ESG confusion continues unabated. Here’s the key question

There is more than the usual amount of confusion surrounding what companies are supposed to do besides pursue their financial interests and obey the law. A measure of the confusion is the explosion in terms describing what reformers would like to see. They would like to see the pursuit, not of “shareholder value,” but “enlightened shareholder value.” They advocate for “purpose-driven” companies, where “purpose” does not mean “making money.”

There are many other terms, the most prominent of which are “corporate social responsibility” or “CSR” and “Environmental, Social, Governance” or “ESG.” (“Sustainable” tends to get used a lot as well, but possibly because it is a rather long word that can’t be compressed into a three-letter acronym, it isn’t quite as common.) There is considerable conceptual confusion among these competing terms, which upon investigation does not seem entirely accidental.

Let’s take as an example “enlightened shareholder value.” This phrase was adopted with considerable fanfare in connection with reforms to the UK’s Companies Act in 2006. Presumably, it means something different from the plain “shareholder value” it replaced, but it is hard to pin down what this might be. The UK Companies Act requires directors to “promote the success of the company” for the benefit of their shareholders, but to take into account the long-term effects of their decisions, as well as the impact of those decisions on employees, suppliers, customers, “others,” the environment, the community, and the company’s reputation.

Practically and conceptually, this seems no different from the shareholder wealth maximization norm that it purports to amend. Any business corporation, whether claiming to pursue “enlightened” shareholder value or not, must work very hard to attract and retain the loyalty of non-shareholder constituencies—employees, customers, suppliers, relevant communities, lenders, and others—as doing so is essential to carry out a company’s profit-making activities. A good way of summarizing the situation is that the 2006 amendments to the Companies Act were a trick played on people who don’t understand (or like) business.

ESG’s weirdest aspect

A different kind of trick produced “ESG,” the most common phrase in use in the United States to describe governance that promotes social and environmental outcomes. This trick was designed to permit institutional investment managers to invest in ways that might arguably violate their fiduciary duty to maximize returns on their funds. Law professor John Coffee explains:

Conceptually, [lawyers] “rebranded” SRI [socially responsible] investing and converted it into ESG investing by asserting that consideration of the “governance factors” associated with public corporations would enable the fiduciary to identify superior investments and enhance risk-adjusted return…. This in turn enabled law firms to opine to their clients that ESG investing was fully compatible with the trustee’s fiduciary obligations.

This explains the weirdest aspect of ESG: how one criterion, “governance,” that has historically been focused on improving risk-adjusted shareholder returns, was incorporated into a conceptual unit that also contained social and environmental criteria focused on improving outcomes for non-shareholder constituencies. In this case, the trick was played on regulators and courts, but the outcome was the same: a conceptually confused phrase that could mean different things to different groups.

This deliberate confusion is not helpful. To be more precise in our terminology, it is necessary to consider what makes a decision made to advance a social or environmental goal different from a decision made to advance a profit-making goal, which only incidentally has positive environmental or social outcomes. A company can give employees a raise, but is that an investment to secure a more egalitarian society, or a necessity imposed by labor markets to prevent the best employees from leaving and working elsewhere?

In theory, almost any social objective can be justified as being in the long-term interests of a corporation. Businesses will best prosper on a planet that is not impoverished by a climate crisis, as well as in stable communities with lower levels of inequality, a vibrant middle class, and a respect for fundamental human rights.

‘How long term?’

The key question is: “How long term?” Not every activity taken to advance a social welfare objective is, in practice, justifiable as commensurate with shareholder value, “enlightened” or otherwise. In the long run, we are all dead, and this is also true of companies that must balance the return expected by certain long-term investments against the possibility that the company will no longer be around to enjoy the fruits of today’s sacrifices.

The discount rate applied to most corporate investments, itself partly a function of the corporation’s weighted average cost of capital, means that cash flows generated more than ten years or so in the future often have a small present value. This in turn means that when the net present value of an extremely long-term investment is evaluated, it is frequently less than the returns on alternative, shorter-term investments.

For example, in a recent paper, the finance scholar, Roberto Tallarita, shows that the discount rates used by investors “massively underestimate the social value of climate mitigation.” We might decry this fact, but that would probably be a mistake. Making investments in ways that generate the highest return for a firm (net of opportunity costs) is the essential mechanism that produces the wealth that makes modern life possible and generates the resources we require to deal with social problems. In any event, a corporation that consistently fails to make investments with the best risk-adjusted return will eventually go out of business.

In practice, deliberately ambiguous terms like “enlightened shareholder value” and “ESG” are rhetorical devices used to disguise the necessity for hard choices, in particular about the relevant time horizon and discount rate for corporate investments.

Read more: