AgPa #76: ESG Myth Debunking

Applying Economics – Not Gut Feel – to ESG (2023)
Alex Edmans
Financial Analysts Journal 79(4), URL/SSRN

I like myth debunking and this week’s AGNOSTIC Paper is one from this category. Alex Edmans, one of the leading scholars in the field, takes on a few widespread ESG beliefs. He shows that economics already offers a lot of tools to deal with the issues. To me, this paper was therefore kind of a relief as it shows that ESG doesn’t have to be as complicated as many people make it.

• Setup and Idea
• Data and Methodology
• Important Results and Takeaways
  • #1: Shareholder value is a very long-term concept
  • #2: Shareholders care about more than just money
  • #3: Sustainability risks affect cash flows more than discount rates
  • #4: Sustainable stocks not necessarily outperform
  • #5: Climate risk is an unpriced externality, not investment risk
  • #6: Companies‘ ESG metrics not necessarily capture their impact on society
  • #7: More ESG is not necessarily better than less
  • #8: More investor engagement is not necessarily better than less
  • #9: Paying for ESG performance does not necessarily improve ESG performance
  • #10: Not all market failures justify regulation
• Conclusions and Further Ideas

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

Considering Environmental Social, and Governance (ESG) issues is currently one of the biggest trend/challenge/development/call-it-however-you-want in the investment industry. At least in my experience and perception, it is also a very subjective (URL) and confusing (URL) topic.

This isn’t surprising. New big topics often create confusion and not everyone invests the effort to examine them in the necessary depth. You can easily recognize that when conversations start with “The market is talking about XYZ.”. Enough with the irony, but one further confession before we finally come to the paper. I also don‘t invested enough effort to understand ESG in all its details. However, I do give my best to avoid spreading unchecked opinions or myths (URL). This post is my attempt to improve and become less ignorant on this actually important topic.

Data and Methodology

The paper is mostly a review of theoretical considerations and prior research. As such, there is no specific data and methodology to discuss at this point.

Important Results and Takeaways

Edmans presents 10 ESG myths and their economic explanations. Before going into them, he illustrates his thought process in the following paragraph. I think this is brilliant and also applies to many other things than ESG.

Indeed, a useful rule of thumb for any ESG issue is to remove the term “ESG” and evaluate the resulting sentence. Is more ESG investment always better? No, because more investment isn’t always better, due to diminishing returns. Do ESG risks affect the cost of capital? Not necessarily, because risks don’t affect the cost of capital if they’re idiosyncratic. Is it consistent with fiduciary duty to take ESG risks into account? Yes, because taking risks into account is consistent with fiduciary duty—in fact, it’s an essential part of fiduciary duty.

[…]

Gut feel has its value, but can only get you so far—gut feel would suggest not giving water to a baby with diarrhea because it will flow out the other end; research suggest otherwise.

Edmans (2023, p.1-2)

In the following, I summarize the 10 myths and their rational economic explanation. As always, I mostly use own words but will also give you the original title from Edmans below each heading.

#1: Shareholder value is a very long-term concept

Shareholder Value is Short-Termist – No, Shareholder Value Is A Long-Term Concept

Shareholder value is often the scapegoat for all evil that some people see in capitalism. In particular, the idea of greedy short-term profitability pops up over and over again. Managers who target quarterly earnings, fund managers who strive for monthly outperformance or whatever else. The idea is that the pressure of markets and capitalism makes people short-sighted. Needless to say, this is not what we want for our economy and society. We want firms and investors to make viable long-term investments instead of squeezing employees and stakeholders for the last cent of quarterly earnings per share.

Edmans argues that the concept of shareholder value is perfectly in-line with this goal. Why? Because shareholder value is simply the present value of all cash flows that a business or project generates over its entire lifetime. True shareholder value is therefore a very long-term concept. Even more important, the situations I mentioned above are examples for too little shareholder value instead of too much. True shareholders shouldn’t (and probably do not) care too much about the next quarter. They understand that most of their firm’s value comes from the more distant future and behave accordingly.

