ESG – A Defense, A Critique (part 2 now), And A Way Forward: An Evidence-Driven Pragmatic Perspective

Continuing from last week, this week I look at evidence related to claims that ESG is a savior of our ecosystem and how profit and shareholder value maximization is the residual claimant of virtually every evil in our society.

2.0 Criticism of shareholder capitalism and business as usual

The other side is not immune to strong claims about their criticism of shareholder capitalism or what ESG can accomplish. Here is a quick overview of some of those claims and evidence for or against these views.

2.1 “ESG can save the world”

A good critique of this view is presented by Ken Pucker and Andrew King in the recent piece in the Harvard Business Review.

Apart from the Pucker and King critique, most of the evidence I get referred to when I ask whether a company can do well by doing good seems to cover relatively small corporate projects of social responsibility. How material are these projects to the bottom line of the firm or to any set of stakeholders? Should we think of these as “small wins” that will eventually lead to a big win or is it difficult to do well by doing good at scale?

Consider a few of such examples: CVS, the pharmacy benefit manager, withdraws cigarette sales. That is a great first step except that the health care system is a mess partly because of pharmacy benefit managers (PBMs) such as CVS. PBMs serve as the ultimate middlemen in the value chain for healthcare as they lead negotiations with manufacturers, pharmacies, providers, private health plans, government payers and self-insured employers. In the process, commentators have accused PBMs of conflicts of interest as they influence drug prices, narrow preferred networks, and effectively restrict patients into their own mail-order and specialty pharmacies.

Pepsi and Coke dropped membership to the plastics coalition. That is good except we are no where close to solving the plastics problem in these companies.

Google hiked its minimum wage to contract labor to $15 an hour. This is a socially useful initiative for sure but allegations suggest that the number of temporary workers at Google outnumber employees and these temp workers are effectively in Google’s employ except for legal appearances.

Shell quit the U.S. oil lobby and advocated aggressive decarbonization. Did Shell’s decision to decarbonize anticipate the Netherlands courts’ ruling against Shell asking the company to cut emissions or would Shell have changed its mind without regulatory pressure?

Starbucks stopped using plastic straws. That is indeed a welcome development but Starbucks appears to use 8,000 paper cups a minute in its stores partly because we love coffee “to go.”

Perhaps the only way out of the micro-projects trap is for sustainability to become an integral part of the company’s business strategy.

2.2 The Business Roundtable’s statement supporting stakeholder capitalism is a “monumental milestone“ (James M. Loree)

Perhaps. I am afraid that I have no evidence to suggest that the Business Roundtable means what it says. In one study, Aneesh Raghunandan of London Business School and I found that the 181 signatories to the Business Roundtable statement have a poorer rap sheet with the environmental regulator (the EPA) and the labor regulator (OSHA). Using the Covid shock as a natural experiment, in another project, my co-authors, Mansoor Afzali, Urooj Khan and I found that the increase in CEO pay caused by a large appreciation in the value of their stock portfolios dwarfed any modest pain imposed by voluntary pay cuts they took to express solidarity with pain imposed on their workforce via furloughs or reduced benefits or layoffs.

2.3 Stock buybacks should be reined in” (U.S. Senator Tammy Baldwin)

The concern, often expressed by some on the political left, is that funds used for stock buybacks should have been invested in expansion of the company or should have been awarded to employees who bore the real of risk of business failure. Congress is considering a corporate tax on stock buybacks as I write this. Let us unpack the headlined statement carefully.

If we ban stock buybacks, managers might end up over-investing in useless projects that produce value for no one if they did not repay the capital via buybacks. Such profligacy was routinely observed in the 70’s and 80’s when oil companies, flush with excess free cash flows, bought unrelated businesses where they had no expertise such as movie studios. Or, shareholders will simply force these slow growth but cash rich companies to go private, as observed during the leveraged buyout (LBO) wave of the 1990s.

Another hypothesis is that the perceived “under investment” in companies that buy back stocks is a mis-measurement problem. Investing in intangibles is expensed in the financial statements. Could intangibles, if appropriately capitalized, mitigate the perception of under-investment, as my co-authors, Aneel Iqbal, Anup Srivastava, Rong Zhao and I find in this paper.

