Is 2023 going to be the year that we witness the triumphal march of ESG (Environmental Social and Governance) investment, or will we witness it’s decline and fall? Should we care?
In this blog I will outline the contradiction within ESG and argue that these need to be resolved. This may seem an academic discussion, but it is consequential.
Most of the world’s largest investors have adopted ESG principles, or at least claimed to.
And these are the guys who invest the economy’s assets; how assets are invested, and how large companies are incentivised to behave by their owners has a significant influence on what sort of economy we live in.
The last few years have seen a dramatic increase in the prominence and importance of ESG within the investment world, after a long period of gestation during which it was only a marginal player.
It is arguably now the main theme within the investment industry. Its importance is demonstrated by the backlash – from accusations of greenwash to Republican state legislators in the USA attempting to blacklist investment firms they accuse of woke-capitalism.
What is ESG? A pithy description of ESG was provided by Professor Robert Eccles of Said Business School. He said that ESG investment is “ simply about companies and investors managing material risk factors to ensure long-term value creation.” [1]
This is in response to the attack against ESG from conservatives in the USA, characterised by former Vice President Mike Pence (quoted by Eccles):
“ESG is a pernicious strategy, because it allows the left to accomplish what it could never hope to achieve at the ballot box or through competition in the free market. ESG empowers an unelected cabal of bureaucrats, regulators and activist investors to rate companies based on their adherence to left-wing values.”
Professor Eccles position reflects the mainstream conception of ESG investment from its proponents. He eruditely and convincingly argues a view of ESG which is precisely wrong, and although I totally disagree with Mike Pence’s sentiment, the odious former vice president is in fact partially correct. ESG is not actually pernicious, because its ineffectual – but it should be, and it does need to guide companies to adopt its values.
In Eccles’ formulation, ESG investment is about value not values, as if these two words have no commonality, whereas they are in essentially the same thing.
Is ESG about “managing material risk factors”?
In risk management it’s important to be un-biased to all the possible risks that you could face, not to pre-prejudge what is important. It is very poor risk management to be fixated on, say, cyber risk, as this would lead you to downplay other-risks.
Whilst ESG factors are indeed important, an ESG investor is by definition focusing on these factors. This does not preclude them at considering other factors, but in that case why are they different from other investors?
Calling oneself an ESG investor implies a thematic investment, like a specialist investor in med-tech, say, but it is not about risk-management. Whilst differentiation in this way may have been justifiable during ESG’s wilderness years, now that ESG has become the main-game of finance, ESG factors cannot be “extra financial” in any meaningful sense, when all of finance proports to take these into account.
If we think about the main risks that have emerged recently – pandemic, war in Ukraine, inflation, and so on – you could argue that these have more or less overlap with ESG.
But some of the overlap is tenuous and it would be easy to come up with risks which have little to do with ESG. Ironically this very debate is an example. By prioritising ESG factors, investors are running up against a political risk that conservative American politicians may prejudice the future value creation ability.
Proponents of ESG would argue that eventually “sustainability” factors will win out. This may happen, but looking at human history, the bad guys can stay in power for a remarkably long time.
ESG is not about “companies and investors managing material risk factors to ensure long-term value creation”; a clue is in the title; ESG is concerned with “Environmental Social and governance factors”..
If it were really about risk management it should be called “managing long-term risk factors to ensure long-term value creation” – MLTRFLTVC investment is not a promising brand..
That’s risk, so what about “value”? What does he value mean?
There are two apparent alternatives – there is the sense advocated by Milton Freidman and his followers – creating shareholder value, where means financial value, or there is another sense, where investee companies are creating value for society by solving society’s problems and in so doing making a profit, as advocated by Colin Meyer (also of Said Business School).
The difference between these two positions is quite nuanced, Freidman argued that companies create value for society by focusing on maximising profits.
The difference between Freidman and Meyer is an ideological divide about the role of companies and government in society – Freidman was quite explicit about that he was engaged in a conservative ideological project.
How we determine a company’s value depends on our values.
As I have argued elsewhere, investment is essentially regulated on Milton Freidman’s framework of optimising risk and return to maximise financial value. The project of ESG to date has been to attempt to shoehorn ESG values into this framework, as exemplified by Professor Eccles’s definition.
Ironically, Eccles and the “mainstream ESG” are in agreement with Mike Pence’s team in agreement (albeit for different reasons) in rejecting Freidman’s framework.
Team Eccles is implicitly rejecting it because they are saying the market needs to be adjusted to add these extra financial factors into play.
Team Pence is saying that capitalism has been captured by woke capitalists, who are trying to impose their values on “real” capitalism, which is not possible in Freidman’s conception as the market knows best even if you don’t like it.
The dilemma is resolved if you accept that ESG is actually about values. A savings system can only pay back it’s beneficiaries if the economy is well managed, that is if investors and the companies they own are well governed, maintain and enhance social cohesion and restore a healthy environment.
If they don’t do that you will end up with thugs storming the Capitol and attempting to lynch the Vice President; a risk with which Mr Pence should be familiar.
If this is the norm, such a society is unlikely to be able to pay long-term liabilities such as pensions, which investment managers have been entrusted to do.
So ESG investors need to form an interest group which uses its influence to make sure that these societal problems are addressed, they need to do so because they are professionals who have been entrusted with this responsibility by their clients.
And they can do so by actively ensuring that the companies they own are managed in a way that is positively contributes to society and the environment, and rapidly decreases harmful activities.
Similar as they lend money to governments via the bond market, they should be using their leverage to get governments to have strong environmental and socially positive policies.
The irony is that Mike Pence can sleep easy because the ESG industry is far away from this approach, instead following the flawed raison d’etre described by Professor Eccles.
That is until an angry mob comes for him again.