The obvious counter-argument are speculators, managers with option payoffs, and shortening holding-periods of stocks. While some certainly deserve the blame, it doesn‘t change the concept of shareholder value. If you speculate over one month, you need an idea about the stock price one month from now. In reasonably efficient markets, prices should be at least in the ballpark of shareholder value.

The punchline: the shareholder value one month from now remains the present value of all future cash flows over the firm’s remaining lifetime. Shorter holding periods, speculators or greedy managers cannot change this forward-looking and long-term nature of shareholder value.¹Of course, this statement assumes that most firms are going-concerns. There are exceptions, but in most cases, this is reasonable. If anything, more focus on shareholder value is the solution and not the root of the problems people are rightly angry about.

#2: Shareholders care about more than just money

Shareholder Primacy Leads to an Exclusive Focus on Shareholder Value – No, Shareholders Have Objectives Other than Shareholder Value

This myth is very close to the previous one. The idea is that greedy shareholders just care about money (i.e. shareholder value) at the expense of everything else. There are a couple of reasons why this does not make sense.

Managers and entrepreneurs can legally not ignore other stakeholders like employees, clients or local communities. Those are usually protected via contracts and laws. Yes, laws and contracts are not perfect. But they are probably good enough that firms can’t just ignore them. So it is just natural that shareholders also care about those things. You can still argue that they are bad people if they only do it because they have to, but this applies to any law…²I would certainly pay less taxes without the tax code…

In addition to that, you can convert almost anything to money.³I fear that this is not what shareholder value critics like to hear… Sorry for that! You can break laws and exploit your employees to boost short-term profits. But this is probably not a viable strategy and will eventually lead to fines which reduce cash flows and thus shareholder value. Edmans therefore argues that shareholders naturally care about other things than just money from pure self-interest. I am 27. Why should I support companies or projects that destroy the world I plan to live in for the next 50+ years? This makes no sense to me.⁴As a convinced capitalist, I really like it when self-interest is in-line with the socially right thing. I firmly believe that this is way more common than many people think…

#3: Sustainability risks affect cash flows more than discount rates

Sustainability Risks Increase the Cost of Capital – No, Sustainability Risks Lower Expected Cash Flows

The myths get increasingly better and I think this is also a good one. Many investors talk about punishing firms with a higher discount rate for ESG risks. They think about all the risks and add a premium to the discount rate. Sounds very plausible, but is an example for the diarrhea-gut-feel problem from above.

Following basic theory (and in some way common sense), the discount rate captures the appropriate risk-adjusted alternative to the investment at hand. Let’s say we have the stocks of Airbus and Boeing. What is the appropriate discount rate? Well, whatever number that represents the risk of manufacturing and selling planes. You cannot evaluate Boeing with the discount rate of Coca-Cola because the business models and their risks are entirely different.

Let’s assume Boeing is currently more risky because it apparently has problems that lead to accidents in the recent past. Does this change the discount rate? No, Boeing still manufactures and sells planes. The risks of the general business model do not change because of internal problems at one firm. Those problems are specific to Boeing and affect its cash flows. It is of course nice for Airbus that its competitor failed, but they still operate in the same business model.

Somewhat more geeky, the discount rate only captures non-diversifiable systematic risk. Idiosyncratic risks of one particular company don’t change the discount rate and should only enter to cash flow estimates.

Edmans argues that most ESG-related issues are such idiosyncratic risks and specific to certain companies or industries. Therefore, there is no need to adjust discount rates. Another way to think about this is in terms of correlation to the stock market. Like it or not (URL), but a common idea in finance is that securities with higher betas are more risky. Justifying discount rate adjustments for ESG risks thus requires that those risks positively correlate with the stock market. According to the author, there is no evidence for this. Virtually all of the past corporate ESG blow-ups were pretty independent from stock market movements. I also don’t see a plausible reason why environmental catastrophes or plane crashes should suddenly only occur during stock market selloffs.

