Interest in ESG investing is expanding at a seemingly exponential rate – and with it the risks of greenwashing only grow. However, Alex Edmans explains why he believes it is possible for companies and investors to create win-win situations for all stakeholders.

Both the level of interest and scrutiny on environmental, social and governance (ESG) investing has arguably never been higher. This is to be welcomed. The power of finance, if directed correctly, could be immense. But this means going beyond impact investing to ensure the entire financial system cleans up its act. Numerous blind spots, loopholes and inconsistencies exist.

Alex Edmans could help us through many of these. A professor of finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit, Edmans is an industry insider turned observer having decided to switch from a career in investment banking to one in academia. He now focuses his attention on corporate governance, responsible business, and behavioural finance.

Edmans’ findings are often provocative and non-intuitive. Data-led and wary of anecdotal stories, a few recent examples of research findings he has either contributed to or helped promote include the surprising amount of green patents produced by fossil-fuel companies, the role of share buybacks in creating value and the lack of evidence for diversity enhancing corporate performance.

AIQ interviewed him to find out more about his views on ESG investing as well as diversity, equity and inclusion.

Your work portrays quite a rosy view of the world, seeming to suggest companies can do good, benefit everyone and be profitable. What underpins your optimism that companies will voluntarily do the right thing and not just greenwash?

You are right that I portray a rosy view of the world in that companies can both benefit shareholders and society. However, I don’t claim companies will do the right thing – they instead may greenwash.

My book stresses that the pie only grows in the long term

There are two tensions. First, my book stresses that the pie only grows in the long term. For example, my study on employee satisfaction shows it takes five years for the benefits of employee satisfaction to be fully reflected in stock prices. Executives may be concerned with the short-term stock price, and you can temporarily boost it by attracting ESG investors through greenwashing.

Second, executives may not be concerned with the stock price at all (either long term or short term) but being seen as the saviour of capitalism. Thus, they may either greenwash, or jump on the bandwagon of whatever ESG issue happens to be the order of the day even if it is not material to their business model.

On that note, have you seen any changes in company behaviour and/or investor preferences and analyses? How can we push for more change in corporate and investor behaviours?

We have seen many changes in both. However, they are not always for the better. There is lots of appetite for ESG, which is fantastic, but the most radical changes are not always the best ones – ‘more haste, less speed‘ is called for.

Tying pay to metrics backfires

For example, many companies are tying pay to ESG metrics, and investors are demanding such changes as well. However, research consistently finds that tying pay to metrics – whether financial or non-financial – backfires because people can ‘hit the target, miss the point‘.

This is particularly a problem with ESG, where many key dimensions are qualitative and thus difficult to measure. Or, investors are dumping holdings of irresponsible companies, when in fact it may be more responsible to hold onto such stocks and engage with them.

The way to push for more effective change is to base it on rigorous evidence

Asking how can we push for more change in corporate and investor behaviours?” might not actually be the right question. We don’t necessarily want more change, but more effective change – just like crash dieting might not be the best way for someone to lose weight, even though it is more radical. The way to push for more effective change is to base it on rigorous evidence, which is what I hope to contribute to the topic.

You make a distinction between Pieconomics and enlightened shareholder value (ESV). Indeed, you point out that measurement and analysis of corporate investment decisions are extremely hard and that measuring the externalities associated with ESG is even harder. How can people get behind something that is so hard to measure?

They are slightly different concepts. You are right that ‘ex ante‘ (i.e. before an executive has made an investment decision), it is extremely hard to predict all the benefits of that investment. For example, if you decide to give employees more parental leave, it is difficult to predict how much more motivated they will be and how much this will translate into higher productivity.

Assessment involves measurement, but also qualitative factors that can’t be measured

However, for an investor to assess a company, this is ‘ex post‘ – i.e. the quality of a company’s current ESG based on its past decisions. While it’s very difficult to measure ESG, even ex post, it is possible to assess it. Assessment involves measurement, but also qualitative factors that can’t be measured. People frequently fret about how there is less-than-perfect data on many aspects of ESG, but people make decisions all the time based on qualitative factors. They choose their job on far more than just the salary, their spouse on (hopefully) far more than just his/her earning potential, and who to hire on far more than exam results.

