The Siren Song of Sustainability: The Theocratic Trifecta's Third Leg!

    You might know, by now, of my views on ESG, which I have described as an empty acronym, born in sanctimony, nurtured in hypocrisy and sold with sophistry. My voyage with ESG began with curiosity in my 2019 exploration of what it purported to measure, turned to cynicism as the answers to the Cui Bono (who benefits) question became clear and has curdled into something close to contempt, as ESG advocates rewrote history and retroactively changed their measurements in recent years. Late last year, I looked at impact investing, as a subset of ESG investing, and chronicled the trillions put into fighting climate change, and the absence of impact from that spending. Sometime before these assessments, I also looked at the notion of stakeholder wealth maximization as an idea that only corporate lawyers and strategists would love, and argued that there is a reason, in conventional businesses to stay focused on shareholders. With each of these topics (ESG, impact investing, stakeholder wealth maximization), the response that I got from some of the strongest defenders was that "sustainability" is the ultimate end game, and that the fault has been in execution (in ESG and impact investing), and not in the core idea.  

    I was curious about what sets sustainability apart from the critiqued ideas, as well as skeptical, since the cast of characters (individual and entities) in the sustainability sales pitch seems much the same as for the ESG and impact investing sales pitches.  In critiquing sustainability, I may be swimming against the tide, but less so than I was five years ago, when I first wrote about these issues. In fact, in my first post on ESG, I confessed that I risked being labeled as a "moral troglodyte" for my views, and I am sure that my subsequent posts have made that a reality, but I have a thick skin. This post on sustainability will, if it is read, draw withering scorn from the righteous, and take me off their party invite list, but I don't like parties anyway.

Sustainability: The What, the Why and the Who?

    I have been in business and markets for more than four decades, and while sustainability as an end game has existed through that period, but much of that time, it was in the context of the planet, not for businesses. It is in the last two decades that corporate sustainability has become a term that you see in academic and business circles, albeit with definitions that vary across users. Before we look at how those definitions have evolved, it is instructive to start with three measures of sustainability, measuring (in my view) very different things:

• Planet sustainability, measuring how our actions, as consumers and businesses, affect the planet, and our collective welfare and well being. This, of course, covers everything from climate change to health care to income inequality.
• Product sustainability, measuring how long a product or service from a business can be used effectively, before becoming useless or waste. In a throw-away world, where planned obsolescence seems to be built into every product or service, there are consumers and governments who care about product sustainability, albeit for different reasons.
• Business or corporate sustainability, measuring the life of a business or company, and actions that can extend or constrict that life. 

There are corporate sustainability advocates who will argue that it covers all of the above, and that a business that wants to increase its sustainability has to make more sustainable products, and that doing so will improve planet sustainability. That may be true, in some cases, but in many, there will be conflicts. A company that makes shaving razors may be able to create razor blades that stay sharp forever, and need no replacement, but that increased product sustainability may crimp corporate sustainability. In the same vein, there may be some companies (and you can let your priors guide you in naming them), whose very existence puts the planet at risk, and if planet sustainability is the end game, the best thing that can happen is for these companies to cease to exist. 

    

    Which of these measures of sustainability lies at the heart of corporate sustainability, as practiced today? To get the answers, I looked at a variety of players in the sustainability game, and will use their own words in the description, lest I be accused of taking them out of context:

• Business schools around the world have discovered that sustainability classes not only draw well, and improve their rankings (especially with the Financial Times, which seems to have a fetish with the concept), but are also money makers when constructed as executive classes. NYU, the institution that I teach at, has an executive corporate sustainability course, with certification costing $2,200, but I will quote the Vanderbilt University course description instead, where for a $3,000 price tag, you can get a certificate in corporate sustainability, which is described as " a holistic approach to conducting business while achieving long-term environmental, social, and economic sustainability." 
• Academia: I read through seminal and impactful (as academics, we are fond of both words, with the latter measured in citations) papers on corporate sustainability, to examine how they defined and measured sustainability. A 2003 paper on corporate sustainability describes it as recognizing that "corporate growth and profitability are important, it also requires the corporation to pursue societal goals, specifically those relating to sustainable development — environmental protection, social justice and equity, and economic development." In the last two decades, it is estimated that there have been more than twelve thousand articles published on corporate sustainability, and while the definition has remained resilient, it has developed offshoots and variants.
• Corporate/Business: Companies, around the world, were quick to jump onto the sustainability bandwagon, and sustainability (or something to that effect) is part of many corporate mission statements. The Hartford, a US insurance company, describes corporate sustainability as centered "around developing business strategies and solutions to serve the needs of our stakeholders, while embracing the necessary innovation and foresight to ensure we are able to meet those needs in the decades to come."
• Governments: Governments have also joined the party, and the EU has been the frontrunner, and its definition of corporate sustainability as "integrating social, environmental, ethical, consumer, and human rights concerns into their business strategy and operations" has become the basis for both disclosure and regulatory actions. The Canadian government has used to EU model to create a corporate sustainability reporting directive, requiring companies to report on and spend more on a host on environmental, social and governance indicators. 

I am willing to be convinced otherwise, but all of these definitions seem to be centered around planet sustainability, with varying motivations for why businesses should act on that front, from clean consciences (it is the right thing to do) to being "good for business" (if you do it, you will become more profitable and valuable).

    While corporate sustainability has taken center stage in the last two decades, it is part of a discussion about the social responsibilities of businesses that has been around for centuries. From Adam Smith's description of economics as the "gospel of mammon" in the 1700s to Milton Friedman's full-throated defense of business in the 1970s, it can be argued that almost every debate about businesses has included discussions of what they should do for society, beyond just following the law. That said, corporate sustainability (and its offshoots) have clearly taken a more central role in business  than ever before, and one manifestation is in the rise of "corporate sustainability officers" (CSOs) at many large companies. A PwC survey of 1640 companies in 62 countries, in 2022, found that the number of companies with CSOs tripled in 2021, with about 30% of all companies having someone in that position. A Conference Board survey of hundred sustainability leaders (take the sample bias into account) of the state of corporate sustainability pointed to the expectation that sustainability teams at companies would continue to grow over time. Finally, going back to academia, an indicator of the buzz in buzzwords, a survey paper in 2022 noted the rise in the number of corporate-sustainability related articles in recent years, as well as documenting their focus:

Burbano, Delma and Cobo (2022)

Note that much of the surge in articles came from ESG, which at least for the bulk of this period marched in lockstep with sustainability. Reflecting that twinning, many of the papers on corporate sustainability, just like the papers on ESG, were framed as sustainability being not just good for society but also good for the companies that adopted them. 

    I will admit that I have no idea what a CSO is or does, but I did get a chance to find out for myself, when I was invited to give a talk to the CSOs of fifty large companies. I started that session with a  question, born entirely out of curiosity, to the audience of what they did, at their respective organizations. After about twenty minutes of discussion, it was very clear that there was no consensus answer. In fact, some were as in the dark, as I was, about a CSO's responsibilities and role, and among the many and sometimes convoluted and contradictory answers I heard, here was my categorization of potential CSO roles:

1. CSO as Yoda: Some of the CSOs described their role as providing vision and guidance to the companies they worked at, about the societal effects of their actions, and doing so with a long term perspective. In short, even though they did not make this explicit, they were projecting that they had the training and foresight on how the company and society would evolve over time, and advice the company on the actions that it would need to take to match that evolution. I was tempted, though I restrained myself, to ask what training they had to be such receptacles of wisdom, since a degree or certification in sustainability clearly would not do the trick. I did dig into Star Wars lore, where it is estimated that it takes a decade or two of intense training to become a Jedi, and left open the possibility that there may be an institution somewhere that is turning out sustainability jedis.
2. CSO as Jiminy Cricket: I am a fan of Disney movies, and Pinocchio, while not one of the best known, remains one of my favorites. If you have watched the movie, Jiminy Cricket is the character that sits on Pinocchio's shoulder and acts as his conscience, and for some of the CSOs in the audience, that seemed to be the template, i.e., to act as corporate consciences, reminding the companies that they work for, of the social effects of their actions. The problem, of course, is that like the Jiminy Cricket in the movie, they get tagged as relentless scolds, usually get ignored, and get little glory, even when proved right. 
3. CSO as PR Genius: There were a few CSOs who were open about the fact that they were effectively marketing fronts for companies, with the job of taking actions that could not remotely be argued as being good for the planet and selling them as such. I am not sure whether Unilever's CSO was involved in the process, but the company's push to have each of its four hundred brands have a social or environmental purpose would have fallen into this realm. 
4. CSO as Embalmer: Finally, there were some CSOs who argued that it was their job to ensure that the company would live longer, perhaps even forever. If you are familiar with my work on corporate life cycles, I believe that not much good comes from companies surviving as “walking dead” entities, but in a world where survival at any cost is viewed as success, it is a by product. 

