Environmental, social and governance investing is ascendant. Its mirror image, stakeholder capitalism, is now the standard mantra on boards and in executive suites.
This is not cause for celebration. Both rest on weak conceptual foundations and should be viewed suspiciously by investors who seek adequate returns, and by citizens who want real rather than cosmetic change.
The business and financial establishments endorse the new consensus. BlackRock, the world's largest asset manager, released an open letter warning companies that it would "be increasingly disposed" to vote against boards moving too slowly on sustainability.
The World Economic Forum in Davos says that companies exist to create value not just for shareholders but "employees, customers, suppliers, local communities and society". A letter from the Business Roundtable, signed by prominent chief executives, promised to "commit to deliver value to all" stakeholders.
Investors have responded. In the first half of 2020, net inflows into ESG funds hit US$21 billion ($32.1b), according to Morningstar, almost matching last year's record total. But behind ESG and stakeholderism lies a dangerous idea: that shareholders' economic interests and the social good always harmonise over the long run.
It is true that when companies subordinate everything to maximisation of shareholder value, it backfires. When IBM, a company that long prioritised technological excellence, shifted its focus in 2012 to a target of hitting US$20 in earnings per share a few years later, it was the beginning of the end for both IBM's industry leadership and its rising share price. General Electric has never recovered from its decision to chase "easy" profits by turning into a finance company in the 1990s. The list goes on.
So ESG supporters are right that companies cannot always maximise long-term profit by aiming to do so. They have to shoot instead to deliver excellent products, which creates profit as a side effect. In many cases, excellence creates good stakeholder outcomes too, from investment in employees to lower carbon emissions. But this does not mean shareholder returns and the social good can always align. And there is one important way in which the two must come apart.
Part of the justification for ESG investing is that divesting from certain industries (fossil fuels or tobacco, say) creates economic pressure for change, in the way that boycotting a company's products might. Divestment increases a company's cost of capital: when fewer investors line up to buy its shares or bonds, it must sell them for less. This makes it more expensive for it to invest in socially destructive projects.
The necessary corollary? ESG-friendly companies' cost of capital goes down, as dollars are channelled their way instead. Their shares and bonds become more expensive. All else being equal, that must mean lower returns for the ESG investors. If returns are not lower, then ESG investors choices have not affected corporate incentives at all.
Given that this is so, many ESG advocates take a different tack. They argue that the point is not to change corporate incentives but to invest in companies that will thrive financially precisely because they take ESG seriously.
There may be a distant and ideal future when this will be achieved. But even the best corporate leaders cannot look out to the end of days. They make choices about what they can foresee with a degree of confidence. At that range, it is obvious that shareholders' and stakeholders' interests can conflict. If they did not, there would be far fewer lay-offs announced and far fewer oil wells drilled. If stakeholder capitalism means anything, it is that corporate leaders must sometimes make choices that benefit stakeholders at the cost of shareholders.
The financial mandarins' manifestos ignore such trade-offs, and say nothing about how they might be managed. They merely repeat that, in BlackRock's phrase, social purpose "is the engine of long-term profitability".
If corporate leaders are silent it is because they know how they will choose when such conflicts arise. They are paid in stock, and if monetary incentives are not enough, there are legal ones. Most US companies are incorporated in states where the law requires them to put shareholders first. Promises of virtue do not change this. As Aneesh Raghunandan and Shivaram Rajgopal of Columbia Business School point out, corporate signatories to the Business Roundtable letter have worse ESG records than industry peers.
Is the answer, then, a top-to-bottom change in executive pay packages, and indeed corporate law? No. Rewriting the internal rules of corporate capitalism would put at risk a system that has served us well in its remit: to create wealth. At the same time, do we want more of the power and responsibility for solving our most pressing problems, from inequality to climate change, to be pressed into the hands of corporations, which will still be run and owned by the richest among us? No again.
Shareholder capitalism is an excellent way to manage our corporate economy and we should stick with it. We also have a very good, if presently neglected, set of tools to ensure that everyone shares in the fruits of economic progress. They are democratic action and the rule of law, which allow us to, for example, set minimum wages, tax carbon emissions and change campaign finance laws. Let's use the right tools for the right purposes.
Written by: Robert Armstrong
© Financial Times