Antitrust vs. ESG

Cutthroat corporate competition means there can be only one bottom line

I admit to feeling a bit ambivalent about ESG investing. For the uninitiated, ESG stands for Environmental, Social, and [corporate] Governance investing, and it means that investment ought to take a lot of stuff into account besides how much profit a company makes. This is traditionally mostly about climate change — not investing in companies that emit lots of greenhouse gases. But the concept is increasingly being applied to other things people want companies to do, like supporting human rights overseas, diversity, employee compensation vs. executive compensation, worker input into corporate decision-making, etc.

I’m ambivalent about ESG because I like most of the goals but I’m suspicious of the methods. On one hand, climate change is very scary, and that threat overrides a lot of other concerns about what investors should and shouldn’t do. Governments in the biggest polluting countries generally seem to be dropping the ball on speeding the transition to renewable energy, so the investor class might as well step in and do what it can. The movement to divest from coal seems to have made progress in speeding the death of that dirty fuel, and that’s a good thing:

Ramez Naam @ramez

Okay. Here's a THREAD about divestment (and why it's driven mostly by economics, not good citizenship), theories of change in climate / energy, and the power of tapping into self-interested economic motivations among corporates, banks, and investers. Ready? Here we go.

And the other goals of the ESG movement generally seem like good things too (though I think a lot depends on the implementation).

On the other hand, fundamentally, ESG seems like the investor class trying to reshape our society to fit its own vision of what that society should look like. The more things get included in the list of ESG considerations, and the more that affects corporate behavior, the more investors’ social preferences become reflected in our day-to-day social relations. And remember, most of the stocks in the U.S. are owned by rich people. That instinctively feels like a vision of dystopian capitalism.

But on the other other hand, you can argue that a monomaniacal focus on shareholder value (i.e. profit) is itself a form of influence over the day-to-day relations of society. A society where everyone is forced to run around making as much money as possible, because rich people tell corporations not to care about anything besides money, is also a society where rich people’s preferences rule our daily lives.

The classic corrective is democracy — voters can vote in politicians who make laws to prohibit pollution, unsafe working conditions, unfair labor practices, and so on. And democracy probably doesn’t lose efficacy under an ESG regime; the only danger is that people might convince themselves that ESG is a substitute for democracy, and reduce their efforts to influence the political process because they assume a benevolent investor class will take care of things.

All of this discussion is a bit moot, however, if ESG doesn’t make economic sense. If abandoning the bottom like for three or five or twenty bottom lines hurts a company’s ability to sustain its market penetration and payroll, that company’s ability to improve society will wane along with its profits.

And here we come to the title of this post: “Antitrust vs. ESG”. Because if the U.S. moves toward an environment of increased competition, that will put more pressure on companies to focus purely on staying alive. And the recent stock crash and earnings squeeze will only increase this pressure.

Applying Becker’s discrimination theory to ESG

In the 1950s, the economist Gary Becker came up with a theory about discrimination. This being economics, he expressed the theory with a lot of math, but the basic idea is this: The more competitive the market is, the less companies can afford to discriminate against women and minorities.

This makes intuitive sense. If you’re an entrenched monopoly, you can basically hire whoever you like (and refuse to hire whoever you don’t like), because if your bottom line takes a hit, well, hey, you’re still a monopoly. Hiring a bunch of ineffectual good ol’ boys instead of competent women and minorities might raise your costs, but you can just pass most of those costs on to your captive consumers. But in a highly competitive market, if you indulge your sexist or racist predilections by refusing to hire the best people for the job, your costs rise above those of your competitors. The market then punishes you by shrinking your market share and eventually driving you into bankruptcy, and your market share gets taken over by companies with fewer hangups about who they hire.

Anyway, that’s the theory. The next question is how well this theory explains reality. Obviously, discrimination is a complex, multi-factorial issue, and Becker’s theory is at best going to be one piece of the puzzle.

That said, there is some evidence that the Becker effect is real. Here are a few papers:

1. “Importing Equality? The Effects of Increased Competition on the Gender Wage Gap”, by Sandra Black and Elizabeth Brainerd (1999)

One big, important source of competition is international competition. So if Becker’s theory is right, then increased import competition should lead to a reduced gender wage gap. Black and Brainerd find that in the 80s, increasing import penetration in an industry was correlated with a decreasing gender pay gap in that industry, and that the effect was stronger in more concentrated industries. That’s certainly very consistent with Becker’s story.

2. “The Division of Spoils: Rent-Sharing and Discrimination in a Regulated Industry”, by Sandra Black and Philip Strahan (2001)

Another important source of competition is deregulation. In this paper, Black and Strahan study state-level banking deregulations in the 1970s that allowed banks to enter new markets. They find that these deregulations compressed the gap between male and female wages. This is even stronger evidence for Becker’s theory than the previous paper, because it relies on a policy experiment rather than just a correlation.