Here are the roles in table form, with the training that would prepare you best for each one:

I am sure that I am missing some of the nuance in sustainability, but if so, remember that nuance does not survive well in business contexts, where a version of Gresham's law is at work, with the worst motives driving out the best.

Sustainability and ESG

    In the last two or three years, corporate sustainability advocates have tried to distance themselves from ESG, arguing that the faults of ESG are of its own doing, and came from ignoring sustainability lessons. I am sorry, but I don't buy it. If ESG did not exist, sustainability would have had to invent it, because much of the growth in sustainability as a money-maker has come from its ESG arm. As I see it, ESG took the abstractions of corporate sustainability and converted them into a score, and it was that much maligned scoring mechanism that caused a surge of adoptions both in corporate boardrooms and among the investment community. It is worth noting that both ESG and sustainability draw their rationale from stakeholder wealth maximization, with the core thesis being that businesses should be run for the benefit of all stakeholders, rather than “just” for shareholders. It is in this context that I used the "theocratic trifecta" to describe how ESG, sustainability and stakeholder wealth are linked, and have been marketed. 

I use the word “theocratic” deliberately, since like theocrats in every domain, some in the sustainability space believe that they own the high ground on virtue, and view dissent as almost sacrilegious. 

    While a scoring mechanism, by itself, can be viewed as having a good purpose, i.e., to create a measure of how much a company is moving towards it sustainability goals, and to hold it accountable, it creates natural consequences that come with all scoring mechanisms:

• Measurers claiming to be objective arbiters, when the truth is that all scores require subjective judgments about what comprises goodness, and the consequences for business profitability and value.
• Businesses that start to understand the scoring process and factors, and then game the scoring systems to improve their scores. Greenwashing is a feature of these scoring systems, not a bug, and the more you try to refine the scoring, the more sophisticated the gaming will become.
• Advocates wringing their hands about the gaming, and arguing that the answer is more detailed definitions of things that defy definition, not recognizing (or perhaps not caring) that this just feeds the cycle and creates even more gaming.

With ESG, we have seen this process play out in destructive ways, with the scoring services (Sustainalytics, S&P, Refinitiv) using not only different criteria to come up with scores, but also changing those criteria in time and companies with the most resources to do so gaming those scoring systems to deliver better ESG scores. Accountants and regulators have added to the mix, by increasing disclosure requirements on almost every aspect of ESG, with little or no tangible benefits to show in terms of actual change.

   Taking a step back and looking at ESG and sustainability as concepts, they share many of the same characteristics:

1. They are opaque: Both ESG and sustainability are opaque to the point of obfuscation, perhaps because it serves the interests of advocates, who can then market them in whatever form they want to. To the pushback from defenders that the details are being nailed down or that there are new standards in place or coming, the argument runs hollow because the end game seems to keep changing. With ESG, for instance, the end game when it was initiated was making the world a better place (doing good), which evolved to generating alpha (excess returns for investors), on to being a risk measure before converting on a disclosure requirement. Defenders argue that there will be convergence driven by tighter definitions from regulators and rule makers, and the EU, in particular, has been in the lead on this front, putting out a Corporate Sustainability Reporting Directive (CSRD) in 2022,  outlining economic activities that contribute to meeting the EU’s environmental objectives. While ESG advocates may be right about convergence, looking to the the bureaucracy in Brussels to have the good sense (on economics and sustainability) to get this right is analogous to asking a long-time vegan where you can get the best steak in town. 
2. They are rooted in virtue: While some of the advocates for ESG and sustainability have now steered away from goodness as an argument for their use, almost every debate about the two topics eventually ends up with advocates claiming to be on the side of good, with critics consigned to the dark side. 
3. Disclosures, over actions:  The path for purpose-driven concepts (sustainability, ESG) seems to follow a familiar arc. They start with the endgame of making the world a better place, are marketed with the pitch that purpose and profits go together (the original sin) and when the lie is exposed, are repackaged as being about disclosures that can be used by consumers and investors to make informed judgments. Both ESG and sustainability have traversed this path, and both seem to be approaching the "it's all about disclosure" phase of the cycle. While that seems like a reasonable outcome, since almost everyone is in favor of more information, there are two downsides to this disclosure drive. The first is that disclosure can become not just a substitute for acting, but an impediment to the change that makes a difference. The second is that as disclosures become more extensive, there is a tipping point, especially as the consequential disclosures are mixed in with minor ones, where users start ignoring the disclosure, effectively removing their information value. 
4. Underplay or ignore sacrifice: Of all the mistakes, the biggest one made in the sales pitch for ESG and sustainability was that you could eat your cake, and have it too. Companies were told that being sustainable would make them more profitable and valuable, investors were sold on the notion that investing in good companies would deliver higher or extra returns and consumers were informed that they could make sustainable choices, with little or no additional cost. The truth is that sustainability will be costly to businesses, investors, and consumers, and why should that surprise us? Through history, being good has always required sacrifice, and it was always hubris to argue that you could upend that history, with ESG and sustainability.

Notwithstanding the money, time and resources that have been poured into ESG and sustainability, there is little in terms of real change on any of the societal or climate problems that they purport to want to change. 

Can sustainability be saved?

    

    I may be a moral troglodyte, because of my views on ESG, sustainability and all things good, but we have a shared interest in making the world a better place, and that leads to  the question of whether corporate sustainability, or at least the mission that it espouses, can be salvaged. I believe that there is a path forward, but it requires steps that many sustainability purists may find anathema:

1. Be clear eyed about what can be achieved at the business level: There is truth to the Milton Friedman adage that the business of business is business, not filling in for social needs or catering to non-business interests. It is true that there are actions that businesses take that can create costs to society, and even if the law does not require it, it behooves us to get businesses to behave better, without asking them to do what governments and regulators should be doing.  For business sustainability to deliver results, that line between business and government action has to be made clearer, and adhered to in practice.
2. Open about the costs to businesses of meeting sustainability goals: Be real about the sacrifices in profitability and value that will be needed for a company to do what's good for society. To the extent that in a publicly traded company, it is not the managers, but one of the stakeholders (shareholders, bondholders, employees or customer), who bear this cost, you need buy in from them, if the sustainability actions are voluntary. For companies that are well managed and have done well for their stakeholders, the sacrifice may be easier to sell, but for badly managed businesses, it will be, and should be, a steeper hill to climb. To the extent that corporate executives and fund managers choose to create costs for others (shareholders in a company, investors in a fund), without their buy in, there is clearly a violation of fiduciary duty that will and should leave them exposed to legal consequences.
3. Clear about who bears these costs: I was recently asked to give testimony to a Canadian parliamentary committee that was considering ways of getting banks to contribute to fighting climate change (by lending less to fossil fuel companies and more to green energy firms), and much of what I heard from committee members and the other experts was about how banks would bear the costs. The truth is that when a bank is either restricted from a  profit-making activity (lending to fossil fuel companies) or forced to subsidize a money-losing activity (lending at below-market rates to green energy companies), the costs are borne by either the bank's shareholders or depositors, or, in some cases, by taxpayers. In fact, given that bank equity is such a small slice of overall capital, it is bank depositors who will be burdened the most by bank lending mandates, and that opens the door to bank failures and worse. 
4. And honest about cost sharing: One of the benefits of recognizing that being good (for the planet or society) creates costs is that we can then also follow up by looking at who bears the costs. It is my view that for much of the past few decades, we (as academics, policy makers and regulators) been far too quick to decide what works for the "greater good", at least as we see it, and oblivious to the reality that the costs of delivering that greater good are borne by the people who can least afford it. 
5. Above all,  drain the gravy train: Both ESG and sustainability have been contaminated by the many people and entities that have benefited monetarily from their existence. The path to making sustainability matter has to start by removing the grifters, many masquerading as academics and experts, from the space. I won’t name names, but if you want to see who you should be putting on that grifter list, many of them will be at the annual extravaganza called COP29, where the useful idiots and feckless knaves who inhabit this space will fly in from distant places to Azerbaijan, to lecture the rest of us on how to minimize our carbon footprint. If you are a business that cares about the planet, fire your sustainability consultants and stop bending business models to meet disclosure needs, and while you are at it, you may want to get rid of your CSO (if you have one), unless you happen to have Yoda on your payroll. 

In all of this discussion, there is a real problem that no one in the space seems to be willing to accept or admit to, and that is much as we (as consumers, investors and voters) claim to care about social good, we are unwilling to burden ourselves, even slightly (by paying higher prices or taxes), to deliver that good. It could be because we are callous, or have become so, but I think the true reason is that we have lost trust in experts, governments and institutions, and who can blame us?  Whether it is the city of San Diego, where I live, trying to increase sales taxes by half a percent or a government imposing a carbon tax, taxpayers seem disinclined to given governments the benefit of doubt, given their history of inefficiencies and broken promises. 

