The ESG concept has been overhyped and oversold | Financial Times 29/07/20, 9:28 a. m.

Opinion Markets Insight

The ESG concept has been overhyped and oversold

Companies and investors should recognise there are costs to being good in many situations

BRAD CORNELL

There has been a surge of investment in companies claiming to have adopted environmental, social and governance principles © FT
montage

Brad Cornell JULY 15 2020

The environmental, social and governance bandwagon is rolling. Companies are becoming
ESG advocates, tempted by promises that they will become more profitable and valuable if
they follow the ESG script, say the right things and spend money improving their ESG
ratings. Meantime, institutional investors, drawn by the allure of earning higher returns
while keeping their consciences clean, are directing tens of billions of dollars to “good”
companies with high ESG ratings.

Much as we would like to accept this virtuous story, we believe that the whole concept has
been overhyped and oversold. Furthermore, it is backed by weak to non-existent evidence
of promised pay-offs for either companies or investors, and fraught with internal
inconsistencies that undercut its credibility.

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The ESG concept has been overhyped and oversold | Financial Times 29/07/20, 9:28 a. m.

Related to ESG is the view that the historical corporate focus on shareholder wealth leads
companies to adopt policies that are bad for society and should be replaced by a broader
stakeholder perspective.

A statement published last year by the Business Roundtable, and signed by chief executives
of big US companies, illustrated how much traction this view has gained. The group
announced that “while each of our individual companies serves its own corporate purpose,
we share a fundamental commitment to all of our stakeholders”.

This is not viewed as a problem because being good is seen as entirely consistent with
maximising shareholder wealth in the long term. Good companies, we are told, will be
more profitable and valuable in the long run. The viewpoint is often offered as accepted
wisdom in business schools, backed up by anecdotal evidence and case studies, lectures on
morality and a selective reading of research.

To assess the current dogma, we start with the premise that for a company’s social
consciousness to affect its value, it has to change either the cash flows that it generates or
alter the risk of those cash flows. From that perspective, the best-case scenario for ESG is
that consumers will buy more of the products and services offered by good companies,
allowing these companies to increase future cash flows.

That argument works for niche companies such as Patagonia, which serve a small, upscale
market of socially conscious consumers. It may not for bigger companies that have to cater
to larger, more price-conscious markets.

A second way that ESG and value may be

positively linked is if bad companies are
A company that loses its punished in capital markets because investors
business focus because of require higher expected returns to hold them,
its desire to do good for leading to lower stock prices. There is, however,
society, may end up being a third and dysfunctional scenario in which bad
bad for both business and companies have lower costs, higher profits and
society higher value than good companies. For instance,
some critics claim that Facebook has been able
to dominate online advertising precisely because
it has been more ruthless than its competitors in
pushing the limits of privacy and free speech.

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The ESG concept has been overhyped and oversold | Financial Times 29/07/20, 9:28 a. m.

The strongest evidence in favour of ESG is on the discount rate front. There are signs that
“sin” stocks such as tobacco or weapons companies face higher costs of funding than good
companies. But that is a double-edged sword. If, as ESG advocates argue, fund managers
prefer to invest in “good” companies and reward them with higher values, investors who
buy at those higher values will earn lower returns over time.

One hopeful note for investors is that there seems to be a pay-off to investing in good
companies before the market recognises and prices in that goodness. But with the attention
paid to ESG growing rapidly, such opportunities are likely to disappear quickly.

It is impossible to have an honest discussion about ESG when its advocates believe that
they occupy the moral high ground and view disagreement as immoral or unethical. We are
not arguing that companies should not strive to be good, or that investors should not
incorporate their preferences — moral, religious and social — into investment decisions.

Instead, we believe that both companies and investors must recognise that there are costs
to being good in many situations, and denying these costs, or arguing that the benefits
always exceed the costs, is dishonest.

Finally, there is a more fundamental, dangerous side to the corporate enthusiasm for ESG,
where corporate executives are called on to make judgments on social issues that they are
not empowered to make, nor equipped to handle. A company that loses its business focus
because of its desire to do good for society, may end up being bad for both business and
society.

If, as an individual, you are upset by a company’s behaviour, the best response is to not
invest in the company or buy its products or services — and vote for governments that will
institute the polices you favour.

The writer teaches climate change and finance at the Anderson Graduate School of
Management at UCLA. His former student, Aswath Damodaran, a finance professor at
the Stern School of Business at NYU, also contributed

Letter in response to this article:

ESG cannot be useless if investors are wanting it / From Gray Schweitzer, Brooklyn, NY,
US

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