By Frederick Alexander, CEO at The Shareholder Commons
Here is a circumstance that neither ESG-oriented investors nor their opponents like to talk about: greed can be bad, even for market-minded capitalists.
We know both sides of the ESG debate. On one side, investors push companies to reduce carbon emissions, address inequalities, and otherwise treat the planet and its inhabitants better; they argue that by doing good, these companies will make more money in the long run. They believe greedy companies will be good, as long as they are also smart.
On the other side, fuming politicians and trade associations characterize ESG as a politically motivated attempt to achieve social ends by sacrificing corporate profit; they warn that if companies prioritize environmental and social impact, there will be less profit for investors. And if you can make your way past their climate denialism and dog whistles, they also make the Smithian claim that allowing individual companies to maximize profit benefits the economy overall, because it is the best way to allocate scarce resources.
So both camps agree that greedy companies are good for shareholders and the economy; they just disagree about whether addressing ESG concerns is actually profitable for individual companies. ESG practitioners say “yes,” but Vivek Ramaswamy and the National Association of Manufacturers say “no.” But almost everyone conveniently ignores a hard truth: successfully greedy companies are often very bad—for the planet, for people, for the economy, and (here is the hard part) for their own investors.
Three facts underlie this conundrum. First, companies can profit—even over the long-term—by externalizing costs that hamper the rest of the economy: if you let someone else clean up your messes, you have fewer expenses, which means higher margins. Second, investors can only optimize risk and return by diversifying their portfolios. Third, the return of a diversified portfolio depends almost entirely upon overall economic performance.
Together, these facts mean that individual companies can increase returns by externalizing social and environmental costs, thereby damaging the economy and reducing the returns that investors earn from the rest of their portfolios. In other words, companies can be profitable while destroying value both for the economy and their own investors.
For example, many companies believe they can maximize their financial returns to their own shareholders with practices that use more than their fair share of the carbon budget, yet one recent study from a sovereign wealth fund showed that the failure to address climate change is likely to decrease compound annual returns of an average portfolio by 30% over the next 40 years.
These divergent perspectives –that of the individual company versus that of a diversified portfolio–create a conflict of interest between corporate managers and their shareholders because, unlike most investors, managers are not diversified—they are incentivized by equity and career interests to optimize the value of their own companies.
This divergence leads corporations to drag their feet on ESG—the problem is not that corporate managers do not understand the impact of carbon reduction on their profits; the problem is that they do. It also explains the need for investor-led system stewardship: shareholders are the only link in the corporate chain of responsibility that has both the power and the incentive to include corporate externalities in their calculus. Value-seeking investors can and should prioritize healthy social and environmental systems over individual company profits.
To do so effectively, investor stewards must end the tyranny of individual company profit in the financial world: a company’s success on behalf of investors cannot be measured solely by its own financial returns—its impact on the rest of investors’ portfolios must be factored in as well. Capitalism’s promise of market-driven economic efficiency can only be satisfied if investors—including fiduciaries like investment advisors, consultants, and trustees—insist that portfolio companies forgo profits based on system-degrading practices that threaten broad market returns. Investors should promote practices, laws, and regulations that leverage the unique and critical role that investor stewards can play in a market economy.
Frederick Alexander is the CEO of The Shareholder Commons, an NGO focused on protecting the interests of diversified investors.
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