#4: Sustainable stocks not necessarily outperform

Sustainable Stocks Earn Higher Returns – No, Sustainability May Be Priced in; Tastes for Sustainable Stocks Lead to Lower Returns

This is something I already mentioned in my previous ESG posts (URL) and one of my favorite ESG misbelief. The ESG boom of the last years was a big tailwind for the marketing departments of asset managers. Many of them created ESG products with higher fees on the promise that investors can do something good for the planet while simultaneously earning higher returns. This sounds already too good to be true, but step by step…

As for all investments, we must first distinguish between good fundamentals and good investment. Everybody wants to have good fundamentals over bad fundamentals, but the question is how much you pay for them. For example, I do believe my apartment has good fundamentals, but it is still a shitty investment at 5-times the fair market price.

Assuming there are positive ESG fundamentals for some firms, they can justify higher returns if the entry price does not already reflect those factors appropriately. But there is no reason to expect outperformance just because ESG-leaders are ESG-leaders.⁵The marketing around thematic investments also suffers from this problem (URL)…

Also note that this myth contradicts with the previous one. If you punish ESG-laggards with additional risk premiums, how can ESG-leaders outperform? Assuming reasonably efficient markets, this makes no sense. It is possible though that investors accept lower returns for ESG-leaders and bid up their prices because they somehow like it. While higher prices lead to lower expected returns going forward, you can have high realized returns for some period of time. With the benefit of hindsight, this is probably what happened during the ESG-boom in 2021.

And since I mixed two myths together in the previous paragraph, let me summarize them again to avoid confusion. There is no plausible reason why either ESG-leaders or laggards should out- or underperform just because of their ESG-characteristics. If ESG-characteristics would perfectly predict stock performance, all of those data providers should immediately stop their services and launch hedge funds instead. As always, the question is all about the information baked into the price. If the market underestimates positive ESG-fundamentals, the stock will outperform (all else equal). If it overestimates them, the stock will underperform.

#5: Climate risk is an unpriced externality, not investment risk

Climate Risk Is Investment Risk – No, Climate Risk Is an Unpriced Externality

At least since Larry Fink used it in his 2020 Letter to CEOs (URL), the phrase Climate Risk is Investment Risk became quite popular. Edmans argues that this statement is misleading and more complicated than it seems at first glance.

His arguments are simple. If climate risk is indeed investment risk, investors must bear the consequences of the harm their companies do to the planet. But this is in most cases not true. Many environmental damages are non- or at least imperfectly-priced externalities. By definition, those who cause externalities do not bear their full consequences. So as long as governments do not fully charge companies for the consequences of their emissions, climate risk is in this sense no risk for investors. Edmans also hypothesizes that this mechanism could explain the historic return premium of ESG-laggards (URL).

What happens if governments do their job and belong those who create negative externalities? Well, if companies and their owners must pay for the full impact of their emissions, climate risk actually becomes investment risk. Strictly speaking, the real risk for shareholders is therefore not climate risk itself, but the regulatory risk that comes from it.

#6: Companies‘ ESG metrics not necessarily capture their impact on society

A Company’s ESG Metrics Capture Its Impact on Society – No, Partial Equilibrium Differs from General Equilibrium

Once again a really nice myth that highlights a widespread problem of human-thinking. Edmans explains that firms face an ever-increasing demand for ESG disclosures to capture their impact on the environment and society. But to measure the impact of businesses on society and the planet, we should look at society and the planet instead of individual businesses. For example, suppose Apple hires a female leader from Microsoft. Apple can now report improved gender equality, but given that Microsoft lost a female leader, the net-effect on society is probably close to zero.

