By Bertrand Badre, Benoit Mercereau
PARIS ( Project Syndicate )—Environmental, social, and governance (ESG) standards are the talk of the investment world these days. But despite the trillions of dollars of investments that have been labeled “ESG,” this form of investing has yet to have much real-world impact.
This is especially true on the environmental front (though such investments’ social impact has not been much more evident). Investor coalitions to combat climate change have exploded onto the scene, promising to steer a massive amount of capital toward “green” businesses and industries.
At last year’s United Nations Climate Change Conference (COP26), private financial institutions pledged to mobilize $130 trillion —a figure greater than global gross domestic product—for clean energy. And yet, the climate outlook is only worsening. Last month’s report from the Intergovernmental Panel on Climate Change offered “the bleakest warning yet” about what awaits humanity on a rapidly warming planet.
Profits drive business
Welcome to the world of greenwashing: Though firms’ owners have committed to cutting carbon-dioxide emissions, they have not actually ordered firms’ managers to do so. But, instead of blaming investors or companies, ESG activists should consider why there is such a large, persistent gap between public commitments and action. Simply put, climate advocates have failed to persuade investors and firms to act because they have failed to understand what ultimately drives business.
Like it or not, most investors quietly share Milton Friedman’s view that “the social responsibility of business is to increase its profits.”
Investment managers hear from clients when their financial returns are too low, not too high. Most investors would like to do good in addition to doing well, but they also prefer it when the right hand can claim ignorance of what the left hand is doing—when they can seize on the exhortation to “save the world” while continuing to maximize profits with ruthless efficiency.
ESG advocates should acknowledge investors’ reality rather than trying to fight or change it. Because businesses will be held accountable by their investors if they do not make more money, ESG proponents must make the business case for such standards. If a company’s positive ESG impact will increase its profits, investors will stop at almost nothing to maximize that impact.
For the business case to be persuasive, it needs to be thoughtful and realistic. According to research by Arabesque, 88% of “operational performance studies show that solid ESG practices result in better operational performance.”
But while ESG can unlock shareholder value, not all ESG actions will boost profits. For example, whereas raising wages by 10% will benefit employees and help to attract and retain talent, tripling wages would likely endanger a firm’s financial viability.
The bottom line
Investors therefore should identify the “material” ESG issues that directly affect a firm’s bottom line. Financially immaterial ESG issues can still be relevant for overall impact, but as George Serafeim of Harvard Business School puts it , “spending resources on immaterial issues is like philanthropy.”
Identifying material ESG issues is not always easy. The French retirement home Orpea /zigman2/quotes/204431094/delayed FR:ORP -0.20% was highly rated in ESG terms; but earlier this year, its stock price fell by 60%, following allegations that it was mistreating elderly patients.
Investors also must set priorities among the various ESG components. ESG ratings are a weighted average of hundreds of indicators. Even if all were material, it would not be feasible for any firm to set hundreds of new goals for itself. Instead, investors must focus on the ESG initiatives that will boost shareholder value the most.