    One argument that I have heard from many advocates for ESG and sustainability is that the pushback against these ideas is coming primarily from the United States, and that much of the rest of the world has bought in to their necessity and utility. If  these people leave the ivory towers and echo chambers that they inhabit, and talk to people in their own environs, they will recognize that the loss of trust is a global phenomenon, and that any consensus that exists is on the surface. There are many reasons that incumbent governments in Canada and Germany (both "leaders" in the climate change fight) are facing the political abyss in upcoming elections, but one reason is the "we know best" arrogance embedded in their climate change strictures and laws, combined with the insulting pitch that the people most affected by these laws will not feel the pain. 

    How do we get trust in institutions back? It will not come from lecturing people on their moral shortcomings (as many will undoubtedly do to me, after reading this) or by gaslighting them (telling them that they are better off when they are clearly and materially not). It will require humility, where the agents of change (academics, governments, regulators) are transparent about what they hope to accomplish, and the costs of and uncertainties about reaching those objectives, and patience, where incremental change takes precedence over seismic or revolutionary change. 

YouTube Video

My posts on ESG, impact investing and stakeholder wealth

1. From Shareholder Wealth to Stakeholder Interests: CEO Capitulation or Empty Doublespeak? (August 2019)
2. Sounding Good or Doing Good? A Skeptical Look at ESG (September 2020)
3. The ESG Movement: The "Goodness" Gravy Train Rolls On! (September 2021)
4. ESG's Russia Test: Trial by Fire or Crash and Burn? (March 2022)
5. Good Intentions, Perverse Outcomes: The Impact of Impact Investing (October 2023)

ESG's Russia Test: Trial by Fire or Crash and Burn?

My views on ESG are not a secret. I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society. That judgment may be harsh, but as the Russian hostilities in Ukraine shake up markets, the weakest links in the ESG chain are being exposed, and as the same old rationalizations and excuses get rolled out, I believe that a moment of reckoning is arriving for the concept. If you remain a true believer, I will leave it up to you to decide how much damage has been done to ESG, and what comes next.

The ESG Response To Russia

When Russian troops advanced into Ukraine in late February, the reverberations across markets were immediate. Stock, bond and commodity markets all reacted negatively, and at least initially, there was a flight to safety across the world. Since one of ESG's sales pitches has been that following it’s precepts would insulate companies and investors from the risks emanating from bad corporate behavior, both ESG advocates and critics have looked to its performance in this crisis, to get a measure of its worth. I am not an unbiased observer, but the reactions from ESG defenders to this crisis can be broadly categorized into three groups.

1. The Revisionists

In the last decade, as ESG has grown, I have been awed by the capacity of some of its advocates to attribute everything good that has happened in the history of humanity to ESG. If these ESG revisionists are to be believed, if companies had adopted ESG early enough, there would have been no banking crisis in 2008, and if investors had screened stocks for ESG quality, they would not have lost money in the corporate scandals and meltdowns of the last decade. In the last week of February 2022, in the immediate aftermath of this crisis, there were a few ESG supporters who argued that ESG-based investors were less exposed to the damage from the crisis. That was quickly exposed as untrue for three reasons:

• ESG measurement services missed the Russia Effect: There is no evidence that Russia-based companies had lower ESG scores than companies without that exposure. In my last post, I looked at four Russian companies, Severstal, Sberbank, Yandex and Lukoil, all of which saw their values collapse in the last few weeks. When I checked their ESG rankings on Sustainalytics ranked each on February 23, 2022, each of them was ranked in the top quartile of their industry groups, though they all seem to have been downgraded since, with the benefit of hindsight. In a short piece in the Harvard Law Forum on Corporate Governance, Lev, Demeers, Hendrikse and Joos, highlight the absence of a Russia effect on ESG ratings with a simple comparison of ESG scores of companies with and without Russia exposure:
  
  
  
  Unlike them, I will not argue that failing to foresee the Russian invasion of Ukraine is an ESG weakness, but it certainly cannot be presented as a strength.
• Following the ESG rulebook after the crisis has been a losing strategy: It is true that the emphasis on climate change that skews ESG scores lower for fossil fuel and mining companies would have kept you from investing in Lukoil and Gazprom, among other Russian commodity companies, but it would also have kept you from investing in other companies in these sectors, operating in the rest of the world. As I noted in my last post on Russia, that would have kept you out of the best performing sector since Russia invaded Ukraine. In short, if there is a lesson that this crisis has taught us, it is that treating fossil fuel producers as evil, when they produce much of the energy that we use, is delusional. 
• ESG funds/lenders lost substantial amounts in Russia: Investment funds and lenders who have long touted their ESG credentials do not seem to have been less exposed than non-ESG funds, early reports notwithstanding. A Bloomberg Quint study of ESG funds uncovered that they had $8.3 billion invested in Russian equities on February 23, 2022, almost all of which was wiped out during the next few weeks. In fact, the saving grace for ESG funds has been the fact that Russia did not have a large investable market, for both ESG and non-ESG funds.

In the weeks after the war, hundreds of US and European companies have announced that they were leaving Russia, and ESG advocates have pointed to this exodus as evidence that its practices are now mainstream.  I would push back against the narrative that these companies were giving up lucrative businesses, because of their consciences:

• Small presence in Russia: In my last post, I noted that the Russian economy represents a sliver (about 2%) of the global economy. If you add the reality that Russia has a closed economy, with well established barriers to outsiders, most of the US companies pulling out of Russia are not giving up much business to begin with. In fact, for companies like Goldman Sachs, whose primary business in Russia came from acting as intermediaries between Russian businesses/investors and investors in the rest of the world, there is a question of whether any business was left to give up, after sanctions were put in place. The companies with the biggest presence in Russia are oil and commodity companies, primarily involved in joint ventures with Russian entities, where the pull out may be designed to preempt what would have been nationalization or expropriation in the future.
• Risk Surge and Economic Viability: In my last post, I noted the surge in Russia's default spread and country risk premium, making it one of the riskiest parts of the world to operate in, for any business. Many companies that invested in Russia, when it was lower-risk destination, have woken up to a new reality, where even if their Russian projects return to profitability, the returns that they can deliver are  well below what they need to make to break even, given the risk. Put simply, exiting Russia makes economic sense for most companies, and it may be cloaked in morality, but it is easy to pick the moral path, when economics and morality converge.
• Suspension versus abandonment: It is telling that many companies that have larger interests in Russia, with perhaps the possibility that investing will become economically viable again, have suspended their Russian operations, rather than abandoning them. These companies will undoubtedly come under pressure from activists, who will try to shame them into leaving, but if that is the best that ESG can do, it is pitiful.

For those who continue to insist that the corporate reaction to the Russian invasion is a sign of moral awakening at companies, I propose a thought experiment. If China had invaded Taiwan, do you think that companies would have been as quick to abandon their Chinese holdings and business? Do you think that investment funds would have been so quick to write off their Chinese holdings? On a more personal level, would you be willing to give up all things “Chinese”, as quickly as you were willing to give up drinking Russian vodka? They are hypothetical questions, but I think I know the answer. 

2. The Expansionists

As the evidence has mounted that ESG, at least as constructed, failed to provide protection to companies and investors from the Russia fallout, there are a few in the ESG movement who have argued that the fix is to expand the definition and measurement of ESG to incorporate Russia-like risks. That is easier said than done, though, because as with all things ESG, those risks are in the eyes of the beholder. For some, it will mean bringing in the nature of governments into ESG measures, with companies in countries with authoritarian governments getting lower ESG scores than companies in countries with democratic governments. Even if you believe that expansion is defensible, and that considering political risk when valuing companies is prudent, it will mean that every ESG measurement service will have the unenviable task of assessing political freedom (or its absence) in a company's operating geographies, to evaluate its ESG score. Taking a bigger picture perspective, using the benefit of hindsight to keep expanding ESG to include the missed variables in each crisis will lead to measurement bloat, as it grows more tentacles and adds more dimensions. Ultimately, if ESG tries to measure everything, it ends up measuring and meaning nothing.

On a different note, the events of the recent weeks have also pointed to the elasticity of the ESG concept. In the weeks right after the war started, two Citigroup analysts suggested that companies making weapons be classified as good companies, as long as they were selling them to the “right” side of the conflict. While ESG advocates were dismissive, I think that what the Citigroup analysts were proposing is more in line with the true nature of ESG, an amorphous, anything goes concept that shifts shape and form, depending on who is defining it, and when.

3. The Utopians

There is a group within the ESG movement that has been unfazed by any critiques of ESG or evidence that it has not done what it set out to do. To these true believers, the problems with ESG come from it being misappropriated, mis-measured and misused, and in their view, ESG, done right, will always deliver its promised rewards. I call this group the "if only" chorus, since in their view, if only services measured ESG correctly, if only companies did not indulge in greenwashing, and, if only, ESG funds did not pick under performers, ESG would work at making the world a better place. I believe that their wait for this awakening will be long because:

1. ESG mis-measurement is endemic, not transient: Even ESG measurement services are willing to admit that the current ESG ratings for companies are flawed, but they all contend that better measurement is around the corner, premised on two assumptions. The first is that ESG disclosures will improve, as regulators force companies to reveal more about their environmental and social performance, and that this data will improve measurement. The second is that as ESG ages, we will develop consensus on what comprises goodness, and when that occurs, there will be a higher correlation across services. I don't believe that either assumption is realistic. Drawing on the experience with corporate governance and stock based compensation, both areas where the volume of disclosure has ballooned over the last two decades, I would argue that disclosure has actually created more distraction than clarity, and I don't see why ESG will be any different. As for converging on what comprises “good”, why in God’s name, in a world where everything is partisan, would you expect consensus to magically form in the investment community? In fact, if a consensus on measurement occurs across services on how to measure ESG, it will be driven more by marketing concerns (since the differences across ratings is getting in the way of selling the concept) than by learning.
2. Greenwashing is an ESG feature, not a bug: There is probably no phenomenon on which there is more handwringing among ESG types than "greenwashing", where companies substitute "looking good" for "doing good". Those complaints, though, ignore an unpleasant truth, which is that greenwashing is exactly the outcome of making ESG a system of scores and rankings. I am willing to take a wager with any ESG true believer that the more ESG services and regulators try to crack down on greenwashing, the more ubiquitous and sophisticated it will become. The largest and most profitable companies will have the resources to game the system better, exacerbating biases that already exist in current ESG scores.
3. ESG Investing underperformance is steady state, not a passing phase: For the last decade, ESG sales pitches were helped out by the seeming over performance of ESG-based investing, though almost all of the out performance could be attributed to ESG's tech focus and sector concentrations. As the market has shifted, and ESG-based strategies are now under performing, ESG investment fund managers are scrambling, trying to explain to clients why this is just a  passing phase, and that good days are just around the corner. That is nonsense! In steady state, once the components of ESG that matter get priced in, ESG-constrained funds will deliver lower returns than funds that don't operate under those constraints. As I noted in one of my earlier posts on ESG, arguing that a constrained optimal can consistently beat an unconstrained optimal is sophistry, and the fact that some of the biggest names in the investment business have made these arguments tells us more about them than it does about ESG.
4. ESG is not about actual change, but the perception of change: Over the last decade, ESG advocates have argued that even if following ESG precepts does not increase shareholder value or generate higher returns, it does good for society, by stopping bad practices. Some of ESG's biggest "wins" have been in the fossil fuel space, with Engine Number 1's success in forcing Exxon Mobil to adopt a smaller carbon footprint, being presented as a prime exhibit. Under investment pressure, there is no denying that publicly traded oil companies, primarily in the West, have scaled back their search for oil and gas, and sometimes scaled back and sold reserves. The key word here is "sold", since those reserves have often been bought by private equity investors, who have collectively invested more than a trillion dollars in fossil fuel reserves and development over the last decade. Is it any surprise then that despite all of the ESG wins, the world remains overwhelmingly dependent on fossil fuels? In fact, all that ESG activists have managed to do is move fossil fuel reserves from the hands of publicly traded oil companies in the US and Europe, who would feel pressured to develop those reserves responsibly, into the hands of people who will be far less scrupulous in their development. If this is what winning looks like in the ESG world, I would hate to see what constitutes losing!

If you are an optimist on ESG, you may keep seeing light at the end of the tunnel, but the more this concept plays out, the more likely it is that the light you are seeing is that of a train bearing down on you. 

The Next Big Thing?

When a concept is as widely sold and bought into as ESG, it is unlikely to be abandoned in a hurry, no matter how much evidence accumulates that it does not work or that it has perverse consequences. In my experience, though, hollow concepts that promise the world and deliver little, eventually hit a tipping point, where even the most loyal adherents abandon them and move on. That moment will come for ESG, and if you are an ESG consultant, advisor or measurer, you will need something to replace its place, the next big thing, that you can sell as the answer to every question in business. Playing the role of a cynic, I will offer you a five step process that you can use to develop this "next big thing", which for generality, I will call “it”.

1. Give "it" a name: Give your next big thing a name, and pick one that sounds good, and if you want to add an aura of mystery, make it an acronym, with three letters seeming to do the trick, in most cases.
2. Give "it" meaning and purpose: As you write the description of the word or acronym, make that description as fuzzy as possible, preferably throwing in the word "long term" and "good for the world" into it, for good measure. (See step 5 for why this works in your favor.)
3. Use history to reverse engineer it’s components: Before you add specifics to your description, examine business and investing history, focusing on the most successful, and looking for characteristics that they share in common in terms. To round “it” out, you should also find failures and see what common features bind them together. Then incorporate these characteristics into your description, with the shared features of successful companies as your must-haves, and those of the failures are things to avoid.
4. Use self-interest to sell "it": To get the business establishment behind you, draw on its powerful drivers, self interest, greed and self delusion. If you have done your job well in step 3, you will have no trouble gaining institutional support, since you have already primed the pump. Case writers and consultants should have no trouble finding supporting cases studies and anecdotal evidence, academic researchers will unearth statistical evidence that your concept works and investment fund managers will unearth its capacity to create "alpha" in past returns.  
5. Delay and deflect: If you get pushback from critics or those with evidence that is contradictory, attribute failures to growing pains and argue that what is needed is a doubling down of fidelity to the concept. Since you have provided no clear or even discernible targets, you can always move the goalposts or claim to have accomplished what you set out to, and thus not be held accountable. Finally, use the “goodness” shield, since that makes any questioning of your big idea seem small minded and mercenary.

So, what will the next big thing be? I don't know for sure, but I am willing to make a guess, since so many ESG experts and advocates have slipped into already using it as an alternative. It is "sustainability", a word that can mean whatever you want it to mean. In its most benign form, I believe that it is just another word for "long term", though the only benefit of replacing one set of words with another is that it offers a chance for those using the new and updated word to state the obvious, claim the outrageous and charge the absurd. In its more malignant form, it becomes a way to try to keep corporations alive forever, a dreadful idea, where zombie and walking dead companies suck up capital and resources, and drag the rest of us down into the abyss with them. 

Conclusion

When I first wrote about ESG two years ago, I did so because I was skeptical of the unquestioning belief that people had in its success. I initially believed that it was a flawed concept that needed fixing , but after two years of interactions with people who claim to know the concept really well, but don't seem to be capable of making solid cases for it, and witnessing its takeover by well heeled entities with agendas, I am convinced that there will soon be room for only two types of people in the ESG space. The first will be the useful idiots, well meaning individuals who believe that they are advancing the cause of goodness, as they toil in the trenches of ESG measurement services, ESG arms of consulting firms and ESG investment funds. The second will be the feckless knaves, who know fully well the void behind the concept, but see an opportunity to make money. I know that those are not edifying choices, but I don't see any good ones, other than leaving the space completely. Good luck!

YouTube Video

Blog Posts on ESG

1. Sounding good or Doing good? A Skeptical Look at ESG
2. ESG: The Goodness Gravy Train rolls on (September 2021)

The ESG Movement: The "Goodness" Gravy Train Rolls On!

Last year, I wrote a post on ESG and explained why I was skeptical about the claims made by advocates about the benefits it would bring to companies, investors and society. In the year since, I have heard from many on the topic, and while there are some who agreed with me on the internal inconsistencies in its arguments, there were quite a few who disagreed with me. In keeping with my belief that you learn more by engaging with those who disagree with you, than those who do, I have tried my best to see things through the eyes of ESG true believers, and I must confess that the more I look at ESG, the more convinced I become that "there is no there there". More than ever, I believe that ESG is not just a mistake that will cost companies and investors money, while making the world worse off, but that it create more harm than good for society.

ESG: Value and Pricing Implications

Rather than repeat in detail the points I made in last year's post, I will summarize my key conclusions, with addendums and modifications, based upon the feedback (positive and negative) that I have received. 