Economists call this partial vs. general-equilibrium-thinking. There is nothing wrong with the perspective of Apple in the example, but it is just the Apple-specific partial equilibrium. To improve society and our planet as a whole, we must look at the general equilibrium. Once we take this perspective, many actions to improve ESG-measures are far less obvious. For example, you could sell your most-emitting business line with questionable labor conditions and drastically improve your ESG-ratings. But every buyer needs a seller and carbon emissions do not suddenly disappear just because the owners of the underlying business change (URL).

#7: More ESG is not necessarily better than less

More ESG Is Always Better – No, ESG Exhibits Diminishing Returns and Trade-Offs Exist

There are very few things in live where more is unambiguously better than less. ESG is no exception. Edmans argues that ESG behaves like any investment and comes with diminishing returns on capital. For example, the advantages of being a Best Company to Work For (URL) tend to be lower in countries where laws already guarantee a certain level of comfort. He also cites research showing that too much diversity eventually backfires as members start to have trouble understanding each other.⁶Imagine a meeting where a mathematician, lawyer, biologist, craftsman, banker, and physician debate corporate strategy. It is certainly interesting, but probably quite difficult to find a consensus.

#8: More investor engagement is not necessarily better than less

More Investor Engagement Is Always Better – No, Investors May Be Uninformed or Undermine Managerial Initiative

This is another more-is-always-better myth. Whenever a corporate scandal pops up, shareholders often receive bad press for not preventing the problem. This seems reasonable. They are the owners and ultimately responsible for their companies. There is no question that shareholders should speak up and engage with managers for the benefit of their firm. However, Edmans presents two arguments why more engagement is not automatically better.

First. Research shows that some shareholders just launch campaigns for their own reputation or to market their funds. Those are of course just two examples for misguided actions. It seems reasonable, however, that effective engagement requires both quantity and quality. One shareholder who actually changes something is probably better than ten who just tell entertaining stories on CNBC.

Second. Edmans cites seminal research from economists who examine the principal-agent conflict between owners and managers in great detail. One key takeaway: too much engagement of shareholders reduces incentives for managers to pursue worthwhile (ESG-)actions. This is the same mechanism that some of us may know from micromanaging bosses. If you know that your boss engages with your work anyway, you have little incentive to make an effort. The same is true for managers. When they know that their actions will be challenged in engagement campaigns anyway, they have less incentives to pursue worthwhile actions in the first place. So there is a trade-off between too much (managers are micromanaged) engagement and too little (managers can do what they want).

#9: Paying for ESG performance does not necessarily improve ESG performance

You Improve ESG Performance by Paying for ESG Performance – No, Paying for Some ESG Dimensions Will Cause Firms to Underweight Others

To be honest, this was one of the most counter-intuitive myths for me. If you want companies to focus more on ESG, just put ESG goals in the bonus agreements of their managers. Ultimately, this should push them in the desired direction, right?

Not necessarily. The key problem is that many aspects of ESG are much harder to measure than other goals. Suppose a CEO has two ESG goals. One is easy to measure (demographic diversity), the other is not (inclusive culture). According to research on compensation structures, CEOs with such goals have an incentive to overly focus on the measurable goal. In this case, they would simply hire a bunch of demographically diverse people. The problem: if you know that your other goal cannot be measured anyway, you will not spend much time and effort on it. The definition of an inclusive culture is highly subjective and it is even less clear what actions can create it.

The counter-intuitive conclusion: it might be better to not set any ESG goals at all. While scientifically true, Edmans also admits that not incentivizing anything is probably also not a viable strategy. The best solution would be to align interests and make managers long-term owners of the business by forcing them to buy shares. Since shareholder value is a long-term concept and goes beyond money (myths #1 and #2), owner-managers should then care about sensible ESG goals from pure self-interest.⁷I have to admit that this theoretically and morally obvious solution is unfortunately very rare in practice…

#10: Not all market failures justify regulation

Market Failures Justify Regulatory Intervention – No, Regulatory Intervention Is Only Justified When Market Failure Exceeds Regulatory Failure

The final myth addresses governments and those who demand more actions from them. Most economists agree about market failures. Those are situations in which markets do not provide optimal outcomes without additional rules. The classic example are negative externalities (myth #5). For instance when companies do not bear the full consequences and costs of their carbon emissions. Although regulation is the appropriate tool to cure such failures, most economist also agree that regulation always comes with costs.