Let us consider the idea that labor is underpaid. The traditional economics view is to argue that everyone is fairly paid or they would have simply quit. What are the constraints that prevent workers from receiving at least their market wage that depends on the demand and supply of labor? Is capital exploiting labor by paying them less than their market wage?

Perhaps the Great Resignation is part of this conversation. Do wage rates have to go up to solve the labor shortage we are experiencing in so many industries? I don’t know whether employees are systematically underpaid and I am not sure how to find out whether that is indeed the case. Incidentally, it is difficult to have a conversation about how the pie is shared between management, labor and the shareholder as Stephen O’Byrne and I discovered when we tried to analyze the relation between shareholder value add and employee value add for corporate America. To have meaningful evidence based conversations about how the total value add in a company is shared by rank and file labor, senior management and shareholders, we need mandatory disclosure of labor costs in U.S. financial statements, an initiative that Collen Honigsberg and I are advocating that the SEC get behind.

2.4 Profit maximization is the driver behind social ills such as inequality of income, human trafficking and environmental disaster

I agree that the profit maximizing private sector enterprises are not perfect partly because they have no incentives to internalize the social externalities they impose via pollution, or to stop the search for low-cost illegal labor or address income inequality. Inequality of income results, more often than not, from unequal distribution of skills and opportunities available to the labor force. As Ronald Coase argues, the externalities problem can arise from lack of markets as opposed to failure of markets. For instance, if carbon pollution rights were assigned to localities where plants operate and pollute, the neighborhoods and plants might negotiate a solution and assign a price to pollution. Of course, this gets far more complicated in practice when production is outsourced to an Asian country whose goods we import. We may not even know where in that country the product is actually produced and the associated carbon emissions.

I am not sure the alternatives to the profit maximization work well either. What else should we maximize? If you say stakeholder value or social welfare, how does one operationalize that such that a board can immediately incorporate such thinking in the incentive plan they create for a CEO? State owned enterprises (SOEs), in effect, place social welfare before profits in their corporate purpose. I can tell you from decades of experience with Indian SOEs that this purpose rarely gets realized fully in practice. We might get neither social welfare nor profits as a result.

On the other hand, one can argue, that as long as companies do not violate laws, they perforce have to take into account the interests of labor, suppliers, customers to even maximize shareholder value. Otherwise, suppliers, customers and labor can all theoretically defect and stop supporting the for-profit enterprise. I recognize that constraints can stop these parties from defecting. Let us invest more in understanding these constraints.

I see three viable paths forward: (i) making private firms aware of profit-making opportunities in addressing social problems; (ii) increased role for social enterprises to demonstrate proof of concept in solving a social problem that can later be scaled up by a private sector firm; and (iii) increased regulation of externalities. Having said that, finding good real world examples of (ii) are pretty hard suggesting deep structural reasons why this is impossible to do.

I doubt companies are unaware of profit-making opportunities in addressing social problems. Assuming they are indeed unaware, goals for decarbonizing our power grids, treating diseases such as cancer, unequal housing, poor quality schools can be addressed by profit seeking firms as long as consumers are willing to pay for these goals. If not, these products will have to be subsidized either by the government or a charity or a well-funded NGO (non-governmental organization). Salman Khan’s initiative to set up an alternate online school in collaboration with Arizona State University is an excellent example of such an initiative to address the quality of education provided by some state funded public schools in the U.S and abroad. Perhaps a for-profit school can scale Sal Khan’s brilliant initiative far beyond the limited number of students that his online school can accommodate.

A mandatory carbon tax passed by Congress will ensure that the social cost of carbon, either via pollution or climate change, will actually be internalized by profit seeking firms. Clearer legislative definitions of who is a contractor and how such a contractor should be treated would also address nefarious attempts by profit seeking companies to exploit labor that does not have a voice.

Of course, poor disclosure of workers, contractors and their compensation costs and corporate political lobbying are bottlenecks that need to be resolved somehow.

The regulatory logjam in getting these disclosures out are non-trivial following the Supreme Court’s recent ruling about the major questions doctrine that could question any disclosure mandate by a regulatory agency as overstepping its authority. A little-known rider inserted in 2015 says that the SEC’s appropriations budget will not be passed by Congress if the SEC were to consider mandatory disclosure of corporate political contributions. The Government Contractor Political Spending Rider stops the executive branch from requiring government contractors to disclose their political spending. The Nonprofit Political Activity Rider stops the U.S. Treasury Department and the IRS from setting standards for 501(c)(4) political activity that clearly define what nonprofits can and cannot do in elections.

