At a cocktail party this week in Davos, one executive [said] something he – and most of the attendees at the World Economic Forum – would most likely never say in public: ‘I hope ESG just goes away.’ The New York Times
This has been a year of reckoning for ESG investors. After an unprecedented surge in assets during the pandemic era, retail inflows to ESG funds in the US have slowed or even reversed. This has been accompanied by a rhetorical backlash from business executives, politicians, journalists and even former ESG practitioners. They say the field is (take your pick) harmful to profits, pointless or ineffective. Those seem like serious problems. So why won’t ESG just go away? Well, let’s take a look at those claims.
Harmful to profits: ‘When companies divert their attention to social goals,’ opined The Wall Street Journal last year, ‘they produce less.’ If that were true, it would be a serious obstacle to mainstream adoption. But there’s very little evidence that good ESG performers are less profitable than their lower-ranked peers. In fact, the evidence generally points the other way.
To take one example, the MSCI KLD 400 Social index is the longest-running responsible index in the US. It has a heavy ESG component, as it excludes companies that rank poorly on MSCI’s widely used rating system. Nevertheless, the profitability measures for that index – which I had a hand in developing 30-plus years ago – have consistently exceeded those of the S&P 500.
There’s a lot to be said about why this occurs and it’s complicated. For this conversation, however, it’s enough to say that the data doesn’t seem to support the claim that good ESG performers are less profitable.
Pointless: Signatories to the UN-supported Principles for Responsible Investment – a group that includes most large asset managers – commit to active ownership. This means they, as capital suppliers to the firm, have promised they will talk with you about ESG matters. As the number of signatories has risen, call volumes to IR teams have increased commensurately. I get the impression that not all IR people view this as a good use of time.
Engagement is definitely not going away because it seems to work, both from an ESG and a financial perspective. The field got a big boost over the past decade, as a series of academic studies demonstrated that it has real economic and stock market effects.
In 2015, Caroline Flammer, now at Columbia, published an influential paper showing that when highly contested social shareholder resolutions pass, the stock market reacts positively, and company fundamentals subsequently improve. Elroy Dimson at London Business School chimed in with a study of one of the top engagement firms in the industry, again finding that successful engagements led to positive stock market reactions. Many other studies have obtained similar results. So those signatories are not just calling because PRI requires it. They’re calling because it seems to work.
Ineffective: ‘Can profit-seeking companies really help save the planet?’ asks The Economist. No, it argues, because their incentives are all wrong. The magazine instead puts the onus on governments to ‘resolve the dilemma’.
It’s a nice thought, but governments aren’t resolving many dilemmas lately. The last global accord on climate change – the Paris Agreement – was signed back in 2015. Nor has it been particularly effective: in 2022 The New York Times reported that ‘none of the world’s biggest emitters – China, the US, the EU and India – have reduced their emissions enough to meet the Paris Agreement goals.’
Given this reality, many stakeholders have shifted their focus to corporations. If governments can’t do the job, perhaps big companies can: they are important players in key issues like climate change and they are politically influential. This is particularly true in the US, where the 2010 Citizens United decision afforded corporations the same free speech rights as individual citizens.
Is ESG the best way to address these problems? Of course not. If we had better regulation, if diplomacy effectively resolved global environmental and social challenges, there’d be no need for it. But that’s not the world we’re living in. And it’s not as if the financial markets are a bad channel. They are remarkably efficient transmitters of information and they have global reach.
So even if it’s a second-best solution, it’s unlikely that ESG will go away any time soon. It has some obvious flaws and a great deal of work will be required to address these. IR professionals can help by working to make clear ESG disclosures, especially in sensitive issue areas, and by taking engagement calls seriously. We’re all learning here and the job is too important to do anything but our best.
Four recommended papers on ESG engagement
- Flammer, Caroline. ‘Does Corporate Social Responsibility Lead to Superior Financial Performance? A Regression Discontinuity Approach.’ Management Science, February 2015
- Dimson, Elroy, Oğuzhan Karakaş and Xi Li. ‘Active Ownership.’ Review of Financial Studies, August 2015
- Barko, Tamas; Martijn Cremers and Luc Renneboog. ‘Shareholder Engagement on Environmental, Social and Governance Performance.’ Journal of Business Ethics, July 2021
- Naaraayanan, S Lakshmi; Kunal Sachdeva and Varun Sharma. ‘The Real Effects of Environmental Activist Investing.’ Working paper, European Corporate Governance Institute, March 2021
Lloyd Kurtz is a senior vice president at Montecito Bank & Trust and a visiting scholar at the Kellogg School of Management, Northwestern University