Expect Search for Corporate Virtue to Get Increasingly Expensive

Last week I wrote about a video from the Financial Times that was meant to explain environmental social, and governance (ESG) investing. Despite mentioning some of the problems and inconsistencies involved, the video concluded with an inappropriately Panglossian verdict that would-be ESG investors really didn’t have anything to worry about.

I’d like to expand on one of the concepts from that previous post, the question of whether investors with environmental and other motivations are willing to accept smaller returns than most other investors. A recent study by Lubos Pastor of the University of Chicago’s Booth Business School and the Wharton School’s Robert Stambaugh and Luke Taylor suggests that so-called green assets do, in fact, generate smaller returns, but that the people who invest in them are happy with that tradeoff.

They write that the expectation of lower returns can be overcome if customers change their purchasing decisions based on a firm’s environmental reputation. This is something many ESG advocates have brought up in the past—even if implementing environmental initiatives costs a firm money today, the marketing opportunities arising from a pro-ESG orientation can be a valuable countervailing asset going forward.  

That’s fair enough—many people buy Ben & Jerry’s ice cream and Patagonia clothing because of the environmental and social values associated with those brands. In the short term, market differentiation based on ideological signaling can be a smart bet.

But in the long term, the logic fails. The goal of reformers and ESG activists is not to have a small handful of boutique brands increase their profits by catering to a correspondingly small subset of motivated consumers. The goal is for every firm to adopt the most ambitious possible level of compliance for each ESG-affiliated goal. As they do, the brand value of that status for each firm decreases.

Every firm that publicly adopts an ostensibly “enlightened” management philosophy erodes the value of that same reputation for every firm that has previously adopted it. Being the first and only firm in your industry to be ESG-certified may bring significant advantages in attracting ESG-focused customers and investors. Being the last will bring zero advantages.

This suggests two things.

First, the supposed brand premium that ESG promoters talk about is small and diminishes significantly over time as such practices diffuse through an industry. No one is going to pay a price premium—either for products or equity shares—when every company has the same environmental or social status.

Second, the only way to counteract that is to continually create increasingly more stringent ESG rankings for companies to comply with.

For example, simply reducing carbon intensity of operations to a specific acceptable standard will not be sufficient. In order to chase the perpetually decaying status of an enlightened company (as the definition of “enlightened” shifts), firms will have to make increasingly strict commitments and place themselves under increasingly cumbersome restrictions. This may sound wonderful to climate or diversity activists, but it will eventually become financially untenable.

Seeking to maximize (or minimize) a small set of high-profile parameters will lead to increasing marginal costs and decreasing marginal returns. Reasonable suggestions to redirect corporate efforts to other values will likely be seen as backsliding on commitments to ESG goals in general, and be denounced as such. Once firms have publicly validated the concept of increasingly strict ESG goals with their own participation, they will have little ethical and political room to maneuver once the process becomes too expensive.  

While some investors may be willing to accept a slightly reduced return in order to advance their environmental and social objectives, the logic of attempting to cultivate a socially enlightened reputation promises to subject companies to an expensive one-way ratchet in which each increment of corporate social validation is both more expensive and less valuable than the last. Like some other no-win scenarios, perhaps the winning move is simply not to play.