Despite the deja vu, it is tempting to think that it really is different this year, as the letter, together with a companion letter to BlackRock clients, discusses multiple concrete actions. There are promises to divest from coal in actively managed funds and to create new active and passive funds that have more ESG analysis baked in. There is also a promise to begin pressuring companies to report against SASB (the Sustainability Accounting Standards Board) metrics, a well-established guide for reporting on sustainability. BlackRock promises to be more transparent about its own voting on ESG matters at portfolio companies. For those who care about the impact corporations are having on our well-being, this appears to be very good news.
But something is missing: these moves are limited to a fraction of what needs to be done.
BlackRock is very careful to make the case that these products and actions are designed to offer investors positive “alpha,” i.e., the amount above or below the market return that a specific stock or portfolio earns. In some sense then, the promises are banal — if ESG factors can be used to create alpha, asset owners and managers would be faulted for not applying these factors, whether or not investors cared about social and environmental issues.
This is brought home by BlackRock’s choice of a disclosure standard. SASB requires companies to disclose social and environmental information that is material to the company’s financial performance. In other words, SASB metrics are not designed to allow anyone to determine whether a company’s carbon output is optimized to address the climate crisis; they are instead designed to allow investors to determine how that output will affect the financial return of that company to its investors.
In essence, BlackRock is saying that each company must act on environmental and social issues only to the extent that they can make a “business case” for such actions. This is great as far as it goes — we need to harvest the low hanging fruit of “doing well by doing good.” But squeezing alpha from ESG is not enough to solve climate change or other social and environmental challenges — chasing alpha, in fact, is the problem, and it ultimately will hurt most investors.
To see why this is so, consider a typical BlackRock client, such as a pension fund or 401(k) investor: they are almost certainly invested in broadly diversified portfolios. This means that their return is almost entirely dependent on the performance of the market overall, which is sometimes called “beta.” (This is slightly confusing, since beta has a more technical meaning in finance related to volatility.) Their focus should not be on individual portfolios outperforming the market (the alpha strategy BlackRock touts), but rather on lifting the average performance of the market.
The issue is not simply that an alpha focus misses the beta opportunity — the deeper problem is that an alpha-first strategy directly undercuts a strategy of lifting average market performance. This follows from the fact that individual companies often can increase profits by externalizing costs. Think about a company that saves money by paying its workers a low wage. Those companies get all the benefits of increased bottom line, while others, including other companies, pay the cost of those low wages in increased taxes for the social safety net, a less productive workforce and social unrest.
Of course, sometimes such behavior catches up with companies, by directly lowering their own long term productivity, angering consumers or triggering expensive regulation. To grow alpha, a company must balance these potential gains and costs by doing the right amount of ESG work to satisfy consumers and regulators, but not necessarily doing its fair share to limit the environmental and social damage that broadly decreases economic productivity and thus overall market performance. Indeed, the best financial option for any one company is often to let others do the heavy lifting on social and environmental responsibility. This is the economics of the “prisoner’s dilemma” or “tragedy of the commons” — if each company follows its own best interests, then all companies (and thus BlackRock’s diversified clients) are made worse off.
It gets worse: the degraded commons is not utilized only by companies: it is shared by the investors themselves. Investors are ordinary human beings who have to live in the world, and who are moral creatures. There may be scenarios in which all corporations are made richer (beta rises), but only in ways that make people’s lives less rich and that violate the basic human values they hold.
Evidence of this degradation is everywhere: the climate crisis is deepening; democracy is under attack and multiple other social and environmental resources are being drained rapidly. In order to preserve economic value, the first order of business must be to preserve those critical systems. It is in the interests of long term, diversified investors — the “universal owners” who numerically dominate the capital markets — to make sure every company and every asset manager they hire is doing their fair share to make that happen before the search for alpha begins.
In other words, investors must create a sustainable and level playing field on which companies and asset managers compete.
I am going to say “one and a half cheers” for BlackRock. The steps they announced are impressive and should be celebrated. But their clients have to tell them it isn’t enough. Next year’s Letter from Larry must build on what he has started by promising to engage with companies that are grazing the commons, without regard to the individual company’s return. Next year, we want to see “beta” repeated 25 times.