A Time for Choosing: Shifting the Investor Narrative to Reduce Environmental and Social Impact
Diversified investors must attend to systemic risk and stop hoping that everything that improves financial return at a single portfolio company will improve financial return of the portfolio overall. — Frederick Alexander, CEO, The Shareholder Commons
The Shareholder Commons has completed its first proxy season catalyzing beta stewardship and advocating for investors to prioritize systemic health over the financial returns of individual companies. We will issue a detailed report this summer recapping successes and challenges and laying out next steps.
We have learned a great deal in the past year. The most important lesson is how ingrained company-first thinking is. Even as environmental, social, and governance (ESG) activists lambaste shareholder primacy, they accept the basic message that a company’s long-term financial return to shareholders is the ultimate measure of success for corporate executives. The movement is haunted by an unspoken assumption (and sometimes a bald assertion) that every company can adequately reform its behavior without having to accept reduced long-term financial return.
But this assumption — that companies face no tradeoffs between ESG impact and financial return — reinforces the dangerously oversimplified belief that companies that optimize for shareholder return also optimize social returns. Because recent activist victories have accepted the premise of this flawed paradigm, there is an increasing risk that the ESG movement will fail to separate itself from a naïve conflation of profit and value creation. But as the questions get harder, this misconstrued association threatens to undermine the utility of shareholder activism as a tool to prevent the catastrophic risks that current business activity creates.
Cost Externalization Underlies the Reality of Tradeoffs
“There are no solutions; there are only tradeoffs.” — Thomas Sowell
The reality is that companies often can and do make money in ways that externalize costs to the rest of society. Imagine a manufacturer that burns coal because it is cheaper than converting to natural gas or a renewable energy source. Its financial returns go up, but as one tiny cog in the economy, it bears only an infinitesimal portion of the incremental increase in climate risk.
As a result of this imbalance, the decision may well be value-enhancing for the company. But from a global perspective, the calculus is much different. Because the economy as a whole bears the full cost of the dirtier fuel, the decision is much more likely to be value-destroying at that level. The same is true for most investors, who are diversified and thus own a slice of the economy. Their portfolios will suffer because they internalize much of the costs that the single coal-burning company was able to externalize.
Doing Well by Doing Good Is Not Enough
But this creates an uncomfortable situation: If what is good for a single company is bad for most portfolios, then investors will need to tell some companies to reduce financial returns. That is a tough message. It is much easier to ask companies to improve their ESG performance in ways that also increase return to the shareholders of the individual company in question. For example, if converting to renewable energy has upfront costs that will take 10 years to recoup, shareholders can make the case to the company that they will support the long-term investment even if it reduces cashflows in the short term.
This strategy of “doing well by doing good,” sometimes called “ESG integration,” does not address the brute economic fact that there will continue to be opportunities to make money by exploiting common resources and vulnerable populations. Forgoing these opportunities to “do even better by doing bad” will reduce a company’s return to shareholders — even over the long term — and it is here that the important, difficult questions reside.
This uncomfortable truth applies to many issues. Maintaining a healthy economy may require that social media companies surrender long-term financial value by giving up advertising revenues that come from carrying anti-vaccination messages and racist podcasts. Food and pharma companies may have to spend more money to limit the amount of antibiotics in the environment to preserve the efficacy of antimicrobials upon which our economy depends. Adequately addressing racial disparities and other inequalities around the globe will require companies to invest in justice to build a more productive society, even if the investment isn’t paid back at every company.
The Risk Management Connection
Proponents of ESG integration will point out that my description of the coal-burning example is too simple: It does not account for potential regulations that will make coal combustion more costly, nor for the likelihood that consumers and workers may avoid companies that are not green enough and that companies that act badly may lose their “social license to operate.” All these possibilities create risks that a company must account for when deciding whether to make the switch in energy sources. Thus, ESG integration is often described in terms of “risk management,” or getting ahead of coming legal and cultural imperatives to reduce externalized costs.
ESG proponents push this risk management concept as far as they can, even to the point of claiming that it eliminates tradeoffs. They argue there is a risk that any significant externalization of costs will eventually catch up with a company through law or stakeholder rejection. But to believe that regulatory and social risks will make irresponsible behavior financially untenable is surely the triumph of hope over experience. Consumer choice and regulation have never yet combined to force business to internalize externalities. More fundamentally, by keeping the focus on risks to the company, investors ignore the risks that companies pose to the systems in which all the investments are embedded.
Moreover, if company risk is the only concern, then the best strategy for a company may be to reduce its legal and social license risk by shaping law and public opinion. This is why many energy companies seem to spend as much on advertising their renewable energy projects as they do on the projects themselves and why companies just cannot quit political spending.
The Trap of Risk Management
But if the only downside of ESG integration were its incomplete nature, we could just applaud it and look for other strategies to address the harder issues. The greater concern is that the focus on company-level return dilutes the power of a systems-first perspective that can reframe the calculus that currently rewards negative-sum behavior. This reframing allows shareholders to legitimately insist that a company’s cost externalization cease, even if cessation lowers the long-term value of the company.
In contrast, continuing the company-first narrative justifies compensation to both corporate executives and asset managers that incentivizes strategies that directly reward returns earned through behaviors that threaten critical systems. It limits the ability of fiduciaries who manage assets to articulate the need for systems-first activism even if it reduces the return of some portfolio companies. It empowers corporate and political actors who want to push back against any investor action on ESG matters that do involve trade-offs and gives license to strategies that continue to threaten social and environmental systems as long as consumers and regulators can be persuaded to accept or ignore them.
Optimizing Within Boundaries
To be effective advocates for maintaining and enhancing the systems in which all their investments are embedded, investors must shift the narrative away from a company-first model and focus first on the ecological and social boundaries that all companies must respect. They should continue to make sure portfolio companies are optimizing financial return, but only within those boundaries. Until this message is made loud and clear, shareholder advocates for better ESG impact will remain mired in the very same conceptual errors that their shareholder-value predecessors made.
The greatest promise of ESG-focused shareholder activism is precisely in filling in the gaps that law and culture otherwise fail to address. The unique opportunity for diversified shareholders is that they have the power to bridge that gap through corporate governance and they have the incentive to do so, because their broad investment in the global economy leaves them no room to escape the consequences of irresponsible corporate behavior.
This article was originally shared in The Shareholder Commons newsletter. B The Change gathers and shares the voices from within the movement of people using business as a force for good and the community of Certified B Corporations. The opinions expressed do not necessarily reflect those of the nonprofit B Lab.
