New Analysis on ESG Investing: Friedman, Edmans, and Materiality

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At times it seems like public events on environmental, social, and governance (ESG) investing are a dime a dozen; some think tank, consulting firm, or advocacy group seems to be hosting one every day of the week. That’s why it’s good to see experts like London Business School Professor Alex Edmans agree to participate in one. This week, Indiana University and the European Corporate Governance Institute co-hosted the event “ESG: Do We Need It and Does It Work?” featuring a presentation by Edmans. I reviewed his recent book Grow the Pie earlier this year for Law & Liberty, and was impressed by his analysis, so I was looking forward to the event.

Edmans (whose view of ESG isn’t entirely in line with my own) gets a lot of points for being reasonable, fair-minded, and data-driven. His entire presentation was worthwhile, but I’ll just highlight a few items that I found especially interesting.

Edmans started with the obligatory-for-an-ESG-event reference to Milton Friedman and his famous 1970 article “The Social Responsibility Of Business Is to Increase Its Profits.” Yet, he pointed out that many critics have misunderstood Friedman’s defense of shareholder primacy. Friedman did not argue that a corporation should disregard the welfare of workers or other stakeholder groups, or that CEOs should pursue profit at the cost of offending everyone around them. On the contrary, Friedman wrote that managers should pursue profit only within “the basic rules of [their] society, both those embodied in law and those embodied in ethical custom.” With that broad caveat, much ESG analysis actually fits within a Friedmanesque model. 

However, Edmans argues that Friedman’s view has three deficiencies that are ultimately incompatible with a rigorous ESG framework:

  1. Serving society is zero-sum (such as in the case charitable donations). Counter: Companies may actually have a comparative advantage over individuals and nonprofit organizations in achieving desirable social goals.
  2. Assumes government intervention is effective. Counter: Many factors are difficult to regulate. What if government decides to decarbonize too fast and kills off blue collar jobs? The law can’t regulate things like “meaningful work” or corporate culture.
  3. Assumes that shareholder value can be maximized instrumentally. Counter: Return on investment calculations are not amenable to the subjective values of many potential interventions. How would we know that something like expanded parental leave for employees justified the investment?

I was especially amused by this analysis, because it casts Friedman as an advocate of more aggressive government intervention in society (#2), which might come as a surprise to his admirers (and detractors). But Edmans might have a point about some firms having a comparative advantage on certain social service projects relative to simply dispensing salaries and dividends that could then be donated to nonprofits to achieve similar goals. But that advantage needs to be real and demonstrable, not just assumed.

Edmans argues that modern firms can no longer be seen merely as following the law and not doing harm, but need to assert a reputation as solving the world’s social problems, in a disinterested way unrelated to profits. That’s certainly the bar that many ESG advocates would like to set, but it’s not clear that society at large is holding them to that. Any individual firm might need to engage in quite a bit of do-gooding to stand out from the ESG-chasing crowd these days, but I haven’t seen any polling data suggesting that Americans (or Brits or Europeans) consider a company illegitimate if it doesn’t have a robust philanthropic profile. We need to distinguish between the what speakers at management conferences say and what citizens at large think. 

Edmans also discussed some of the research from his recent book, particularly regarding employee satisfaction. He uses a firm’s presence on Fortune’s list of “100 Best Companies to Work for in America” as a proxy for being socially responsible because it means that, at the very least, a company is treating its workers well. I agree that this is a good measure, because it prioritizes a stakeholder group as close as possible to the firm’s core operations.

The problem with much ESG advocacy is that essential, “inner” groups like employees and customers are often at the top of a much longer laundry list of undifferentiated, “outer” stakeholders. Such lists often include amorphous entities like “the global environment” and “society at large.” Holding CEOs responsible for their actions toward abstract concepts is not the same as keeping one’s customers happy. That also leads to what I call the “Lorax Effect,” in which anyone who stands up and shouts above the crowd loudly enough becomes a de facto spokesperson, regardless of whether they deserve such authority. Speaking for society at large is a heck of a gig.

This leads into another Edmans research point, which is that firms that try to be all ESG things to all people will likely not be as successful as ones that focus on a smaller subset of relevant and material topics. Edmans cites a 2015 study by Mozzafar Khan of the University of Minnesota, George Serafeim of Harvard Business School, and Aaron Yoon of Northwestern University that found that firms outperform when they score high on topics most closely related to their own firm and industry, but not when they score high on all possible ESG topics. They note, “firms with good ratings on immaterial sustainability issues do not significantly outperform firms with poor ratings on the same issues.” Hopefully findings like these are being considered by the policy makers at the Securities and Exchange Commission who are currently drafting a notice of proposed rulemaking on ESG disclosures (climate in particular) for U.S. public companies. (My comment on that proceeding is here.)

Finally, Edmans answered some questions from the online audience on topics such as whether a firm can go overboard in prioritizing ESG topics over core business concerns (perhaps the case with French multinational food giant Danone) and how the “green finance” plans of central banks and national governments can impact corporate climate commitments (carbon taxes first, says Edmans).

The idea of a firm like Danone being distracted by ESG concerns reminded me of the story of computer industry pioneer William C. Noriss and his company, Control Data Corporation (CDC). Noriss, who became interested in job training and urban renewal in the mid-20th century, created a series of social improvement schemes in the 1960s and 1970s aimed at, among other things, providing employment opportunities to minority and disabled Americans. He ran these mostly though his company rather than through an independent foundation or nonprofit organization. Over time, the do-gooding tail began wagging the corporate dog.

As management scholar James O’Toole describes it in his book The Enlightened Capitalists (my review here), Norriss in effect left his career as an engineer and executive behind “to become a full-time business reformer, activist, and public scold.” For years, “Noriss’s attention was almost exclusively focused on CDC’s social mission, and a great many of the company’s executives and managers were similarly distracted from the day-to-day operations of the company’s core business.” While such corporate activism would be fashionable in today’s ESG environment, it’s no longer possible to add CDC to your socially responsibly investment portfolio. By the 1990s, after a disappointing decline from its glory days, the firm had essentially ceased to exist, all of its divisions having been closed down, sold off to pay debts, or acquired by larger firms. A cautionary tale indeed.