1. Goodness is difficult to measure, and the task will not get easier!

The starting point for the ESG argument is the premise that we can come up with measures of goodness that can then be targeted by corporate managers and used by investors. To meet this demand, services have popped up around the world, claiming to measure ESG with scores and ratings. As I noted in my last post, there seems to be little consensus across services on how to measure goodness, and the low correlation across service measures of ESG has been well chronicled. The counter from the ESG services and ESG advocates is that these differences reflect growing pains, and just as bond ratings agencies found convergence on measuring default risk, services will also find commonalities. I think that view misses a key difference between default risk and goodness, insofar as default is an observable event and services were able to learn from corporate defaults and fine tune their ratings. Goodness is in the eyes of the beholder, and what you perceive to be a grevious corporate sin may not even register on my list, as a problem. To illustrate how investors can differ on core values, consider the chart below, where investors were asked to assess which issues should rank highest, when considering corporate goodness:

Based on this survey, younger investors want the focus to be on global warming and plastics, whereas older investors seem to focus on data fraud and gun control. If you expand these factors to include other social and religious issues, I would wager that the differences will only widen. As ESG scores and ratings get more traction, researchers are also looking at the factors that allow companies to get high scores and good rankings, and improve them over time. Studies of ESG scores find that they were influenced by company size and location, with larger companies getting higher ESG scores/rankings than smaller companies, and developed market companies getting higher scores and rankings than emerging market companies:

LaBella, Sullivan, Russel and Novikov (2019)

It is entirely possible that big companies are better corporate citizens than smaller ones, but it is also just as plausible that big companies have the resources to play the ESG scoring game, and that more disclosure is a tactic used by these companies that want to bury skeletons in their current or past lives, rather than expose them. In fact, a JP Morgan study of ESG Ratings and disclosures also points to a larger danger from enhanced ESG disclosure requirements, which is that the ESG ratings seems to increase across companies, as disclosure increase. 

Chen et al, JP Morgan

While I am sure that there will be some in the ESG community who will view this as vindication that disclosure is inducing better corporate behavior, the cynic in me sees companies learning to play the ESG game, at least as designed by services, and using the disclosure process to check boxes and up their scores. To me, the parallels to the corporate governance movement from two decades ago are uncanny, where services rushed to estimate corporate governance scores for companies, accountants and rule writers added hundreds of pages of disclosure on corporate governance, and promises were made of a "golden age" for shareholder power. The fact that the corporate governance movement enriched services, consultants and bankers, and left shareholders more powerless than they were before the movement started, holding shares in companies with dual class shares or worse, should act as a warning for ESG disclosure/measurement advocates, but I have a feeling that it will not.

2. Being “good” will add to value some companies, hurt others, and leave the rest unaffected!

If the ESG sales pitch to companies, which is that if you are a "good" company, you will be worth more, is right, why do we need ESG? In fact, Milton Friedman, the bête noire of ESG advocates, would stand vindicated, and companies would do good, because it made them more profitable and valuable, and not because of lectures about morality and goodness. This may be cynical, on my party, but the very fact that ESG advocates keep insisting that being "good" increases value must be because they are themselves unsure why or whether this is true. The framework for tracing out the effect of ESG on value is a simple one, since ESG, if it affects value, has to affect one of four variables: revenue growth (by increasing or decreasing growth), operating profit margins, reinvestment efficiency (the payoff to investing in new capacity)  or risk (through the cost of funding/capital and failure risk). In last year's post, I noted that the empirical evidence that ESG has a positive payoff is weak, at best, and inconclusive, for the most part:

The strongest evidence that is supportive of ESG comes on the risk front, with evidence that it does not pay to be a "bad" company, with some  a higher cost of funding and greater risk of catastrophes, but much of that evidence comes from fossil fuel companies. The weakest evidence in ESG's favor is on profitability and cash flows, since almost every study that purports to find positive correlation between profitability and ESG scores trips up on the causality question, i.e., are "good" companies more profitable or are companies that are more profitable able to take the actions that make them look good? An objective look at the data would lead us to conclude that while one can make a reasonable case that companies should work at "not being bad", there is very little evidence that there is a payoff to  spending more money to be "good".

3. The ESG sales pitch to investors is internally inconsistent and fundamentally incoherent

If the argument that ESG translates into higher value is weak, the argument that incorporating ESG into your investing is going to increase your returns fails a very simple investment test. For any variable, no matter how intuitive and obvious its connection to value might be, to generate "excess" returns, you have to consider whether it has been priced in already. That is why investing in a well managed company or one that has high growth does not translate into excess returns, if the market already is pricing in the management and growth. Applying this principle to ESG investing, the question of whether ESG-based investing pays off or not depends on not only whether you think ESG increases or decreases firm value, but also on whether the market has already priced in the impact.

• If the market has fully priced in the ESG effect on value, positive or negative, investing in 'good' companies or avoiding 'bad' companies will have no effect on excess returns. In fact, if being good makes companies less risky, investors in good companies will earn lower returns than investors in bad companies, before adjusting for risk, and equivalent returns after adjusting for risk.
• If the market is over enthused with ESG and is overpricing how much being "good" will add to a company's profitability or reduce risk, investing in 'good' companies will generate lower risk-adjusted returns than investing in 'bad' companies.
• If the market is underestimating the benefits of being good on growth, margins and risk, investing in 'good' companies will generate higher returns for investors, even after adjusting for risk.

In the latter two cases, the excess returns (negative in the "markets are over estimating" case and positive in the "markets are under estimating") will manifest only when the market corrects its mistakes.   Bringing in market pricing into the discussion is important for two reasons. 

• The first is that it suggests that much of the research on the relationship between ESG and returns yields murky findings. Put simply, there is very little that we learn from these studies, whether they find positive or negative relationships between ESG and investor returns, since that relationship is compatible with a number of competing hypotheses about ESG, value and price. 
• The second is that bringing in market pricing does shed some light on perhaps the only aspect of ESG investing that seems to deliver a payoff for investors, which is investing ahead or during market transitions. In my last post, I pointed to this study that find that activist investors who take stakes in "bad" companies and try to get them to change their ways generate significant excess returns from doing so. Another study contends that investing in companies that improve their ESG can generate excess returns of about 3% a year, but skepticism is in order because it is based upon a proprietary ESG improvement score (REIS), and was generated by an asset management firm that invests based upon that score. 

If you are interested in making market transitions on ESG work in your favor, you also have to be clear about the strengths you will need to get the payoffs, including skills in divining not only what social values are gaining and losing ground and which changes have staying power.

4. Outsourcing your conscience is a salve, not a solution!

    Even if being “good” does not increase value or make investors better off, could it still help, by making the world a better place? After all, what harm can there be in asking and putting pressure on companies to behave well, even if costs them? In the short term, the answer may be no, but in the long term, I believe that this will cost us all (as society). The ESG movement has given each of us an easy way out of having to make choices, by outsourcing these choices to corporate CEOs and investment fund managers, asking them to be “good” for us, while not charging us more for their products and services (as consumers) and delivering above-average returns (as investors). Implicit in the ESG push is the presumption that unless companies that are explicitly committed to ESG, they cannot contribute to society, but that is not true. Consider Bill Gates and Warren Buffett, two men who built extraordinarily valuable companies, with goodness a factor in decision making only if it was good for business. Both men have not only made giving pledges, promising to give away most of their wealth to their favorite causes in their lifetimes, and living up to that promise, but they have also made their shareholders wealthy, and many of them give money back to society. As I see it, the difference between this “old” model of business and the proposed “new ESG” version is in who does the giving to society, with corporate CEOs and management taking over that responsibility from shareholders. I am willing to listen to arguments for why this new model is better, but I am certainly not willing to concede, without challenge, that a corporate CEO knows my value system better than I do, as a shareholder, and is better positioned to make judgments on how much to give back to society, and to whom, than I am.

    For a perspective more informed and eloquent than mine, I would strongly recommend this piece by Tariq Fancy, whose stint at BlackRock, as chief investment officer for sustainable investing, put him at the heart of the ESG investing movement. He argues that trusting companies and investment fund managers to make the right judgments for society will fail, because their views (and actions) will be driven by profits, for companies, and investment returns, for fund managers. He also believes that governments and regulators have been derelict in writing rules and laws, allowing companies to step into the void. While I don’t share his faith that government actions are the solution, I share his view that entities whose prime reasons for existence are to generate profits for shareholders (companies) or returns for investors (investment funds) all ill suited to be custodians of public good.

Cui Bono? The ESG Gravy Train (or Circle)!

    If ESG is a flawed concept, perhaps fatally so, and if the flaws are visible for everyone to see, how do we explain the immense push in both corporate and investment settings? I think the answer always lies in asking the question "Cui Bono, or who benefits?". With ESG, the answer seems to be everyone, but those it is purported to help, i.e. corporate stakeholders, investors and society. The picture below captures the groups that have primarily benefited from the ESG boom, and how they feed off each other.

Given how much ESG disclosure advocates, measurement services, investment funds and consultants feed off each other, it is no wonder that they have an incentive to sell you on its unstoppable growth and inevitable success. Given that shareholders in companies and investors in funds are paying for this gravy, you may wonder why corporate CEOs not only go along with this charade, but also actively encourage it, and the answer lies in the power it gives them to bypass shareholders and to evade accountability. After all, these are the same CEOs who, in 2019, put forth the fanciful, but great sounding, argument that it is a company’s responsibility to maximize stakeholder wealth, rather than cater to shareholders, which I argued in a post then that being accountable to everyone effectively meant that CEOs were accountable to no one.  In some cases, flaunting goodness has become a way that founders and CEOs use to cover business model weaknesses and overreach. It is a point that I made in my posts on Theranos, at the time of its implosion in October 2015, and on WeWork, during its IPO debacle in 2019, noting that Elizabeth Holmes and Adam Neumann used their “noble purpose” credentials to cover up fraud and narcissism. 

