The end of ESG

There is not really such a thing as ESG investing, only ESG analysis

Alex Edmans

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Now is the peak of ESG.

Companies are appointing chief sustainability officers, justifying strategic decisions based on their ESG impact and tying CEO pay to ESG metrics. Investors are signing the Principles for Responsible Investment, with the number of signatories now at 4,375 compared to 63 in 2006.

Regulators are establishing taxonomies of which corporate activities may be labelled “sustainable”, and tiering funds by their ESG incorporation.

In this context, it seems crazy to title an article The End of ESG. But this title intends not to signal ESG’s death, but ESG’s evolution from a niche subfield into a mainstream practice.

The biggest driver of this ascent is the recognition that ESG factors are critical to a company’s long-term value. For example, in my book Grow the Pie, I explain – and use evidence to show – that companies that deliver value to their stakeholders are not sacrificing returns to their shareholders, as a fixed-pie mindset would suggest. Instead, they are growing the pie, generating returns for both stakeholders and shareholders alike.

If ESG is a set of value-relevant factors, then it is both extremely important and nothing special.

It is extremely important because it is critical to long-term value, and so any practitioner or academic should take it seriously, not just those with “ESG” in their job title. Therefore, ESG does not need a specialised term as that implies it is niche.

A company’s relationships with its employees, customers, communities, suppliers and the environment are highly value-relevant; there is nothing particularly cultish, liberal or – dare I say it – “woke” in considering them.

Considering long-term factors when valuing a company is not ESG investing; it is investing. Indeed, there is not really such a thing as ESG investing, only ESG analysis. ESG is nothing special since it is no better or worse than other intangible assets that drive long-term value such as management quality, corporate culture, and innovative capability.

Of course, ESG is not just about creating higher returns for shareholders, but also society. But intangible assets also have substantial externalities.

An innovative new product creates a huge amount of value over and above what customers pay for it (known as “consumer surplus”), competitors build on it to launch their own versions, and suppliers earn “producer surplus” from selling inputs for more than their cost.

Training employees increases their human capital, and many of the benefits will not be captured by the firm providing the training: they may leave for a competitor, relocate for family reasons or be more likely to find another job if their current employer shuts down.

Turning to a negative externality, a sluggish executive team can impose huge costs on society. Kodak went bankrupt after missing the digital revolution, leading to 150,000 employees losing their jobs.

The following implications follow:

1. ESG should not be put on a pedestal compared to other drivers of long-term financial and social value. Companies and investors are falling over themselves to demonstrate their commitment to ESG, with company performance on ESG metrics given a special halo, and investors praised even more for engaging on ESG issues than productivity, capital allocation and strategy. But we want great companies, not just companies that are great at ESG.

2. Investors who greenwash are correctly being held to account. But so should other investors who fail to walk the talk, such as actively-managed funds that closet index or systematically underperform, value funds that buy stocks that are not actually good value or growth funds which invest in companies that do not end up growing. Clients of non-ESG funds deserve the same protection as clients of ESG funds. Yet a fund that underperforms the market five years in a row is unlikely to be as publicly shamed as a manager of a sustainable fund who opposes a high-profile ESG proposal.

3. Practitioners should not rush to do something special for ESG factors that they would not for other drivers of value, such as demand that every company tie executive pay to them, force a firm to report them even if not relevant for its particular business or reduce complex intangibles to simple numbers. It is well known that the relevant intangible assets differ across companies; a Key Performance Indicator (KPI) must be key to the firm’s business model. It is also well known that intangibles must be assessed qualitatively, not just by box-ticking – the number of minorities on the board tells you little about whether the company has a culture of diversity and inclusion. Yet many clamour for a one-size-fits-all set of ESG metrics and think they can evaluate a company’s sustainability at arm’s length using a spreadsheet.

4. It makes little sense to classify companies as “ESG” or “non-ESG”. Prior to Russia’s invasion of Ukraine, many investors considered defence companies as the latter, and then did a hushed-up U-turn. Instead, a company’s value-creation potential lies on a continuum, rather than being black or white. Moreover, thinking of ESG as intangible assets reminds us how the value of any asset must be compared to its price. Yet many ESG advocates would give three cheers to environmentally-friendly, diverse companies that donate generously to charity without any regard for its price, which can lead to ESG bubbles (as we have seen with electric cars).

5. Many of the controversies surrounding ESG become moot when we view it as a set of long-term value factors. It is no surprise that ESG ratings are not perfectly correlated because it is legitimate to have different views on the quality of a company’s intangibles. We do not need to get into angry fights between ESG believers and deniers, because reasonable people can disagree on how relevant a characteristic is for a company’s long-term success. Yet if you view ESG as an ideological fight, you cheer the people who fight most aggressively – a practitioner was lauded for labelling those who raise healthy scepticism as spreading “nonsense around ESG” and “just complete BS”; an academic called them “Taliban” and “Flat Earthers”. If you view ESG as understanding what drives long-term value, you celebrate the people who contribute most to your understanding, by helping you see both sides of an issue.

Alex Edmans is professor of finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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