Claims about the end of ESG or that ESG is irretrievably flawed do not address the bigger question: what is the firm’s role in society? Should the private sector or the public sector be responsible for holding firms accountable?
I have been on several panels where someone invariably says “ESG” is a useless label with too much political baggage or is definitional Swiss cheese. Fair enough. Well, there’s a lot of heated rhetoric about the ESG debate today with critics across the political spectrum. But when you put the politics aside, the big debate is the division of labor between the public and the private sector.
Right now, most of the ire on the right is directed at investors but it is ultimately companies who make the resource allocation decisions that shareholders and other stakeholders care about and pay attention to. The core issue here is ‘corporate accountability.’ For what should companies be held accountable under existing laws and how can they be held so?
That is, can we instead focus on identifying firms that misallocate shareholder capital, human capital, natural capital, and taxpayer money? That’s why I am interested in the area, and I could not care whether these ideas are packaged under one set of letters or the other.
I think a conversation needs to occur around the following ideas:
· Natural capital: We set the cost of natural capital to zero in firms’ balance sheets. I don’t know how to value natural capital, but I do know that the value thereof is not zero. There is a robust discussion of valuation of natural resources of the country in sovereign accounting. Some of that discussion needs to be imported into the domain of corporate finance.
· Positive externalities: The reporting model we use today, by and large, does a poor job of measuring externalities, both negative and positive, that companies generate. Companies retain a tiny fraction of the benefits of the R&D they create. Yes, Pfizer made a lot of money on the Covid vaccine. But they saved us even more money via recovered GDP by getting more people to work after their jabs. Where does the value of the saved GDP show up?
· Negative externalities: And, of course, companies such as Starbucks leave behind thousands of paper cups that are not recycled or Coca Cola is perhaps the largest producer of unrecycled plastic in the world. Where do the costs imposed by these negative externalities show up on their income statements? Of course, they do not show up anywhere. Even if they did, it’s not clear investors would or should care, if dealing with them would hurt shareholder value. The same can be said for positive externalities.
May be the issue here is investor horizon. Investors with short to medium horizons that bet on these negative externalities not getting internalized in the firms’ cash flows or cost of capital would likely not care. A “universal” owner who holds the stock till it gets kicked out of the index would care because that owner has a longer horizon. As the political right has done, you can always question whether something that far down the pike is forecastable or material given that discount rates these days are somewhat meaningful. To make matters worse, companies actively lobby to ensure that these negative externalities are not internalized, a point I come to later.
· Taxpayer funds: We also need a better sense of what companies pay the US Government by way of taxes and conversely, how much they get from the Government by way of grants, loans, subsidies, bailouts and, on the net, who comes out ahead: the taxpayer or the shareholders of the firm?
· Lobbying: What companies say they care about and are doing in their sustainability reports may be at variance—sometimes substantially so—with their lobbying efforts and the dollars put on them. To what extent are companies supporting policies about things they say they care about vs. saying one thing but doing another to undermine policies which would support their stated commitments? And, lobbying is so lucrative that a cynic would argue that firms under-invest in this activity!
· Managerial accountability: This is the meta category of ideas because it’s basically where they all come home to. How well does the manager use shareholder funds, the natural, human capital and taxpayer money they are entrusted with? As discussed in my series on passive investing, I worry that such accountability has become harder to enforce. Perhaps ESG as a movement emerged concurrently with passive indexing to raise some of these questions related to accountability.
What about measurement and disclosure?
As I said above, there is a fundamental question regarding the role of the corporation in society. To what extent should a company be held accountable for the positive and negative externalities it produces even if these are unrelated to shareholder value? Of course, it’s hard to know if they are or not if shareholders don’t have the information they need which gets to my fundamental argument about the need for measurement.
Accounting rules and even the ISSB don’t get into the externalities (e.g.., double materiality). It’s hard to measure these things but not impossible. Coming up with a stakeholder value add statement is not impossible. As Steve O’ Byrne and I show here, we can compute the value that the corporation adds to employees as the compensation the worker gets relative to her next best alternative. We routinely calculate the value the firm added to shareholders. We can extend the same idea to the value that the corporation adds to its suppliers (the price that she gets from the company relative to her next best alternative), customers (the price that she pays to buy a product or a service from the company relative to her next best alternative), and the taxpayer (what the company pays via taxes relative to the subsidies and grants and the cost of concessional loans and an extended version could include the indirect jobs and the tax revenue the firm helps to generate).
But why should companies incur the costs of doing so? For at least three conceptual reasons.
· Perhaps shareholders need to know. But if they know and don’t care, these issues must be addressed by public policy rather than saying management should be accountable for these things.
· The possibility of tail risk: If you are a universal owner such as one of the Big three indexers as in the long run, mis allocating natural capital, human capital and taxpayer money will come back to bite the firm. Many of my friends on the political right claim this argument is a red herring. I respond that the risk is as real as accounting fraud. Perhaps 5% of your portfolio commits accounting fraud. As and when that gets revealed, you lose the entire principal associated with your investment.
· Branding and advertising: As the new generation of investors and customers begin to care about the footprint that companies leave on society, there are at least some payoffs to be had in measuring and disclosing relevant parts of stakeholder value added, either in terms of market share or dedicated shareholder clientele or even regulatory largesse or forbearance (the regulator is less likely to go after the firm if its stakeholder value add is very high). Note that the regulatory largesse idea has been used many times in the recent past when the US government bailed out banks, the Detroit auto industry, or provided substantial grants (not loans) to the airline industry during Covid.
So, bottom line, claims about the end of ESG or that ESG is irretrievably flawed are partly right. But, in my mind, they do not address the bigger question: what is the firm’s role in society? Should the private sector (via naming and shaming or celebration via branding payoffs) or the public sector (via effective regulation and enforcement or subsidies) be responsible for holding firms accountable for (i) externalities; and (ii) misallocation of capital (natural and human); and (iii) use of taxpayer money.