ESG has become a very popular concept among the investment community and, therefore, among the management boards of large corporations. Corporate governance reports, webinars, press articles, and blogs discuss ESG and very often go as far as claiming that applying these frameworks leads to corporate profitability improvements and eventually stock price outperformance. But is that truly the case? And if it is, why have corporations missed it for centuries?
The matter is a bit more complex than it appears at first glance. Arguably, the broad adoption of ESG works insofar as it drives the right behaviour by corporations, but that is mostly because it essentially internalises what were previously cost-less externalities, rather than improving profitability.
ESG and externalities
An externality is an economic term used to describe an indirect cost or benefit to an uninvolved third party that arises as an effect of another party’s activity. Air pollution caused by, say, motor vehicles or factories, is a classic example of an externality. The automotive company manufacturing a truck, or the energy company operating the coal-fired power station, do not typically bear the healthcare and social costs of highly polluted air. Yet they do financially benefit from those activities, and therefore have no economic incentive to curtail them. For instance, very often it is more profitable to operate the old polluting coal-fired power plants than invest in less power-efficient solar and wind energy facilities.
Furthermore, externalities are quite difficult to manage even if the market is an oligopoly and coordination would be expected to be easier. For instance, a single energy company deciding to do the right thing and operating cleaner energy-producing facilities will end up having either lower profits or sales, or possibly both, depending on whether it passes its higher costs to its customers or not, unless all its competitors play by the same rules. The same applies to the farmer raising chickens in more spacious and humane facilities, or the fast fashion retailer not exploiting a child labour force.
An incentive to cheat
Particularly when non-compliance with the principles is difficult to detect, the incentive to cheat is very high, or is the dominant strategy, as the economist, game theory researcher, and Nobel Prize winner John Forbes Nash would describe it.
A dominant strategy is such that a player will choose a strategy that will lead to the best outcome regardless of the strategies that the other players have chosen.
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By GlobalDataFrom the point of view of a single energy company, if all its competitors do not adopt more expensive clean energy production technologies, its best strategy to maximize profits and retain market share is to not do so either.
If, on the other hand, its competitors decide to incur higher production costs to adopt green energy principles, its best strategy to maximize profits is still to not do so, as it will become the market participant with the lower production costs and would be able to compete on price.
Policymakers have long grappled with the need to internalise those externalities, so enterprises will be forced the do the right thing because to do otherwise will cost them financially. The easier way to do this has historically been regulation with a combination of proportionate fines and incentives. This is how working conditions at factories improved during the 19th century, and the safety of many products was improved.
ESG is a force to internalise externalities, rather than improve profitability
Enter ESG-driven responsible investment. This approach explicitly acknowledges the relevance of environmental, social, and governance factors, and of the long-term health and stability of the market as a whole. In a way, it incorporates both a longer-term horizon and a ‘greater good’ principle into the mix.
While investing in the stock of a higher-profitability but polluting company would drive higher returns for an equity portfolio in the near term, its contribution to the destruction of the earth and overall higher health and social costs means that it is not a good idea in the long term.
If enough investors follow responsible investment principles, they will end up increasing the cost of capital for non-ESG-compliant companies, as they will find it more difficult to raise capital to fund their operations. This is effectively a way to internalise their polluting externality.
Indeed, since the term ‘ESG’ was first used back in 2004 in the Who Cares Wins report by a joint initiative of financial institutions at the United Nations (UN), the ESG movement has grown into a global phenomenon representing more than $30 trillion in assets under management.
Damage to the brand
Another way in which ESG is driving the internalisation of externalities is reputational, particularly via ESG scores, such as Bloomberg ESG Ratings, CDP Scores, or FTSE Russell’s ESG Ratings. At this point, most public companies are very aware that having low ESG scores damage their brand, ultimately driving customers away. Again, what was an externality now becomes an internalised cost in potential revenue losses.
Interestingly, there is significant research showing that stocks of companies with higher ESG scores tend to deliver a better price performance over time. That said, in this type of analysis the issue of correlation versus causality is always present.
It is difficult to know whether management teams adopting ESG principles are simply better managers on average and therefore also drive better returns via their superior operational skills.
ESG works by driving the right corporate behaviour and therefore creating overall value for all organisational stakeholders, such as customers, suppliers, employees, leadership, and the environment. But let us not fool ourselves, this is mostly because ESG essentially helps internalise what previously were cost-less externalities, rather than improving corporate profitability.