A relevant aside: the usual objection to any disclosure regulation is excessive cost burdens, an issue I try to take head on in my SEC comment letter on climate rules. One has to wonder whether claims that more disclosure all part of a Woke agenda isn’t simply pro-crony capitalism and hence anti-free market.

2.5 “Activist hedge funds promote short-termism and affect sustainability goals”

The impact of activist hedge funds on a company’s prospects is heavily researched and there is no real consensus on whether or not activist hedge funds promote corporate short termism. Having said, it is probably no co-incidence that markets that make it hard to activists to intervene and potentially correct misallocation of capital such as continental Europe are associated with lower stock market valuations. Why? Who has the incentives to do the hard fundamentals based research needed to question companies about their missteps: short sellers who profit from betting on overvalued stocks and activists who profit from undervalued securities. The passive indexers, whose business model rests on selling low cost relatively undifferentiated index funds, do not have similar incentives to invest in producing information about the strategic missteps of firms unless activists themselves intervene.

2.6 Stakeholders is a grab-bag term that requires deeper thinking to create real value over time

I could not agree more. One of the ways to make progress here is to ask the CEO and the board to clarify two of their most important stakeholders. Such focus would radically help simplify the ESG mess. Rating agencies would now focus on evaluating progress on these two ideas. Investment analysts can begin to model the impact of those two ideas on stock or bond performance. In any case, do we ever ask CEOs to focus on 10 odd objectives in the non-ESG world? Then, why do we impose so many ESG KPIs on them?

2.7 Earnings guidance creates a short-term managerial focus

I am not so sure. Companies tend to drop guidance when they are performing poorly and uncertainty about the probability of hitting the promised earnings target increases, as my co-authors Dawn Matsumoto and Shuping Chen found a while back. We saw this again in 2020 when companies stopped guiding post Covid. My senior colleague and co-author, Baruch Lev, has found that guidance encourages analysts to follow a firm and cuts stock price volatility.

2.8 Boards with employee representation have long term focus

Again, I am not sure. German car manufacturers have employees on boards. Were they sluggish in adopting the electric car revolution partly because EV manufacturing is more robot-intensive and needs fewer workers? My read of the academic literature is that the German experience has been mixed. Some authors claim that workers were routinely bypassed and ignored on German boards when they sit on supervisory boards as executive boards take the most important decisions anyway. See 4.4.3 in my article here. Worker-run firms in the U.S. have a mixed history of success. United Airlines has not fared well but Publix Supermarkets has. More needs to be done to understand why certain employee run firms fail while others succeed.

2.9 After the original capital raising, for the company itself the public markets are of no direct importance. Financial capital is no longer a scarce resource. Why grant it so much power?

I don’t quite agree. I have often argued that for fast growing tech firms, maintaining a high stock price is the business model. With a high and growing stock price, you can pay workers in a stealthy manner, acquire other companies via stock-for-stock acquisitions and hence grow market share and of course raise cash in a secondary offering.

2.10 What is the result of decades of focus on shareholders? Low employment engagement scores, unions in decline, low levels of investment in retraining, decline in the R&D, levels of inequity similar to Argentina and communities fractured by lack of economic opportunity

This statement has the flavor of blaming all the ills of modern society on shareholder capitalism. Could these reflect the primary impact of globalization and deregulation after the Berlin Wall fell? Can we link shareholder focus and these evils in the data? Are the interests of the shareholders of a company inconsistent with what might be in the national interest? If yes, whose job is it to correct these ills? Why do we not blame the political process as much as we blame shareholder capitalism? Have we effectively given up on fixing our politics but harbor some hope of fixing our companies to act in the national interest?

One more quibble: inequality ratios between US and Argentina may be similar but not median incomes, which are $31,000 in the U.S. and $5,000 in Argentina. A lot of middle-class folks I know in India would be ecstatic to come to the U.S. and earn median levels of income at the outset for a chance to grow later.

Next week, in the final part, I propose a list of questions that investors might want to ask boards and CEOs.

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