The ESG movement has been taking a bit of a beating in recent months — a not-surprising blowback to what appeared to be an emerging conventional wisdom. Many of my clients are asking whether ESG is a fad that will fade in the coming years or whether it represents a fundamental change in the way western business enterprises will operate going forward. ESG is also a central topic of discussions in many of my Oxford EMBA courses and is clearly a subject very much front-of-mind for current and future business leaders and academics. My strong sense is that ESG, in one form or another, is here to stay. There are clearly faddish aspects to the ESG movement, but there are several core ESG concepts that I believe will remain with us for decades.
I share here my perspectives on the philosophical underpinnings of ESG and argue that it is in fact consistent with shareholder capitalism. I then provide some thoughts on how businesses can and should address ESG issues in practical and profit-maximizing ways.
The Theory: Consideration of ESG Issues is Consistent with Shareholder Capitalism
The often-discussed ESG-versus-profit-maximization dichotomy presents a false choice. I generally accept Milton Friedman’s position that “there is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” (Friedman, 1970) While there are persuasive critiques of the absolutist version of this statement,1 in my view it is not necessary here to choose between shareholder and stakeholder capitalism because there is enough “play in the joints” of the profit maximization theory to accommodate — and indeed to encourage — consideration of ESG issues in managing a business enterprise. Friedman’s two embedded qualifiers are key.
The first is that the profit maximizing corporation must operate “within the rules of the game.” ESG considerations are now and will increasingly play a role in forming the “rules of the game.” There are, of course, the actual rules of the game set by laws and regulations, with which all businesses must comply. Currently, ESG rules are largely limited to disclosure requirements largely focused on climate impact and governance issues (executive pay, board diversity, etc.) A company can face liability for misrepresenting its activities and impacts in these disclosures, but the current legal regimes are not particularly strong or prescriptive. It is reasonable to expect, however, that governments will increasingly regulate and legislate on ESG-related issues and that compliance with those legal regimes increasingly will become a price of doing business.
Beyond laws and regulations, there are also softer considerations involving the expectations of stakeholders (governments, media, customers) that a business be, and be perceived as, ESG-responsible. These expectations are forming a bar corporations must clear in order to be considered to be legitimate and viable and to operate with social license. Each business operates in society and ultimately depends on social license, without which there can be no business and thus no profit maximization.
The second qualifier is implied in the profit-maximization imperative: Profit maximization for shareholders must be considered over time, and the goal should be to increase enterprise value over the long term. Many ESG initiatives are entirely consistent with long-term profit maximization. For example, there can be a direct relationship between good environmental stewardship and simple cost reduction, which is directly aligned with profit maximization. Eliminating waste and securing a viable long-term sustainable energy supply simultaneously check both ESG and profit-maximization boxes.
Longer term, ESG issues may affect profitability by potentially impacting a firm’s cost of capital. Some key sources of capital are expressing a preference for ESG-responsible firms. According to a recent McKinsey report, investment inflows into self-described sustainable funds increased from $5 billion in 2018 to $70 billion in 2021. (Perez, et al., August, 2022). BlackRock, the world’s largest asset manager, has made it quite clear that it values and prefers companies that prioritize ESG: “As stewards of our clients’ capital, we ask businesses to demonstrate how they’re going to deliver on their responsibility to shareholders, including through sound environmental, social, and governance practices and policies.” (Fink, 2022) While there certainly has been considerable pushback to the notion of asset managers imposing their personal views on controversial political subjects through investment choices (manifested most obviously in the philosophy and approach of Strive Asset Management2), the pro-ESG bias appears to be real. And lower cost of capital leads to increased profitability.
Considering ESG in corporate decision making can also positively impact long-term profitability in other ways, including the following:
- ESG-conscious decision making can result in less regulation for the firm in the future, and more freedom to operate without regulatory interference can increase the firm’s profitability.
- Good governance and solid ethics and compliance can help a company avoid expensive and disruptive regulatory enforcement actions and even receive more lenient treatment in the event that regulatory violations do occur. (Hong & Liskovich, 2015)
- Companies that take ESG seriously may have an edge in attracting talent, which many businesses consider to be the most critical challenge in sustaining long-term profitability.3
- Good governance aligns incentives appropriately, avoids conflicts of interest and other misalignment of interests, and thus affects profitability long term.
A corporate decision based solely on ESG considerations, not required by law or regulation, that had no impact on the firm’s social license to operate, and that would reduce corporate profits consistently and over time would, in my view, be indefensible. That would turn the corporation into a charity, would breach numerous duties to shareholders, and writ large would virtually assure overall economic decline. But, as explained above, the either/or choice is a false one and, in fact, ESG can and should be taken into account by any profit-maximizing firm.
The Practical: How ESG Issues Should be Taken into Account by Profit-Maximizing Firms
Having rejected the false choice of either pursuing ESG goals or pursuing profitability for the benefit of shareholders, I now turn to the problem of how firms can and should use ESG considerations in making business decisions.
