A sceptical look at ESG

Anyone with more than a casual interest in business will be familiar with the increased focus on Environmental, Social and Governance (ESG) issues. There are sound arguments being made on both sides of the debate but I will admit upfront that I approach the topic with a somewhat ESG positive bias. Given my bias, it is all the more important to pay attention to what the sceptics are calling out rather than looking for affirmation amongst the true believers.

A post by Aswath Damodaran titled “Sounding good or Doing good? A Skeptical Look at ESG” is one of the better contributions to the ESG debate that I have encountered. I discussed one of his earlier contributions to the debate here and it is clear that he is not a fan of ESG. I am still working through his arguments but I like the analytical framework he employs and the way in which he supports his arguments with evidence.

I intend to do a couple of posts digging down into the ESG debate using Damodaran’s post and few other sources but want to start by laying out his arguments with some very limited comments.

Damodaran starts by framing ESG as part of a tradition of business ideas that have tended to prove to be more noise than substance, describing the ESG “sales pitch” as follows

“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”

There is no doubt that ESG, like many other business ideas, is prone to being over-hyped. There is room to take issue with the question of whether this is a fair description of the ESG movement as a whole. My gut feel is that presenting the “sales pitch” version is not representative of ESG advocates who genuinely believe that ESG can address problems in the ways the market currently operate, but it will be more productive to focus on the specific weaknesses that Damodaran discusses.

Damodaran starts with the problem of measurement

“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.”  

Assuming the measurement issues can be resolved, the second problem is identifying exactly how incorporating ESG factors into the business model or strategy contributes to improving the value of a company. Damodaran uses the following generic model of value drivers to explore this question

Figure 1: The Drivers of Value

Using this framework, Damodaran identifies two ways in which a company can derive benefits from incorporating ESG principles into its business strategy

  1. Goodness is rewarded – i.e. companies behave in a socially responsible way because it creates positive outcomes for their business
  2. Badness is punished – i.e. companies behave in a socially responsible way because bad behaviour is punished

Damodaran also identifies a third scenario in which “The bad guys win”

“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.”

Damodaran argues that the evidence supports 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) Some evidence that ESG focussed companies do reduce their risk of failure or exposure to 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.”

Damodaran sums up his argument

“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.”

There is a lot more to say on this topic. The evidence that certain types of companies do get punished for failing to be socially responsible is especially interesting. I see a fair degree of cynicism applied to the ESG stance adopted by the Australia banks but I suspect they are a good example of the type of company that will in fact benefit from making real investments in socially responsible business strategies.

Tony – From the Outside

Costco capitalism

I came across this blog post by Bryan Lehrer titled “Costco Capitalism” which I think offers an interesting variation on the discussion of companies seeking to do good, or even better, to “be” good.

It poses two questions:

  • whether some companies are built on “structurally fair” foundations that make it easier for them to be perceived as “good” or “fair” companies; and
  • what exactly does it mean to be an “ethical” company

This extract will give you a flavour of the author’s analysis of the Costco business model

Sustainable Capitalism? – What Costco shows us about the blurry relationship between ethical and fair

Costco shows that … simply providing your customers the feeling that they aren’t getting ripped off, and doing so in a way that matches mainstream views of acceptable externalities, is all that is required for success. If this sounds reductive, it’s because it is. The key to Costco’s success is just how straightforward the alignment of stakeholders within its business model are.

That being said, there are externalities associated with Costco’s business model, even if they aren’t viewed by the mainstream as such. The main thing here is a retail model that promotes rampant consumption, and the fallout from this which includes broad waste and sustainability concerns. Interestingly, because of Costco’s large purchasing power, dominance over its supply chains, and upper-middle class income of its shoppers, it generally has more progressive product standards than other retail brands in comparable price tiers.

Costco Capitalism, Bryan Lehrer

Lehrer argues that the foundation is to provide customers with “the feeling that they aren’t getting ripped off thereby building that elusive intangible asset of Trust that many companies routinely include in their statement of corporate values (e.g. “a Trusted Partner”). However, equally important is that the company can do this “in a way that matches mainstream views of acceptable externalities.

This qualification regarding externalities is the interesting part.

Other companies may have a credible claim to being able to provide a good or service cheaply but the often unasked question is what is the full cost of the good or service; i.e. is the low cost at the company/consumer level based on paying workers a subsistence wage with uncertain working hours, or reliance on an external supply chain with dubious environmental and labour standards. Lehrer notes that Costco could be vulnerable to criticism on a number of fronts (e.g. its business is, at its heart, a mass consumption model) but Costco is protected by virtue of adopting a position which fits community standards. Costco can afford to spend some of its efficiency dividend on progressive product standards but it is not necessarily pushing the boundaries of what might be done because it is also sensitive to what its customers are willing to pay for being good.

This framework (i.e. is our business built on an operating model that is structurally fair) offers a useful perspective when thinking about financial services companies. Initiatives such as the Bankers’ Oath have a contribution to make in addressing the cultural issues in banking but I suspect that there is as much value (potentially more) in exploring the structural features of the industry that create the pressure to cut corners in the pursuit of financial targets.

I don’t expect anyone will change their mind about bankers and banking in general on the basis of this post. I do hope to make the point that there are subtle structural challenges in banking that complicate the capacity to do good. Developing a better understanding of the structural issues is I think essential to crafting a lasting solution to the cultural issues. I don’t have any neat answers but I do feel that the issues covered in Bryan Lehrer’s analysis of Costco offer some insights.

Tony – From the Outside