Many people unfortunately forget about those costs and immediately call for regulation whenever the market fails. There is nothing wrong with laws and rules, but like anything in economics, they should provide more benefits than costs. In English: market failure with bad regulation can be worse than market failure without regulation. This seems obvious, but it is very difficult to estimate the costs of regulation in practice. Especially the more hidden ones.⁸The classic example for this is the Cobra Effect. According to the story, India had a problem with too many cobra snakes. The government therefore rewarded people for killing cobras. What sounds like a smart idea lead Indians to breed cobras and earn a nice income from the government. As a consequence, India had more cobras than ever… It is therefore far less clear that regulation improves ESG outcomes than many people think.

Conclusions and Further Ideas

I really like the idea of this paper even though ESG is not my primary area of expertise and interest. Apart from all the individual aspects, I think the biggest takeaway is perspective. Yes, we need innovation and (net-positive)regulation to address climate change and ESG. There is no doubt about that. But I think the paper shows that we already have a lot of tools at hand and that ESG is not too different from other challenges. As the title suggest, we should Apply Economics – Not Gut Feel – to ESG and I think this is exactly right…

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Since this is primarily an investing website, let me again summarize the myths related to the returns of ESG-leaders or laggards. In myth #3, Edmans argues that there is no impact on discount rates as ESG risks are typically company or industry-specifc. All else equal, this suggests that expected returns of ESG leaders and laggards should be the same.

The argument in myth #4 is somewhat different. Once again, there is no reason why an ESG leader or laggard should out or underperform just because it is an ESG leader or laggard. Edmans argues, however, that positive ESG fundamentals might be mispriced by the market. Mispricing in either direction allows for profitable investments and outperformance. But it is not the ESG characteristic itself that opens the path to profits, it is the fact that other investors do not evaluate it correctly in the market price.

In myth #5, Edmans finally hypothesizes that ESG laggards might have outperformed in the past because they could get away with unpriced externalities. In a sense, this means that those companies socialized some of their costs to the advantage of their shareholders. The other perspective on that is regulatory risk. If you invest in high-emission companies or industries, you bear the risk that governments will eventually hold you responsible for the full consequences of those damages. If that risk materializes you will lose. If not, you will collect a premium in form of higher returns.

Overall, the impact of ESG on stock returns is not so clear. ESG is most likely not a systematic factor (URL) such that you can expect outperformance from ESG leaders just because they are ESG leaders. For individual firms or industries, you could make the case that historic outperformance (URL) is some type of compensation for regulatory risk related to ESG. But this is very hard to prove. Finally, it is of course possible to find ESG characteristics that are misunderstood or unrecognized by the market. Outsmarting other investors has been and will always be a viable strategy for outperformance. ESG characteristics are no different in this respect.

Note that everything so far were rational expected-return-considerations. Another argument you often hear is that ESG stocks should outperform because so much money flows into them. A few thoughts about that. First, every buyer needs a seller (URL) and for every ESG overweight there must be an ESG underweight somewhere else. Second, the statement is in my opinion nothing but the confession of speculation – “I believe ESG stocks will outperform because many people will buy them at higher prices in the future.”. As long as people don’t want to sell me their speculation as investing, I have no problem with that. The title of the paper nonetheless comes to mind again – Apply Economics – Not Gut Feel – to ESG…

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• AgPa #76: ESG Myth Debunking2024-04-15
• AgPa #75: Optimal Investment Committees2024-04-01
• AgPa #74: Peer-Reviewed Research is Not Helpful to Predict Returns – Really?2024-01-01

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