Similarly, for companies, where reliable ESG metrics exist, we should use them. But for other aspects, it involves having ‘boots on the ground‘ and getting into the weeds of a company – meeting its management, visiting its stores, even talking to its employees and customers as investors like Peter Lynch [a renowned US fund manager] used to do. As a finance professor, I certainly believe in the power of data, but I am also cognisant of its limitations, and investment decisions cannot be made from a desktop.

What, if anything, does the sacking of ESG-friendly Danone CEO Emmanuel Faber tell us about investor patience for sustainability initiatives and values?

It is popular to tell the story of Danone as a heroic visionary CEO unfairly dismissed by pesky impatient shareholders, but let’s look at the evidence. Danone’s stock price was flat during his six-and-half year tenure, compared to a nearly 50 per cent rise for its closest competitor Nestlé and around the same for the French stock market overall. Note the time period; so, it’s not that investors were impatient. Nor is it clear Danone was an ESG leader.

A truly purposeful CEO is quietly creating long-term value for shareholders and society, not writing headlines

Faber certainly was able to draw a lot of attention to himself, claiming to have “toppled the statue of Milton Friedman” – but a truly purposeful CEO is about quietly creating long-term value for shareholders and society, not writing headlines. Danone's poor performance led to it having to cut 2,000 jobs at the end of 2020, despite being the first company to become an “entreprise à mission” – pledging to serve society rather than just shareholders.

One of the themes you explore is whether there is evidence companies that score well on ESG metrics also perform better relative to peers. It is such a nuanced area – what has your research revealed?

My research shows some dimensions of ESG do indeed pay off. For example, my paper on employee satisfaction shows the Best Companies to Work For in America delivered shareholder returns that beat their peers by 2.3-3.8 per cent per year over a 28-year period.

Scoring well on material ESG issues is linked to long-term shareholder value

However, not all dimensions pay off. For example, charitable donations harm shareholder value, yet they serve to increase CEO pay and protect the CEO from being fired from poor performance – particularly if the CEO donates to charities their directors are affiliated with. In addition, scoring well on material ESG issues is linked to long-term shareholder value, but not immaterial issues.

Part of the recent critique of the ESG investment community by Tariq Fancy from The Rumie Initiative asserts “sustainable investing is not a substitute for the rule changes we really need”. Where do you see the greatest need for rule changes to deliver a sustainable future for all? In carbon taxation, developing accounting frameworks and mandatory reporting – or somewhere else?

Few serious people within the ESG investing industry claimed it was a substitute. Some of Mr. Fancy’s criticisms are valid, but he criticises a straw man – and had the incentive to make his critiques as extreme and sweeping as possible to attract attention. Thus, one should not take his assertions as representative of the whole industry.

Many ESG investors strongly support regulation

It's not binary – either ESG investing or regulation. Instead, many ESG investors strongly support regulation. In July 2021, investors representing over $6 trillion in assets called for a global carbon price. Indeed, this is where I think regulation is most needed – to correct market failures by internalising externalities.

Given the need to transform businesses significantly by 2030 if we are to reach net zero by 2050, is a five-year horizon for “long-term shares” to be paid to executives still too short?

Not necessarily, because CEOs are given new shares for each year of their tenure. For example, if a CEO is hired in 2021 and given five-year shares, although they will vest in 2026 the CEO will also have been given shares in 2025 that will vest in 2029. So, the CEO’s horizon is longer than five years.

Five-year shares do not equate to a five-year horizon

In addition, five-year shares do not equate to a five-year horizon. Stock prices are forward-looking –Tesla’s current stock price is extremely high despite its profits being so low because of its future prospects. Thus, the value of shares in 2026 will depend on the company’s outlook far beyond then.

What are your thoughts on directing investment decisions to create social value? What does the investment community need to factor in and understand better, and what are the most common pitfalls for those that set themselves up with ambitious social goals?

“Directing investment decisions to create social value” is often interpreted as investing in high-ESG companies and divesting from low-ESG companies. That is certainly a good strategy to improve long-term shareholder returns – as mentioned earlier, certain ESG factors are linked to shareholder returns.

Divesting from low-ESG companies doesn’t deprive them of capital

However, we need to be realistic about whether this will actually create social value. Divesting from low-ESG companies doesn’t deprive them of capital, because you can only sell if someone else buys – indeed, it might be better to hold onto those companies to have a seat at the table and engage. There is nothing wrong with integrating ESG into stock selection as a means of improving returns, but the ESG industry should be realistic about the extent to which this will create social value. (This is one of the critiques by Mr. Fancy I agree with.)

