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The Hubris of ESG Ratings by Sven R. Larson

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The Hubris of ESG Ratings

Jörmungandr, the World Serpent, from a 17th-century Icelandic manuscript.

In Norse religion, the serpent Jörmungandr encircles the world and holds it together by biting its own tail. Its bite is painful, making the snake angry; the anger makes it bite even harder.

Eventually Jörmungandr cannot endure the pain anymore. The snake lets go of its own tail, and when it does, the world unravels. That is when Ragnarök begins. 

There are different versions of the world-encircling serpent in many religious and cultural traditions around the world. They all have one feature in common: the snake tries but eventually cannot keep its grip on the world. Its efforts are unsustainable because its method—biting its own tail—is self-defeating.

This anecdote brings us wisdom that, humility permitting, we should apply to our own lives. From a broader perspective, the failure of the snake to prevent Ragnarök is a lesson for us about social, economic, and most of all political ambitions. The tail bite is metaphorically hubris, which in turn emanates from ambitions that are not bound by a sense of reality. 

When we are led by our hubris into believing that we can, and should, try to keep the world from falling apart, then we may actually bring about the very catastrophe we were trying to prevent. 

History is full of leaders—often of the kind that are up to no good—whose grand schemes for world change have brought death, destruction, and despair. Sometimes, as in the Third Reich, the journey from hubris to humiliation has been short and violent. Others take a longer time to rise and fall; the seven decades of the Soviet empire imploded slowly, almost like a soufflé. 

The challenge, of course, is to see the tail-biting snake in real time. Just because we have big ambitions to change the world, does not mean that our ambitions will necessarily collapse into the very antithesis of what we envisioned.

There are also times when hubris is on full display. A case in point is the environmental and social-justice movement of our time. Ever since the green-politics trend gained momentum in the 1970s, rising from highly dubious ideological origins, it has made no secret of its desire to save the world. Activists for social justice play in the same league, claiming to fight injustices based on people’s racial, social, religious, or economic status. As these two movements have amalgamated into a green-social-justice force in politics and policy, the desire to hold the world together by means of system-changing legislation has gained even more momentum.

We know one expression of this momentum by the three letters “ESG.” Short for “Environmental, Social, and Governance,” this acronym represents a new ratings system for investors. Recently, the ESG agenda has also spread to government policies, with one ambition being to influence investors in sovereign debt.

It is here, in the combination of ESG and government debt, that the snake bites into its own tail. 

Todd Huizinga explains the ESG phenomenon as applied in the corporate world, and how large investment corporations are already hard at work implementing the ESG agenda:

[Massive] financial firms such as BlackRock, the world’s largest investment manager, are promoting the exponential growth of right-thinking asset management, otherwise known as environmental, social, and governance (ESG) investing. … And ESG investing is not just a toothless do-gooder project, open to those who want to join the movement. 

Quite the contrary, in fact. Since the ratings system is off to a relatively slow start, its proponents want to give it momentum by involving government (and we are all very surprised). In February this year, the European Securities and Markets Authority issued a “call for evidence” on ESG ratings:

The Call for Evidence’s purpose is to develop a picture of the size, structure, resourcing, revenues and product offerings of the different ESG rating providers operating in the EU. 

The goal, of course, is to figure out how to best encourage the growth of this ratings system by means of regulatory, perhaps even statutory, initiatives

In short: unless a countervailing movement emerges, we should expect the ESG ratings to become mandatory and as universal as traditional financial credit-rating systems. The EU will very likely be the vehicle in which it travels: as Huizinga notes, the “Eurocracy” can essentially do whatever it wants, as it never has to face accountability from the people. They are, he explains, impervious to “bothersome concerns” like elections.

The silver lining in this is that even if ESG ratings become mandatory, it does not mean that investors must take them into account when managing their portfolios. However, if there is an ESG ratings mandate, businesses are likely to try to score as highly as possible. This means downgrading, even setting aside investments and other activities that promote profitability. Businesses will spend money not to do more with less for their buyers, but to score well on a virtue scale. 

Nobody makes money off moral virtues, except activists who campaign for them and tax-paid bureaucrats who enforce them. Therefore, as the ESG agenda proliferates, corporations will make less money, be less productive, and create fewer jobs. Over time, the consequences will spread throughout the economy; the eventual, inevitable result is an impoverished society in much the same way as the Soviet economies were held back by the enforcement of Marxist labor-value principles in business operations.

In other words, investors who follow the ESG criteria agenda because they think they will help save the world, slowly sink their teeth into the very forces of prosperity. As the pain grows, as businesses become less profitable, they end up losing money, without any detectable positive impact on the world around them.

The green-social-justice movement is not done, however. They are about to make sure that our downslope from prosperity to industrial poverty becomes even steeper. Hold on to your hat as Morgan Stanley Capital International explains its criteria for ESG ranking of governments:

A country’s relative ESG risk exposures are measured against its applied ESG risk management practices and demonstrated ESG performance results to form the basis of our final ESG Government Ratings. Efficiency of resource utilization, performance on socio-economic factors, financial management, corruption control, political stability and other factors define the parameters for measuring ESG risk management. 