3. “Racial Discrimination and Competition”, by Ross Levine, Alexey Levkov and Yona Rubinstein (2011)

Levine et al. do something very similar to Black and Strahan, except that they look at racial discrimination. They find that state-level bank deregulations reduced the Black-White wage gap, and that this reduction was correlated with greater market entry in non-financial sectors (who could now get loans more easily). In other words, deregulation led to more competition and a lower racial wage gap.

4. “Competition and Gender Prejudice: Are Discriminatory Employers Doomed to Fail?”, by Andrea Weber and Christian Zulehner (2014)

This study finds that startup companies with lower-than-average female employment for their industry tend to fail at higher rates. And those that do survive tend to increase their employment of women over time.

There are some other papers that I didn’t consider to be as high-quality, so I didn’t include them in this list, but all of the ones I found agree with the results of the papers above — the Becker discrimination theory does appear to be a real thing that’s actually happening in the world.

So how does this apply to ESG? ESG isn’t the same thing as sexist/racist discrimination (or at least, hopefully not). But it’s another example of “a thing that companies might care about that doesn’t affect their bottom line”. ESG is basically companies choosing to discriminate in favor of certain business activities over others, for reasons of personal taste (or the personal taste of their investors). And so like discrimination in the Becker model, ESG should tend to get pushed out of the market by increased competition.

There is a pretty large research literature confirming that ESG investing isn’t just virtue-signaling or hype, and that ESG investors really are less sensitive to financial payoffs than other investors (For example, see here, here, here, and here). In theory, caring less about money should lead to companies getting outcompeted in the market.

But if there’s a lot of monopoly power in the market, that process will get short-circuited.

People argue about whether competition has waned in America. Economists have been producing lots of comprehensive, well-argued papers suggesting that there has been a general increase in market power in America over the last two decades. Unrestrained mergers, light-touch regulation, and the network effects created by the internet seem to have combined to produce a lot of dominant companies within various industries. The jury is still out, but the evidence seems to be leaning toward the market power hypothesis, and this has spurred a wave of interest in renewed antitrust.

That antitrust action is now being spearheaded by Lina Khan, the chair of the Federal Trade Commission. A leader of the “Neo-Brandeisian” legal and academic movement, Khan has implemented a far more aggressive approach toward big companies, especially in the tech industry. Actual antitrust actions may ultimately prove less important than the general message they send, which is that the government is now less tolerant of the things corporations do to achieve dominant market shares. That could boost competition and decrease profitability at dominant companies. At least, the Neo-Brandeisians intend for that to be the outcome.

Greater competition would be good for consumer prices and workers’ wages. It could also decrease the political influence of dominant corporations. But it will also force companies to focus more on the bottom line. The profit cushion that allowed companies to prioritize their political and social values over economic efficiency will be thinner.

(That effect could be mitigated by ESG’s positive reputational effect — companies that advertise themselves as socially responsible are generally able to attract more productive, motivated workers. But to the extent that this simply represents a reallocation of workers, via effective advertising, rather than increased motivation of the workforce overall, this won’t matter much at the national level.)

The recent stock market crash might be another factor that forces companies to focus more on their bottom line. Disappointing earnings, the imminent threat of recession, and a new mood of pessimism in the tech industry mean that investors are feeling the pinch. They may thus lean on corporate management to pay a little more attention to profitability and a little less attention to moral crusades.

Already, we can perhaps see glimmers of this beginning to happen. Netflix’s stock is down over 70% from its peak in late 2021, amid a subscriber plateau and fierce competition from new streaming services. And recently, Netflix released a new corporate culture memo de-emphasizing its role as a cultural crusader:

[T]he document adds a new directive for employees to act with fiscal responsibility — a change that comes as Netflix in Q1 saw its first decline in subscribers in more than a decade. The updated Netflix Culture memo also includes a new section called “Artistic Expression,” explaining that the streamer will not “censor specific artists or voices” even if employees consider the content “harmful,” and bluntly states, “If you’d find it hard to support our content breadth, Netflix may not be the best place for you.”

An increased focus on the bottom line won’t always mean a decrease in what conservatives pejoratively call “woke capital”. Many consumers care deeply about diversity, representation, etc., and being in tune with these consumers’ values will doubtless be beneficial to many companies’ bottom line. But where employees’ social and cultural crusades conflict with profitability, expect to see management putting its foot down more now.

In any case, I expect ESG investing approaches to suffer somewhat in an era of reinvigorated antitrust, disappointing earnings, and lower stock prices. Milton Friedman wasn’t 100% right when he said that “the business of business is busines”. But as markets move in the direction of the competitive ideal Friedman envisioned, his statement becomes a better approximation of reality.

Update: And, as if on cue…

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