ESG and the Limitations of Corporate Responsibility
By Afreen Shafeeque
Environmental, social, and corporate governance (ESG) is a term that has become almost synonymous with sustainable finance. The main premise of ESG or impact investing is that being socially conscious and maximising returns for shareholders is not a conflict of interest. It is marketed as a win-win situation whereby society, investors, and companies all benefit. However, much skepticism has grown over the past years with inconclusive evidence on how and whom ESG initiatives benefit. Therefore, this raises several questions. Do these initiatives and financial instruments incentivise companies to enact real change or do they incentivise companies to appear socially conscious? What does it mean to be a “good” company and who should decide the moral principles of the market? How does this benefit society?
The ESG pitch - why it sells
Some of the world’s largest asset management and consultancy companies have championed the ESG movement. Firstly, it is argued that improving ESG scores has several benefits for a company’s long-term profitability. By focusing on issues such as their carbon footprint, labor conditions, inclusion and transparent governance, companies may attract a loyal consumer base of increasingly socially conscious consumers, retain content and productive workers, avoid reputational damage, mitigate the risk and cost of litigation, tap into emerging markets such as renewables and reduce their vulnerabilities to resource depletion and climate change. By lowering their downside risk, companies lower their cost of funding through equity and debt as investors require a lower risk premium and lenders are willing to offer lower interest rates.
Through public availability of ESG scores, investors can be aligned with investments that match their values and are profitable due to the aforementioned reasoning. Finally, society benefits as companies have the incentive to make these helpful measures. So what is the problem?
Measuring impact and the market mechanism
What does it mean to be a “good” company? This is what ESG scores aim to answer. With the growing popularity of corporate social responsibility, came along specialised services and analysts to report ESG scores. How should the different issues within ESG be prioritised? Should companies in different industries have different ESG priorities? This fundamental inability to standardise social priorities coupled with the difficulty of measuring social impact is reflected in the well-researched lack of consensus in ESG scores. Even with more standardised and transparent reporting measures, are these market players capable of encapsulating society’s and investors’ best interests?
A foundational understanding of the market also pokes holes in the ESG argument. Investors may receive short-term excess earnings by investing in ESG-friendly stocks early, when it is undervalued. Over time, the market will account for ESG measures among other measures that affect profitability, such that the price reflects its value. Through this mechanism, investors are unlikely to benefit from excess earnings. It is also worth questioning that if being socially responsible is so profitable, why have companies not abided by these principles all along? Why would we need this movement of corporate responsibility and ESG funds?
Conclusion
In reality, there may be an overlap between corporate profitability and society’s interests. But this overlap represents a tiny portion of the large magnitude of change that policymakers
suggest we need. Furthermore, portfolio managers and large corporations are bound by a legally enforceable fiduciary duty to their stockholders - they cannot use others’ financial assets to make socially responsible decisions if it isn’t profitable. Hence, this may be a small right step but even with the best intentions, the scope of change is limited.
There is mixed evidence regarding the link between ESG scores and the profitability/value of a company (Bhagat, 2022). Similarly, the benefit to investors is questionable as research does not show that ESG funds outperform other investments (Samuel et al., 2019). Perhaps, investors may be willing to accept lower performance if it benefits the environment. However, further research into arbitrary scores and companies that pledged for change, show disappointing compliance to environmental and labor standards (Raghunandan & Rajgopal, 2022). Some may say that this benefits no one, except of course, portfolio managers and consultants that charge a premium for these services.
Whether or not corporate responsibility has positive effects on all stakeholders, it is clear that externalities such as carbon emissions cannot be sufficiently targeted by corporate responsibility alone. We cannot outsource our social conscience to corporations, but rather focus on government policies that truly cost businesses for damaging society.
Bibliography
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