The environmental, social and governance bandwagon is rolling.
Companies are becoming ESG
advocates, tempted by promises that they will become more profitable and valuable if they follow
the ESG script, say the right things and spend money improving their ESG ratings. Meantime,
institutional investors, drawn by the allure of earning higher returns while keeping their
consciences clean, are directing tens of billions of dollars to “good” companies with high ESG
ratings.
Much as we would like to accept this virtuous story, we believe that the whole concept has been
overhyped and oversold. Furthermore, it is backed by weak to non-existent evidence of promised
pay-offs for either companies or investors, and fraught with internal inconsistencies that undercut
its credibility.
Related to ESG is the view that the historical corporate focus on shareholder wealth leads
companies to adopt policies that are bad for society and should be replaced by a broader
stakeholder perspective.
A statement published last year by the Business Roundtable, and signed by chief executives of big
US companies, illustrated how much traction this view has gained. The group announced that
“while each of our individual companies serves its own corporate purpose, we share a
fundamental commitment to all of our stakeholders”.
This is not viewed as a problem because being good is seen as entirely consistent with maximising
shareholder wealth in the long term. Good companies, we are told, will be more profitable and
valuable in the long run. The viewpoint is often offered as accepted wisdom in business schools,
backed up by anecdotal evidence and case studies, lectures on morality and a selective reading of
research.
To assess the current dogma, we start with the premise that for a company’s social consciousness
to affect its value, it has to change either the cash flows that it generates or alter the risk of those
cash flows. From that perspective, the best-case scenario for ESG is that consumers will buy more
of the products and services offered by good companies, allowing these companies to increase
future cash flows.
That argument works for niche companies such as Patagonia, which serve a small, upscale market
of socially conscious consumers. It may not for bigger companies that have to cater to larger, more
price-conscious markets.
A second way that ESG and value may be positively linked is if bad companies are punished in
capital markets because investors require higher expected returns to hold them, leading to lower
stock prices. There is, however, a third and dysfunctional scenario in which bad companies have
lower costs, higher profits and higher value than good companies. For instance, some critics claim
that Facebook has been able to dominate online advertising precisely because it has been more
ruthless than its competitors in pushing the limits of privacy and free speech.
The strongest evidence in favour of ESG is on the discount rate front. There are signs that “sin”
stocks such as tobacco or weapons companies face higher costs of funding than good companies.
But that is a double-edged sword. If, as ESG advocates argue, fund managers prefer to invest in
“good” companies and reward them with higher values, investors who buy at those higher values
will earn lower returns over time.
One hopeful note for investors is that there seems to be a pay-off to investing in good companies
before the market recognises and prices in that goodness. But with the attention paid to ESG
growing rapidly, such opportunities are likely to disappear quickly.
It is impossible to have an honest discussion about ESG when its advocates believe that they
occupy the moral high ground and view disagreement as immoral or unethical. We are not arguing
that companies should not strive to be good, or that investors should not incorporate their
preferences — moral, religious and social — into investment decisions.
Instead, we believe that both companies and investors must recognise that there are costs to
being good in many situations, and denying these costs, or arguing that the benefits always exceed
the costs, is dishonest.
Finally, there is a more fundamental, dangerous side to the corporate enthusiasm for ESG, where
corporate executives are called on to make judgments on social issues that they are not
empowered to make, nor equipped to handle. A company that loses its business focus because of
its desire to do good for society, may end up being bad for both business and society.
If, as an individual, you are upset by a company’s behaviour, the best response is to not invest in
the company or buy its products or services — and vote for governments that will institute the
polices you favour.
The writer teaches climate change and finance at the Anderson Graduate School of Management
at UCLA. His former student, Aswath Damodaran, a finance professor at the Stern School of
Business at NYU, also contributed
