Book review: Measuring Good Business - Chap. 4
Marie-Josée (MJ) Privyk
ESG Disclosure Coach. Agent of change. Human. How can I serve? All insights are mine, not Gen AI's.
Book review: Measuring Good Business - Making Sense of Environmental, Social and Governance (ESG) Data - Chapter 4 - Making a difference
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In my introductory post, I explained that I have endeavored to summarize key insights and takeaways from this book (which I highly recommend) in five weekly posts, each one corresponding to a different chapter. This week is Chapter 4: Making a difference.
(I offer my gratitude to the author Richard Hardyment for his thorough research and captivating narrative.)
This chapter is about the limitations of the ESG World business case and the need for systemic change if ESG is to fulfill its original purpose, which is for finance to effect real change towards sustainability.
As the author points out, despite the meteoric rise in popularity of the concept of ESG and the rebirth of corporate sustainability, we are not moving the needle on addressing systemic issues and (spoiler alert) we are nowhere near on track to achieving the Sustainable Development Goals; “the hyperbole has run ahead of the reality. The noise from the ESG World bandwagon is totally out of proportion with its record”.
From theory to practice
In theory, companies that embrace sustainability make better, more profitable, and therefore more valuable companies, and ESG is financially profitable for providers of capital. Capital markets reward good firms and drive their valuations higher. Capital flows provide a virtuous feedback loop, incentivizing companies to adopt sustainable practices, lest they lose access to capital and suffer lower valuations.
The author points to two flaws in this theory: (1) how can we have both companies enjoying a lower cost of capital and investors enjoying a higher rate of return at the same time (what Alex Edmans reportedly called ‘ESG Doublethink’); and (2) buying and selling stocks on the secondary market (i.e., the stock market) has little or no effect on companies’ cost of capital because there’s no inflow/outflow of capital to/from the company.
An explanation comes from understanding that capital providers are very focused on managing risks and seek not the highest returns, but the highest risk-adjusted returns. Strong performing companies on sustainability are better at managing their risks. They are protecting themselves against catastrophic downsides that smooth out earnings and reduce their volatility (read: beta or market risk), and are less exposed to litigation, product recalls, fines, pollution disasters, or fraud. As a result, they can raise capital on better terms. If this is done through debt, the lower cost of debt may increase the return on equity to investors. In addition, the lower [weighted average] cost of capital results in higher valuation estimates determined through discounted cash flow models. Conversely, capital providers will require a higher return for holding poor sustainability performers, because they present a higher risk profile.
But as the author points out, different perceptions and expectations about the future payoffs of managing risks is what creates the market. Different time horizons will also make a difference. While stronger sustainability performers can raise capital on better terms, poor performers seen as riskier can reward investors with higher returns, assuming or as long as the risks don’t materialize. I would add that it becomes a gamble (which the stock market is sometimes described as), where the probability that sustainability-related risks materialize increases the longer you play. I call it playing the hot potato game.
The author also points out that while strong sustainability performance should improve future cash flows, in a perfect market where all participants have access to the same information the prospect of stronger cash flows is immediately fully reflected in the stock price, neutralizing the potential for future outperformance; “when the playing field is truly level, the competitive advantage from sustainability vanishes for both the firm and its investors”. However, this is not what happens in reality because markets are not perfect, at least in the short run. Sustainable investing is profitable because markets are imperfect and fundamental analysis still pays. Once again, it’s a question of differing perceptions and expectations, and especially different time horizons. While stock prices should reflect long term outlooks, in reality they’re extremely short-term focused, so long-term risks that materialize take them by surprise – and most sustainability-related risks are the long-term kind.
Even with the possibility of better risk-adjusted returns, the author notes that the bulk of ESG World’s assets are invested in ways that promise rather modest and perhaps even negligible investor impact, likening the situation to moving around the deckchairs on the Titanic… meanwhile, the ship continues to sink.
Limits to the business case for sustainability
The author very pointedly asks: “If sustainable investing makes money, why aren’t capital markets turbo charging the transition? “If good behaviour is good business, why are companies still polluting, cheating and greenwashing?”
In his view, the business case for sustainability is limited because it’s layered and case-specific: some actions will be profitable, while others will not. Most responsible and sustainable business practices are a cost. Risks may never materialize. And unsustainable products still sell (case in point: our global consumption of fossil fuels).
“Change is possible; sustainability can make business sense. But we do a massive disservice if we pretend that sustainable business is always a commercial no brainer on every topic. It typically requires some external change - a shift in consumer tastes, in the economics, in technology and above all in regulation.”
While the direction of travel towards greater transparency and rising awareness of social and environmental issues is clearly established, “there are limits to how far the market can take us on its own, and how far financial materiality will deliver change” [...] there may be a strong ethical case for action, but proving a direct, measurable business case may remain elusive”. Hence, the author believes corporate sustainability leaders should welcome a role for others – like associations, civil society, and above all governments – in driving the transition we seek to achieve. My own interpretation here is that companies alone will not achieve transformational change in their activities until the system changes, and they can/should encourage system change through industry associations, collective action, and lobbying activities.
We need to change the rules of the game
For the author, the solution lies in changing the system, by changing the incentives, rewards, penalties, and consequences. “We need to make risks riskier, the costs more costly, the revenues more rewarding and the reputational impacts more consequential. As long as externalities remain external, they don’t impact cash flows. We need to change the cost-benefit equations to make investing in people and planet the more profitable and less risky thing to do. [...] “When private profit diverges from public welfare, changing the rules of the game is the only way to tip the balance.”
“The great irony for ESG World is that it cannot deliver its promise of making more money and making an impact without changing the rules of the game.” [aha moment # 1]
Beyond market incentives, such as empowering customers with better impact information, and self-regulation, such as pre-competitive industry collaborations, government action through both economic incentives and regulatory enforcement is the only thing that can bring change at scale. The author boldly points out that “targeted government action isn’t a threat. It’s an enabler of ESG World’s sacred objective of shareholder value creation.” [aha moment # 2].
Such system change requires a pretty radical transformation in capital allocation, which will only be possible with data that gives real insight into what good and bad performance looks like. “For finance to make a difference, we have to find better solutions to measurement.”
Next up: Chapter 5 - Solutions for inclusive impact