I should add that, notwithstanding my negative views about ESG, I do not think that ESG consultants, fund managers and analysts are venal, but I do think that they, like everyone else, are driven by self interest. I also believe that many in the ESG ecosystem are driven by good motives, a desire to do good for society and make the world a better place, but that are being used by a few at the top of the ESG pyramid, whose commitment to the cause is skin deep. If you are someone working in the ESG space or a true believer, please do look to the highest profile spokespersons for your cause, mostly corporate CEOs and investment fund titans, and remember the adage about waking up with fleas, if you lie down with dogs.

A Roadmap for being and doing Good

    My skepticism about ESG notwithstanding, I understand its draw, especially on the young. As individuals, each of us has a moral code, sometimes coming from religion, sometimes from family and sometimes from culture, but whatever its source, our actions should be consistent with that code. Since those actions involve what we do at work, and in investing, it stands to reason that there are some investments you will and should not make, because it violates your sense of right and wrong, and other investments that you will make, because they advance your view of goodness. It is for this reason that I would suggest a more nuanced and personalized version of ESG, built around the following principles:

1. Start with a personalized measure of goodness, and don’t overreach: The key with moral codes is that they are personal, and for goodness to be incorporated into your investment and business decisions, you have to bring in your value judgments, rather than leave it to ESG measurement services or to portfolio managers. I would also recommend that you focus on core values, rather than try to find a match on every one, not only because adding too restrictions will constrain you in your choices, perhaps to the point of paralysis, but also because you may find yourself accepting major compromises on your key values in order to meet secondary values. 
2. As a business person, be clear on how being good will affect business models and value: If you own a business, you are absolutely within your rights to bring your personal views on morality into your business decisions, but if you do so, you should work through the effects on growth, margins and risk, and be at peace with the fact that staying true to your values may, and probably will, cost you money. If you are making decisions at a publicly traded company, as an employee, manager or even CEO, you are investing other people’s money and if you choose to make decisions based upon your personalized moral code, you cannot justify these decisions with hand waving and double talk. In fact, you have an obligation to be open about what your conscience will cost your shareholders, a twist on disclosure that ESG advocates will not like.
3. As an investor, understand how much goodness has been priced in: If you are an investor, you don’t have to compromise on your values, as long as you start with the recognition that, at least in the long term, you will have to accept lower returns than you would have earned without that constraint. If you are tempted to have your cake and eat it too, and who isn’t, you may be able to do so by getting ahead of the market in detecting shifts in social mores and pushing for change in the companies you invest in, to change. 
4. As a consumer and citizen, make choices that are consistent with your moral code: If you believe that owning a portfolio of “good” stocks or running a “good” business is all you have to do to fulfill your moral or societal obligations, you are wrong. Your consumption decisions (on which products and services you buy) and your citizenship decisions (on voting and community participation) have as big, if not greater, an effect. Put simply, if your key societal issue is climate change, your refusal to own fossil fuel stocks in your portfolio is of little consequence, if you still drive a gas guzzler, air condition your house to feel like an ice box all summer and take private corporate jets to Davos every year.

On a personal note, I have always found that the people that I've known who do good, spend very little time talking about being good or lecturing other people on goodness. I would extend that perspective to companies and investment funds as well, and I reserve my skepticism for those companies that spend hundreds of pages of their annual filings telling me how much "good" they do.

In conclusion

    The ESG movement’s biggest disservice is the message that it has given those who are torn between morality and money, that they can have it all. Telling companies that being good will always make them more valuable, investors that they can add morality constraints to their investments and earn higher returns at the same time, and young job seekers that they can be paid like bankers, while doing peace corps work, is delusional. In the long term, as the truth emerges, it will breed cynicism in everyone involved, and if you care about the social good, it will do more damage than good. The truth is that, most of the time, being good will cost you and/or inconvenience you (as businesses, investors or employees), and that you choose to be good, in spite of that concern. 

YouTube Video

Sounding good or Doing good? A Skeptical Look at ESG

In my time in corporate finance and valuation, I have seen many "new and revolutionary" ideas emerge, each one marketed as the solution to all of the problems that businesses face. Most of the time, these ideas start by repackaging an existing concept or measure and adding a couple of proprietary tweaks that are less improvement and more noise, then get acronyms, before being sold relentlessly. With each one, the magic fades once the limitations come to the surface, as they inevitably do, but not before consultants and bankers have been enriched. So, forgive me for being a cynic when it comes to the latest entrant in this game, where ESG (Environmental, Social and Governance), a measure of the environment and social impact of companies, has become one of the fastest growing movements in business and investing, and this time, the sales pitch is wider and deeper. Companies that improve their social goodness standing will not only become more profitable and valuable over time, we are told, but they will also advance society's best interests, thus resolving one of the fundamental conflicts of private enterprise, while also enriching investors. This week, the ESG debate has come back to take main stage, for three reasons. 

• It is the fiftieth anniversary of one of the most influential opinion pieces in media history, where Milton Friedman argued that the focus of a company should be profitability, not social good. There have been many retrospectives published in the last week, with the primary intent of showing how far the business world has moved away from Friedman's views. 
• There were multiple news stories about how "good" companies, with goodness measured on the social scale, have done better during the COVID crisis, and how much money was flowing into ESG funds, with some suggesting that the crisis could be a tipping point for companies and investors, who were on the fence about the added benefits of being socially conscious. 
• In a more long standing story line, the establishment seems to have bought into ESG consciousness, with business leaders in the Conference Board signing on to a "stakeholder interest" statement last year and institutional investors shifting more money into ESG funds.

In the interests of openness, I took issue with the Conference Board last year on stakeholder interests, and I start from a position of skepticism, when presented with "new" ways of business thinking. If the debate about ESG had been about facts, data and common sense, and ESG had won, I would gladly incorporate that thinking into my views on corporate finance, investing and valuation. But that has not been the case, at least so far, simply because ESG has been posited by its advocates as good, and any dissent from the party line on ESG (that it is good for companies, investors and society) is viewed as a sign of moral deficiency. At the risk of being labeled a troglodyte (I kind of like that label), I will argue that many fundamental questions about ESG have remained unanswered or have been answered sloppily, and that it is in its proponents' best interests to stop overplaying the morality card, and to have an honest discussion about whether ESG is a net good for companies, investors and society.

Measures of Goodness

    We have spent decades measuring financial performance and output at companies, either at the operating level, as revenues, profits or capital invested, or at the investor level, as market cap and returns. Any attempts to measure environment and social goodness face two challenges. 

• The first is that much of social impact is qualitative, and developing a numerical value for that impact is difficult to do. 
• The second is even trickier, which is that there is little consensus on what social impacts to measure, and the weights to assign to them.  

If your counter is that there are multiple services now that measure ESG at companies, you are right, but the lack of clarity and consensus results in the companies being ranked very differently by different services. This shows up in low correlations across the ESG services on ESG scores, as indicated by this study:

Correlations across six ESG data providers

This low correlation often occurs even on high profile companies, as shown in a comprehensive analysis of ESG investing by Dimson, Marsh and Staunton, as part of their global investment returns update:

Source: CS Global Investment Returns Yearbook 2020, Dimson, Marsh and Staunton

Note the divergence in both the overall ratings and on the individual metrics (E, S and G) across the services, even for widely tracked companies like Facebook and Walmart. There are some who believe that this reflects  a measurement process that is still evolving, and that as companies provide more disclosure on ESG data and ESG measurement services mature, there will be consensus. I don't believe it! After all, what I find to be good or bad in a company will reflect my personal values and morality scales, and the choices I make will be different from your choices, and any notion that there will be consensus on these measures is a pipe dream.  

Even if you overlook disagreements on ESG as growing pains, there is one more component that adds noise to the mix and that is the direction of causality: Do companies perform better because they are socially conscious (good) companies, or do companies that are doing well find it easier to do good? Put simply, if ESG metrics are based upon actions/measures that companies that are doing better, either operationally and/or in markets, can perform/deliver more easily than companies that are doing badly, researchers will find that ESG and performance move together, but it is not ESG that is causing good performance, but good performance which is allowing companies to be socially good.

The ESG Sales Pitch - Promises and Contradictions

The power of the ESG sales pitch has always been that it offers something good to everyone involved, from companies adopting its practices, to investors in those companies, and more broadly, to all of society. 

• For companies, the promise is that being "good" will generate higher profits for the company, at least in the long term, with lower risk, and thus make them more valuable businesses.
• For investors in these companies, the promise is that investing in "good" companies will generate higher returns than investing in "bad" or middling companies. 
• For society, the promise is that not only will good companies help fight problems directly related to ESG, like climate change and low wages, but also counter more general problems like income inequality and uneven healthcare.

