Investing for impact and profit: 'ESG advocates should acknowledge investors’ reality, not fight it'

Climate advocates have failed to persuade investors and firms to take genuine climate action, because they have failed to understand what ultimately drives business. ESG advocates should acknowledge investors’ reality rather than trying to fight or change it, write Bertrand Badré and Benoit Mercereau.

The Hong Kong skyline.
The Hong Kong skyline. If a company’s positive ESG impact will increase its profits, investors will stop at almost nothing to maximise that impact, write Bertrand Badré and Benoit Mercereau. Image: gary yim/Shutterstock

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 GDP – 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.

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 maximise that impact.

For the business case to be persuasive, it needs to be thoughtful and realistic. According to research by Arabesque, 88 per cent 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 per cent will benefit employees and help to attract and retain talent, tripling wages would likely endanger a firm’s financial viability.

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 was highly rated in ESG terms; but earlier this year, its stock price fell by 60 per cent, 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. Collaborative platforms like ESG for Investors offer free tools with which to frame such an approach for more than 2,000 firms.

Financial incentives will elicit the desired response from investors and firms much more reliably than will exhortations to save the planet. By focusing on ESG actions that will unlock the most shareholder value, we can create a virtuous circle between financial returns and real-world impact. Research by ESG for Investors suggests that adopting best practices on just two key ESG issues – emissions and waste management – can boost a firm’s share price by 22 per cent, on average.

If all firms reduced their CO2 emissions in line with their most advanced peers, global emissions would fall by 65 per cent, and those firms’ share prices would increase by 8 per cent, on average. Moreover, adopting best practices in waste management would reduce global waste by 72 per cent and give shareholders a 5 per cent windfall, on average.

Now that we have these new data and tools, ESG proponents should stop bickering and start recognising ESG for what it is: a tremendous business opportunity. If you are an investor who wants to make more money, you should embrace ESG thoughtfully, with a focus on improving material issues. And if you are an ESG activist, you should urge investors to do their (traditional) job seriously, by identifying where maximising positive impact also maximises profit.

Once these basic principles are widely adopted, we can start to add more complexity. There will need to be more discussions about measuring and auditing impact, fleshing out norms and standards, and adding non-financially material impact into the mix. An unwavering business approach could unlock the potential of old concepts, giving them – and all of us – a more promising long-term outlook.

Bertrand Badré, a former managing director of the World Bank, is CEO and Founder of Blue like an Orange Sustainable Capital and the author of Can Finance Save the World? (Berrett-Koehler, 2018). Benoit Mercereau is Chief Investment Officer at Arvella Investments and a contributor at ESG for Investors.Copyright: Project Syndicate, 2022.www.project-syndicate.org

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