG ETFs and instead outcompetes Blackrock and other peers on lobbying more aggressively for government measures to stop polluting being profitable. While from a marketing perspective this sort of an approach could go wrong, it depends on the execution. Many might criticize Vanguard for making money from oil companies while supporting measures to move away from fossil fuels. However, if Vanguard’s marketing team would play its cards right, customers might perceive it as more honest and impactful than its competitors. They would also have a more accurate perception on how to effectively tackle climate change - as opposed to their competitors, whose ESG marketing is misleading people into believing what Fancy describes as the “dangerous illusion” of corporate self-regulation being the solution.
Cooperatives have played a pioneering role in lobbying for consumer protection laws in numerous countries. (Theien, 2016, Webster et al. 2020) Perhaps environmental protection laws could be the next area where cooperatives should focus more of their lobbying efforts towards. While this area of legislation might seem less obvious than consumer protection legislation (at least for consumer cooperatives) there is a historical precedent of the movement playing an unique role in other areas of legislation as well. One notable example is labour rights laws in Nordic countries, which are arguably the strongest in the world. 
The labour movement in Nordic countries has historically been deeply involved in building a large cooperative sector. It played an important role in organising consumer-owned grocery stores, banks and insurance companies, many of which have developed into large and even leading businesses in their respective industries. 
In the early 20th century, the relationship between the labour movement and consumer cooperatives faced a similar choice when it came to labour rights as the environmental movement and consumer cooperatives face today when it comes to environmental protections. Because one of the key goals of the labour movement was to increase wages for workers, many in the movement advocated for grocery store cooperatives to pay higher wages for their workers than the rest of the sector. This represents an approach where an individual enterprise takes voluntary action within the existing competitive circumstances that are derived from laws on wages, working conditions, etc.
However, the labour movement realised that, all else being equal, it would lead to the cooperative stores being at disadvantage compared to its competitors and instead took another approach. The working conditions were made to be exemplary while the wages were set at roughly the same level as those of competitors. Next, the cooperatives would help lobby for wage increases across the retail sector and society. As one very direct manifestation of this, there are many instances of employers firing strikers or other union organisers, only for the organisers to be hired by cooperative stores affiliated with the labour movement. This sort of help played a crucial role in enabling it to implement sectoral bargaining agreements that raised wages across entire industries, reducing income inequality to lower levels than in any other market economies.
It also gave critics an easy opportunity to score shots at the cooperatives for “not practising what they preach”. Nevertheless, it could be argued that the approach fostered structural change that increased wages more than what “practising what they preached” would have. A less competitive and therefore less powerful cooperative branch of the labour movement would have reduced the movement’s ability to increase wages across the society. These wage increases might have far surpassed any that an individual cooperative could alone afford to give to its employees. For exactly the same reason, why voluntary actions by individual corporations are less effective in solving climate change than changing the rules and incentives for every company in the market.
Lobbying for stricter environmental regulations could be done avoiding partisan party politics and ideological associations if that would be more suitable for the cooperative. For example, the “Economists’ Statement on Carbon Dividends” advocates for pricing carbon by taxing it and distributing the proceedings as a dividend to all US citizens, similar to universal basic income. The statement has been signed by 28 Nobel Laureate Economists and nearly every living Republican and Democratic chair of the Council of Economic Advisers.
The cooperative movement could organise something similar, where a bipartisan group of top experts would produce a statement establishing minimum requirements on climate action from politicians that receive donations from cooperatives. Perhaps it could be even combined with a “members council”, where a randomly chosen panel of ordinary members would discuss together with experts on what proposals for environmental legislation the cooperative should support.
There is of course a lot that individual cooperatives can do within the existing regulatory framework to tackle climate change. In doing so, they might have advantages over their competitors - cooperatives have a longer time frame than quarterly profit and have a fiduciary duty to benefit members rather than maximise profits for shareholders, which can give them more flexibility in taking into consideration environmental concerns.
While cooperatives might have some benefits compared to conventional companies in tackling climate change, they cannot solve the key problem of polluting being profitable. They can be forerunners in their respective industries, but the ecological progress a cooperative can make is limited by competitive pressures derived from existing framework of laws, tax incentives, etc. There is plenty of room to manoeuvre within this framework - but not enough for cooperatives to take actions consequential enough to match the urgency that the climate emergency demands. While the primary purpose of the cooperative is not to engage in making policy, cooperatives have often stood out in the history of corporations lobbying for legislation that corrects for market failures. The moral duty to do so is now greater than ever: climate change is the greatest market failure in human history. When it comes to climate action, cooperatives should differentiate themselves with disproportionate focus on lobbying for changing the rules of the game rather than just trying to do their best to act against incentives the existing rules create.
Although ESG ETFs are exploiting consumer preferences for environmental sustainability with greenwashing and marketing, this should not lead us to conclude that those preferences aren’t or couldn’t also be channelled into spending that makes the economy more sustainable. Although there are good reasons to be cautious about the actual impact of announcements around stakeholder capitalism, it demonstrates that even those who have benefited from the conventional shareholder maximising firms the most are now publicly denouncing, not defending, the core principles behind the model. 
Cooperatives should be humble and honest when it comes to environmental sustainability and avoid overpromising and underdelivering. It is the most pressing issue of our time, and demands more drastic action than can be expected to be voluntarily taken even by the best-intentioned enterprise within the current set of ill-designed incentives. It is a problem that first and foremost requires regulatory reform, and cooperatives should act accordingly by “outcompeting” their peers by lobbying more aggressively for legislation to make polluting less profitable. 
An alternative - invest in cooperatives
While the cooperative movement can and should play a crucial part in tackling climate change, a transformation towards a carbon free economy cannot centre around cooperatives in the sense that we need existing, overwhelmingly shareholder owned firms to reduce emissions - there is no time to wait for cooperatives to replace them as the centre of the economic system before that happens. The cooperative sector cannot expand rapidly enough to lead to decarbonization of the entire economy, but the decarbonization of the economy can lead to rapid expansion of the cooperative sector.
The increased interest towards investment that provides social benefits alongside profits provides an opportunity to channel more funding towards cooperatives. Perhaps somewhat paradoxically, often people who are most willing to voluntarily contribute to tackle challenges like climate change are also most convinced about structural changes being more important than individual choices in tackling the challenges. For investors who want to make a difference through structural change, investing in companies that are structured differently could be a straightforward way to pursue this goal. Cooperatives are perhaps the best proven alternative corporate structure.
Below is a table showing how investments into the cooperative solidarity economy differs from the conventional ESG approach. In future issues of the newsletter, I will present some real life success stories and new ideas about how to form a mass movement around cooperative investment and how it can provide a more meaningful form of socially oriented investment.
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