Given that ESG has been marketed as all things good, to all people, it is no surprise that its usage has soared, with companies signing on in droves to social compacts, and investors pouring hundreds of billions of dollars into ESG funds and investments. In the process, though, its advocates have either glossed over, or mixed up, three separate questions that need to be answered, on ESG:

The reason it is useful to separate the three questions is that it opens up possibilities that are often missed in both debate and research. For instance, it is possible that ESG does nothing for value, but that it offers a sheen to companies that allows them to be priced more highly than their less socially conscious counterparts and enriches investors, who trade on its basis. Alternatively, it is also possible that ESG does increase value, but that markets adjust quickly to this and that investors do not benefit from investing in ESG stocks. It also illustrates the danger of overreach from ESG research. Much of the research on ESG is compartmentalized, where only one of these questions is addressed, but the researchers seem to use the results to draw conclusions about answers the other two. Thus, a research study that finds that investors make higher returns on companies that rank high on ESG often will go on to posit that this must mean that ESG increases value, a leap that is neither justified nor warranted. 

ESG and Value

The framework for answering the question of whether ESG affects value is no different from the framework for assessing whether acquisitions or financing or any other action affects value. It is both simple and universal, and I have captured the drivers of value for any business in the picture below:

Figure 1: The Drivers of Value

In fact, my favorite propositions in value is the "It Proposition", which posits that for "it" (investing, financing, dividends, ESG) to affect value, "it" has to affect either the cash flows (through revenue growth, operating margins and investment efficiency) or the risk in those cash flows (which plays out in the cost of equity and capital). 

Goodness will be rewarded

Applying this proposition to ESG, the most direct way to induce companies to behave in a socially responsible manner is to make it in their financial best interests to do so. There is a plausible scenario, where being good creates a cycle of positive outcomes, which makes the company more valuable. Figure 2 describes this virtuous cycle:

In this story, being good benefits the company on multiple dimensions. Customers, attracted by the company's social mission, are more likely to buy its products and pay higher prices, increasing both growth and margins. The company is able to attract more loyal employees and suppliers, and build a model for investing that leads to more payoff from investments, i.e., more efficient growth. On the risk front, the company benefits from  investors who are willing to pay premium prices for their shares (thus lowering cost of equity), and lending that comes with lower rates and fewer covenants. Finally, by operating as a good corporate citizen, the company minimizes the chance of a scandal or a catastrophic event that could put its business model at risk. In the language of ESG, it creates a more “sustainable business”.  For proponents of corporate social responsibility, this is the best-case setting for their cause, because being good and doing well financially converge. This scenario holds, though, only because customers, employees, investors, and lenders all put their money where their convictions lie, and are willing to make sacrifices along the way, and it is more likely in some companies/businesses than others:

1. Smaller, rather than larger: While it is not impossible for a large company to hit all the high notes in the virtuous cycle, it is far easier for a small company than a large one, because even a small subset of all investors (consumers) can provide the capital (revenues) at the favorable terms needed for this scenario to unfold. 
2. Niche business, with a more socially conscious customer base: Adding to the smallness theme, it is easier for a company that serves a small customer base to attract customers with its ‘good company’ mantle than a company that seeks to reach a mass market. A company like Patagonia, with revenues of $750 million, can more easily make the compromises to stay socially responsible than a company like Nike, with revenues of $34 billion, which will be forced to make compromises that will undercut its goodness.
3. A privately held company or a public company with an investor base that values corporate goodness and prices it in: Being a private company can help, especially if the payoff to corporate goodness is long term, another point working in Patagonia’s favor. A public company that is closely held or controlled by its founders can also make choices that may not be feasible for a widely held company with a vocal stockholder base. 

It is worth noting that the companies that tend to be most vociferous about their social consciences tend to meet these criteria, at least early in their corporate lives. However, they will face a challenge, if they are successful and want to grow, because growth will bring in customers and investors not so committed to ESG. The acid test of social consciousness occurs when a company scales up and must decide whether to continue to grow or accept a lower ceiling on growth, and perhaps lower value, in order to preserve it good company status.

Badness will be punished

There is an alternate story that can be used to argue that companies should try to be socially responsible, but it is a more punitive one, where it is not good companies that get rewarded, but bad ones that get punished. This less upbeat scenario is described below:

Here, the punishment for bad companies is meted out from every direction, with customers refusing to buy their products, even if they are lower priced. These companies face higher operating expenses (and lower margins) in the long term, as they have trouble holding on to employees and finding suppliers. Equity investors avoid buying their shares, leading to higher costs of equity, and lenders are leery about lending money to these companies, leading to higher costs of debt. Finally, these companies risk exposure to grievous, or even catastrophic events, arising from operating with too little consideration of societal costs. It is often these events, such as the Union Carbide gas leak in Bhopal, Vale’s dam bursting in Brazil and BP’s oil spill in the Gulf of Mexico, that highlight shortcomings and create long term problems for the company. 

The Bad Guys win!

With regard to promoting social responsibility, the "bad behavior gets punished" scenario is not as good as the virtuous cycle, because it will tend to scare companies away from being “bad”, rather than induce them to be “good", but it is still better than a third and potentially devastating scenario for ESG advocates, where bad companies are rewarded for being bad, and become more valuable than good ones:

In this scenario, bad companies mouth platitudes about social responsibility and environmental consciousness without taking any real action, but customers buy their products and services, either because they are cheaper or because of convenience, employees continue to work for them because they can earn more at these companies or have no options, and investors buy their shares because they deliver higher profits. As a result, bad companies may score low on corporate responsibility scales, but they will score high on profitability and stock price performance. 

The Evidence

The question of which of these three scenarios is the right one is not one that can be settled by logic or with anecdotal evidence, but with data. For more than two decades now, researchers have examined the link, with the following conclusions:

1. A Weak Link to Profitability: There are meta studies (summaries of all other studies) that  summarize hundreds of ESG research papers, and find a small positive link between ESG and profitability, but one that is very sensitive to how profits are measured and over what period, leading one of these studies to conclude that “citizens looking for solutions from any quarter to cure society’s pressing ills ought not appeal to financial returns alone to mobilize corporate involvement”. Breaking down ESG into its component parts, some studies find that environment (E) offered the strongest positive link to performance and social (S) the weakest, with governance (G) falling in the middle. 
2. A Stronger Link to Funding Costs: Studies of “sin” stocks, i.e., companies involved in businesses such as producing alcohol, tobacco, and gaming, find that these stocks are less commonly held by institutions, and that they face higher costs for funding, from equity and debt). The evidence for this is strongest in sectors like tobacco (starting in the 1990s) and fossil fuels (especially in the last decade), but these findings come with a troubling catch. While these companies face higher costs, and have lower value, investors in these companies will generate higher returns from holding these stocks.
3. And a link to Failure/Disaster Risk: An alternate reason why companies would want to be “good” is that “bad” companies are exposed to disaster risks, where a combination of missteps by the company, luck, and a failure to build in enough protective controls (because they cost too much) can cause a disaster, either in human or financial terms. That disaster can not only cause substantial losses for the company, but the collateral reputation damage created can have long term consequences. One study created a value-weighted portfolio of controversial firms that had a history of violating ESG rules, and reported negative excess returns of 3.5% on this portfolio, even after controlling for risk, industry, and company characteristics. The conclusion in this study was that these lower excess returns are evidence that being socially irresponsible is costly for firms, and that markets do not fully incorporate the consequences of bad corporate behavior. The push back from skeptics is that not all firms that behave badly get embroiled in controversy, and it is possible that looking at just firms that are controversial creates a selection bias that explains the negative returns.

In summary, based upon the studies so far, the strongest evidence in support of ESG seems to be that "bad" companies face higher funding costs (from debt and equity), whereas the evidence on ESG paying off as higher profits and growth is elusive. There is some evidence supporting the proposition that being socially responsible (or at least not being socially irresponsible) can protect companies from damaging disasters, but selection bias is a problem.

ESG and Returns

To begin with, the notion that adding an ESG constraint to investing increases expected returns is counter intuitive. After all, a constrained optimum can, at best, match an unconstrained one, and most of the time, the constraint will create a cost. In one of the few cases where honesty seems to have prevailed over platitudes, the TIAA-CREF Social Choice Equity Fund explicitly acknowledges this cost and uses it to explain its underperformance, stating that “The CREF Social Choice Account returned 13.88 percent for the year [2017] compared with the 14.34 percent return of its composite benchmark … Because of its ESG criteria, the Account did not invest in a number of stocks and bonds ... the net effect was that the Account underperformed its benchmark.”  In fact, there is an inherent contradiction, at least on the surface, between the argument that ESG leads to higher value and stock prices, made to CEOs and CFOs of companies, and a simultaneous argument that investors in ESG stocks will earn higher (positive excess) returns, by investing in these companies.