Another common pitfall is the use of ESG metrics. Metrics are certainly useful but should only be one factor that enters into an investment decision, since they ignore qualitative factors. Also, many metrics capture 'do no harm' rather than 'actively doing good' (growing the pie). For example, MSCI’s warming tool studies the contribution of your portfolio towards global warming. I’m on the responsible investment advisory committee for an asset manager; we ran our portfolio through this tool and found the worst offenders were semiconductor companies since the manufacturing process releases perfluorocarbons, which are even worse than CO2 in trapping in heat. But semiconductors may power the solutions to global warming.

What is your view of public versus private ownership and the increasing concentration (oligopolistic nature) of many industries? For example, you talk quite positively on Apple but do not mention the fact most of the technologies the iPhone make use of were publicly-funded.

I indeed talk positively about Apple, to highlight how companies create shareholder value as a by-product of serving other stakeholders. However, I do not argue that its success was due to private ownership; indeed, in Chapter 8 of the book where I give the example of Vodafone launching M-Pesa, I highlight how it partnered with the UK Department for International Development.

Both private and public are important

The role of private vs. public is beyond the scope of the book, but it probably won’t surprise you my view on this is that both are important, just like my view on most things is balanced. To repurpose capitalism, we need companies, investors, the government and citizens to play their part.

You argue we need to get rid of the ‘them’ and ‘us’ mentality in finance, where the person on the street does not feel connected to the people making financial decisions on their behalf. How have ordinary pension holders become so far removed from the assets they own?

Many pension holders may not understand how pensions work, since financial literacy is almost never taught at school. In addition to my position at London Business School, I also have a position at Gresham College. Gresham College is an unusual institution in that it doesn’t offer any degrees, but only free lectures to the public, similar to how Michael Faraday used to give free public lectures on science.

Chris Whitty, the UK government’s Chief Medical Officer, is the current Gresham Professor of Medicine, and I am the Gresham Professor of Business. My fourth and final lecture series for 2021-2 is entitled “The Principles of Finance” and aims to make basic financial literacy available to everyone. It’s available on the Gresham website – both the lectures and the accompanying notes.

Your views on diversity, equity and inclusion are interesting. As an advocate for more diverse organisations, you also caution against reading too much into the classic consultant studies that purport to prove the business case. This seems slightly contradictory; can you elaborate?

There is no contradiction. Many studies claim to have uncovered a clear business case – that increasing diversity causes a company’s profits to go up. Ignoring the causation/correlation issue, there isn’t even a corelation to begin with. One study, unfortunately by London Business School, ran 90 regressions relating diversity to EBITDA and found none were significant, yet still claimed in bold “these results suggest gender-diverse boards are more effective than those without women”.

I am arguing for more diversity because it is the right thing to do

The McKinsey study has been shown to be irreplicable, even with its chosen performance measure (EBIT) and preferred methodology. Moreover, there is no link between diversity and other performance measures – gross margin, return on assets, return on equity, sales growth, or total shareholder return – or when using more established methodologies. Yet despite both studies being so flimsy, they have been lapped up uncritically due to confirmation bias; people want them to be true, so they don’t scrutinise the findings.

Why there is no contradiction with my advocacy of diversity is that my advocacy is not based on the business case, but the ethical and moral case. I am arguing for more diversity - not because doing so will make more money, but because it is the right thing to do. I buy organic food, not because it is good for my bank balance, but because of the ethical and moral case.

Will it ever be possible to measure diversity of thought across organisations?

No, but this is not a problem. You can assess it – for example, by asking management about the processes they put in place to encourage people to speak up and share their views. There seems to be an obsession with measuring everything, and people are uncomfortable with ESG factors that can’t be measured. But as Albert Einstein is quoted as saying, “not everything that counts can be counted; not everything that can be counted counts”.

We make many important decisions in life on more than just metrics

We can’t measure a CEO’s competence, trustworthiness, credibility, or leadership ability, but we can assess it. As mentioned earlier, we make many important decisions in life on more than just metrics – without them being arbitrary or finger-in-the-air – and the same is true for investment decisions.

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AIQ: Cleaning Up Capitalism

To tackle the climate crisis, economies and markets need a systems reboot. In AIQ: Cleaning Up Capitalism, we examine what it will take to get us back on track to achieve net zero; from transforming the financial system and accounting, to decarbonising heavy industries and ensuring polluters pay.

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