Morgan Stanley do not give any real explanation as to what they mean by “socio-economic” factors. However, the term is commonly used with a socialist ideological slant: it is popular in the academic literature about economic redistribution and the welfare state. In other words, Morgan Stanley appears to believe that a country should be ranked based on the degree to which its government redistributes income, consumption, and wealth among its citizenry.

But wait—is it really a given that Morgan Stanley wants to score countries on these unabashedly ideological criteria? Could it not be that they simply want to give their investment partners an opportunity to evaluate the broader social and economic conditions in a country, before committing their money to it?

There are two reasons to answer “no” to this question. First, the socio-economic ranking criteria are part of the ESG agenda, which is openly ideological in nature. Its hard left-leaning profile leaves no doubt that any socio-economic evaluation of a country will be based on a scale where countries leaning socialist will score well and countries that favor conservatism will be ranked poorly. If Morgan Stanley had anything else in mind with its socio-economic ranking criteria, it would reasonably have said so.

The second reason is that any other ideological leaning would have been redundant. Normally, when credit- and investment-evaluating entities rank businesses and countries, they do so with the intent of helping their business partners make more money. In this case, where Morgan Stanley seeks to evaluate countries, the normal approach would be to highlight the economic and political variables that indicate a favorable investment climate: abundant economic freedom, regulatory restraint, modest taxes, and a strong judiciary that can enforce contracts and protect property rights. 

In regular, technical parlance, these are not socio-economic factors: they do not reflect the social configuration of a country. That does not mean the socio-economic moniker cannot be used in relation to non-socialist analysis—on the contrary, it is aptly applied to the analysis of a conservative welfare state, such as the Hungarian one. Therefore, if Morgan Stanley wanted to explain to its investment partners how certain social policies promote economic growth, they could use a set of socio-economic criteria and link them to the performance of a nation’s economy.

Hungary would be a case in point here, leading Europe in economic growth, jobs creation, and capital formation for almost a decade now. However, the socio-economic profile of the Hungarian economy is not such that it matches the rest of the ESG criteria that Morgan Stanley is putting to work. As Patrick Tyrrell with the Heritage Foundation explains, those criteria are blatantly activist along the same lines as the broader left-leaning political agenda often referred to as “wokeism.” 

Tyrrell, like Huizinga, focuses on ESG as it applies in the corporate world, where as Tyrrell explains, the agenda leads to a “dereliction of … fiduciary duty to those who have invested” in a company. This is bad enough, but once the ESG criteria are elevated to entire countries, it gets much worse. The policies that earn a country high scores on the socio-economic scale, and therefore should be attractive to investors, are in reality the exact wrong policies for investment profitability. 

Policies that promote economic redistribution span both taxation and government spending. On the tax side, they require not only high taxes, but progressive taxes: the higher the income, the higher the marginal tax rate on the last made euro. Such taxes discourage people from productive participation in the workforce, they disincentivize entrepreneurship, and they lower the return on career development. At the same time, the taxes collected are spent on programs that benefit lower-income families, where benefits taper off as the family income rises. This reinforces the negative incentives from progressive income taxes.

Over time, the economy is trapped in low economic growth, which means three things that Morgan Stanley’s investment partners do not benefit from:

  • Weaker growth in individual markets, which tightens profit margins and growth opportunities for individual businesses;
  • Government budget deficits, as welfare-state spending keeps rising while tax revenues lag behind; monetary accommodation pushes interest rates down;
  • More speculative “hot air” in stock markets, due to the lack of return on other investment opportunities.

Europe has lived with this triad of economic malaise for two decades now. It is not difficult for the astute investment analyst to identify the differences between an economy that is doing well (Hungary, Poland) and one that is in perennial stagnation (most of the rest of Europe). Yet if ESG criteria become applicable to a country’s credit rating, the intelligent analysis that identifies its consequences suddenly dwells on the precipice of oblivion.

Ironically, once the ESG criteria are put to work, they will lead to yet more, yet deeper, economic stagnation. The following sequence unfolds:

  1. Vigorous implementation of socialist welfare-state policies weakens the economy and erodes the tax base for the welfare state.
  2. Weaker tax base forces governments to cut down on welfare-state spending, thus limiting their ability to comply with ESG criteria.
  3. As the economy drifts into permanent stagnation, there are profitable investment opportunities; more and more investors are forced into increasingly speculative markets.
  4. Failure of the country’s government to fully comply with ESG criteria leads to a weaker rating, which in turn compels the government to double down on its compliance policies.

As the serpent sinks its teeth into its own tail, trying for dear life to hold together a world that does not need its help, it slowly but inevitably makes the world unravel. 

Can we convince it to let go while we can still save the world without the help of the serpent?

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.

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