Value, Price and Returns: The Interplay

Whatever your beliefs may be on whether ESG increases or decreases value, you have to start with a fresh slate, and incorporate market behavior, to make judgments on whether investors will benefit from ESG investing, as can be seen in the table below:

Consider the first outcome, where ESG increases the value of a company, but markets overreact to the goodness of the company, pushing up the price too much: investors in good companies will earn lower returns (negative excess) returns over the long term. Flipped around, this table also yields the counter intuitive result that studies that conclude that ESG investing earns positive (or negative) returns tell us nothing or very little about the underlying benefits of ESG, since the market acts as the intervening variable. 

The Evidence on ESG and Returns

It should come as no surprise then, that the research on the link between ESG and investor returns comes to split results:

• Invest in bad companies: There are the studies that we referenced earlier as backing for good firms having lower discount rates, including the ones that showed that sin stocks deliver higher returns than socially conscious companies. A comparison of two Vanguard Index funds, the Vice fund (invested in tobacco, gambling, and defense companies) and the FTSE Social Index fund (invested in companies screened for good corporate behavior on multiple dimensions) and note that a dollar invested in the former in August 2002 would have been worth almost 20% more by 2015 than a dollar invested in the latter.
• Invest in good companies: At the other end of the spectrum, there are studies that seem to indicate that there are positive excess returns to investing in good companies. A study showed that stocks in the Anno Domini Index (of socially conscious companies) outperformed the market, but that the outperformance was more due to factor and industry tilts than to social responsiveness. In a different study,  researchers looked at the payoff to socially responsible investing by comparing the returns on two portfolios, created based upon eco-efficiency scores, and concluded that companies that are more eco-efficient generate higher returns. Some of the strongest links between returns and ESG come from the governance portion, which, as we noted earlier, is ironic, because the essence of governance, at least as measured in most of these studies, is fealty to shareholder rights, which is at odds with the current ESG framework that pushes for a stakeholder perspective. 
• ESG has no effect: Splitting the difference, there are other studies that find little or no differences in returns between good and bad companies. A Morningstar Quantitative study of ESG stocks in 2020 found that companies that scored high on ESG generated mildly lower returns than companies that scored poorly, though the difference was statistically insignificant. In fact, studies that more broadly look at factors that have driven stock returns for the last few decades find that much of the positive payoff attributed to ESG comes from its correlation with momentum and growth.

In steady state, it is internally inconsistent to argue that good companies will benefit from lower funding  costs (lower costs of equity) and that investors can also earn higher returns at the same time. 

Glimmers of Hope for ESG Investing

There are two possible scenarios where being good may benefit both the company (by increasing its value) and investors in the company (by delivering higher returns).

1. Transition Period Payoff: The first scenario requires an adjustment period, where being good increases value, but investors are slow to price in this reality. During the adjustment period the highly rated ESG stocks will outperform the low ESG stocks, as markets slowly incorporate ESG effects, but that is a one-time adjustment. Once prices reach equilibrium, highly rated ESG stocks will have greater values, but investors will have to be satisfied with lower expected returns. The presence of a transition period, where markets learn about ESG and price them in can also explain why there may be a payoff to more disclosure and transparency on social and environmental issues, by speeding the adjustment. It is perhaps this hope of transition period excess returns that that has driven some institutional investors to become more activist on ESG issues and can explain why some have been able to show excess returns from increasing (reducing) their holdings in good (bad) companies. It is not just the large players like Blackrock and Vanguard that have jumped on this bandwagon, but also pure return-focused investors like Elliott Management and Third Point which recently targeted utility companies about their excessive carbon footprints. Their activism goes well beyond jawboning management and includes efforts that range from stopping mergers to proxy fights to altering boards of directors. This study examined 613 public firms that were targeted by an activist institutional investor focused on improving ESG practices and found positive excess returns in the 18% of engagements where the activism succeeded. 
2. Limit Downside: The other scenario where incorporating ESG into investing may yield a payoff is when investors are concerned about limiting downside risk. To the extent that socially responsible companies are less likely to be caught up in controversy and to court disaster, the argument is that they will also have less downside risk than their counterparts who are less careful. There is some evidence of this in this paper that finds that companies that adopt better ESG practices are less likely to see large drops in value. 

If there is an investing lesson embedded here, it is the unsurprising one that investors who hope to benefit from ESG cannot do so by investing mechanically in companies that already identified as good (or bad), but have to adopt a more dynamic strategy built around either aspects of corporate social responsibility that are not easily measured and captured in scores, or from getting ahead of the market in recognizing aspects of corporate behavior that will hurt the company in the long term.

The COVID effect

The last few months have been a test of ESG investing, and while the consensus view seems to be that ESG has passed the test, it is worth separating the facts from what is debatable. 

• Fund Flows (not debatable): It is not debatable that investors, whatever their reasons, have been investing more in ESG funds, both passively (through index funds) and actively (through ESG funds that contend that they can do better than the market). By early September 2020, impact investing index funds had risen to $250 billion in the US and more than a trillion dollars globally, with both numbers rising over the course of the COVID months. 
  
  
  
• Performance (debatable): The question of whether ESG funds have outperformed during the COVID crisis is more debatable. Early in the crisis, Blackrock asserted that sustainable investing had shown its value added, pointing to the fact that ESG indices were outperforming their market counterparts during the crisis months. The problem, though, is that Blackrock is not a neutral commenter on this issue, partly because Larry Fink has been a vocal salesman for ESG and  partly because Blackrock has ESG products to sell. It is true that Morningstar seems to provide backing for this proposition, when they presented the results on ESG funds during the first half of 2020:
  
  
  Morningstar noted that ESG funds in all 26 categories that they track outperformed their conventional index fund counterparts. The consensus view that ESG investing outperformed the  market is now getting push back, with this paper arguing that once you control for the sector tilt of ESG funds (they tend to be more heavily invested in tech companies), ESG, by itself, provided no added payoff during the down period of the crisis (February and  March 2020) and pushed returns down during the recovery phase.

If success in active investing is defined as attracting investor money, ESG has had a successful run during COVID, but if it is defined as delivering returns, it is far too early to be doing victory dances in the end zone.

The Bottom Line

In many circles, ESG is being marketed as not only good for society, but good for companies and for investors. In my view,  the hype regarding ESG has vastly outrun the reality of both what it is, and what it can deliver, and the buzzwords are not helpful. That is the reason I have tried to under use words like sustainability and resilience, two standouts in the ESG advocates lexicon, in writing this post. I believe that the potential to make money on ESG for consultants, bankers and investment managers has made at least some of them cheerleaders for the concept, with claims of the payoffs based on research that is ambiguous and inconclusive, if not outright inconsistent. The evidence as I see it is nuanced, and can be summarized as follows:

• There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.
• The evidence that investors can generate positive excess returns with ESG-focused investing is weak, and there is no evidence that active ESG investing does any better than passive ESG investing, echoing a finding in much of active investing literature. Even the most favorable evidence on ESG investing fails to solve the causation problem. Based on the evidence, it appears to me that just as likely that successful firms adopt the ESG mantle, as it is that adopting the ESG mantle makes firms successful.
• If there is a hopeful note for ESG investing, it is in the payoff to being early to the ESG game. Investors who are ahead of markets in assessing how corporate behavior, good or bad, will play out in performance or priced, will be able to earn excess returns, and if they can affect the change, by being activist, can benefit even more.

Much of the ESG literature starts with an almost perfunctory dismissal of Milton Friedman’s thesis that companies should focus on delivering profits and value to their shareholders, rather than play the role of social policy makers. The more that I examine the arguments that advocates for ESG make for why companies should expand mission statements, and the evidence that they offer for the proposition, the more I am inclined to side with Friedman. After all, if ESG proponents are right, and being good makes companies more profitable and valuable, they are on the same page as Friedman. If, on the other hand, adopting ESG practices makes companies less valuable, the onus is on ESG’s proponents to show that societal benefits exceed that lost value.

The ESG bandwagon may be gathering speed and getting companies and investors on board, but when all is said and done, a lot of money will have been spent, a few people (consultants, ESG experts, ESG measurers) will have benefitted, but companies will not be any more socially responsible than they were before ESG entered the business lexicon. What is needed is an open, frank, and detailed dialogue concerning ESG-related corporate policies, with an acceptance that being good can add value at some companies and may destroy value at others, and that in the long term, investing in good companies can pay off during transition periods but will often translate into lower returns in the long term, rather than higher returns. 

YouTube Video

Paper on ESG (with Brad Cornell)

1. Valuing ESG: Sounding good or Doing good? (with Brad Cornell)

My blog posts on stakeholder wealth maximization

1. From Shareholder Wealth to Stakeholder Wealth: CEO Capitulation or Empty Doublespeak? (August 2019)