This is a fundamental challenge given the uncertainty surrounding ESG targets and the sometimes-inconsistent goals in ESG metrics. One of the valid criticisms of ESG is the lack of meaningful standards and metrics for measuring firms’ performance. The trendiness and fickleness of ESG criteria make it difficult to take ESG into account in making rational business judgments. A number of private ratings agencies (e.g., MSCI, Refinitiv, S&P Global, Sustainalytics) provide ESG metrics and are competing to become the standard measure of ESG performance for business. (Perez, et al., August, 2022) But the absence of a single standard creates challenges. And the ratings systems are inconsistent with each other, prioritize different aspects of ESG, and can even be contradictory, with advancement in one goal or priority necessarily coming at the expense of another.
In addition, the shifting sands of ESG priorities make rational ESG-driven business decisions difficult. It would be impossible and incoherent to pursue all ESG-related goals simultaneously, and there is frankly no way to know which way the fickle ESG winds will blow in the future. The focus on emissions today might be viewed as of secondary importance in 10 years, and responsible water use may get all the attention. Diversity and inclusion may be top of mind in 2022 but replaced as a priority by concerns over forced labor issues in 2023. Moreover, it is nearly impossible to prioritize between and among the various ESG goals and objectives. What should a company do when faced with a business decision that requires a tradeoff between, say, reducing emissions or taking care of local employees? While the ratings will improve and perhaps universalize, ESG, which is founded on some notion of a consensus view of what is “good and right,” will always be subject to shifting media and public opinion. Yesterday’s polar bears become today’s ocean plastics become tomorrow’s who-knows-what. The absence of a clear set of targets will always pose an obstacle to rational, profit-maximizing business decision making.
Rather than chase the ESG “cause of the day,” smart companies will focus their ESG investments and consider ESG issues in three profit-maximizing ways:
- Companies should invest in good governance and strong compliance and internal financial control systems. Governance has been a critical component of profit-maximizing business operations long before it was the G in ESG. Investments in compliance and internal audit personnel and good controls technology generate ESG credit for the firm and also help it avoid legal, compliance, and reputational problems that destroy shareholder value. Good governance also helps assure compliance with the law and with the baseline standards (e.g., not employing child labor) to protect a firm’s social license to operate.
- Firms should favor investment in projects that reduce waste, promote energy conservation, and reduce emissions in a way that promotes long-term profitability. This preference should be built into the firm’s models of assessing project profitability and for making strategic sourcing and other supply chain decisions. Lowering waste, reducing energy costs, and minimizing emissions through individual decisions will check both ESG and profit-maximization boxes.
- Companies should deploy the approach outlined by Professors Porter and Kramer for dealing with Corporate Social Responsibility (CSR) issues (the ESG of an earlier era), which advocates for advancing ESG goals in a very company-specific way that maximizes the impact for society and provides a competitive advantage for the company. (Porter & Kramer, 2006) Strategic ESG efforts “move[] beyond good corporate citizenship and mitigating harmful value chain impacts to mount a small number of initiatives whose social and business benefits are large and distinctive” and help develop the firm’s competitive advantage. (Porter & Kramer, 2006)
A good example of this sort of strategic ESG effort was IDEXX Laboratories’ response to the Russian invasion of Ukraine. IDEXX is the global leader in pet healthcare products and services. In furtherance of its S(ocial) goals, the company wanted to do something to support displaced Ukrainians affected by the war. But rather than simply donate to a pro-Ukrainian cause, IDEXX focused its effort on supporting both refugees and their pets, supporting animal shelters and zoos and veterinary teams at border crossing points between Poland and Ukraine.4 This approach brilliantly helps build IDEXX’s brand while advancing an ESG initiative.
One final word: It may go without saying, but it is critically important for companies to ensure that ESG representations made on their behalf are accurate, as misrepresentations can lead to liability today. Smart companies will build good controls and systems to prevent “greenwashing” and to ensure communications about ESG efforts are fair and accurate.
David W. Simon originally posted this essay on LinkedIn.
1 For what it’s worth, Professor Freeman’s core critiques of the absolutist profit maximization imperative are powerful. From a legal perspective, society has always imposed limits on what corporations can and cannot do. Moreover, corporate law — a social construct that allows for-profit firms to exist — gives only certain legal rights to shareholders and does not treat them as unfettered “owners” in any meaningful sense; shareholders have specifically defined rights (usually, voting, dividends and residual value) created by corporate law and individual corporate charters, articles and bylaws. From an economic perspective, there are always externalities to operating a business, which the absolutist version of Friedman’s position assume away. (Freeman, 1994)
2 See https://www.strivefunds.com/about-us.php?utm_medium=ad&utm_source=rta_googlesearch&utm_campaign=rta_strive_launch_20220809_strivebm_na_googlesearch_na_25-99_us_a053_all_na_na_na_bc0087_search_lp005_na_na
3 A Deloitte survey of Millennial and Gen Z workers found that their level of satisfaction with their employer’s commitment to societal impact, diversity and inclusion, and sustainability have a direct impact on job loyalty. (Deloitte, 2022)
4 See https://www.linkedin.com/feed/update/urn:li:activity:6913111657556631552/
