COP26 Net Zero 2050 Make a plan for our future written in the sand on a beach

03 Nov 2021

Is ESG just noise in the financial system?

Harold Hutchinson

Head of UK Research at Investec

In today’s blog, Harold takes issue with those keen to dismiss ESG, arguing that, at least since the Scottish Enlightenment, the importance of taking a social view of humanity has been evident. Without this, current financial theory and auditing manuals risk being transformed into unrecyclable waste.

Is ESG a wasting asset?

In a recent post, The ESG Movement – the goodness gravy train rolls on (available at aswathdamodaran.blogspot.com), the acclaimed finance professor Aswath Damodaran suggests ESG is a mistake that will cost companies and investors money while making the world worse off. He asserts that the starting point for ESG is the premise that we can come up with measures of goodness that can then be targeted by corporate managers and used by investors. In the process, he argues, we create a rent-seeking set of financiers but worse-than-useless market noise.

There may be a gravy train steaming ahead in some parts of the ESG agenda, but then again, easy-money locomotives travel to many destinations, including within mainstream finance itself. However, an important aspect of ESG does not start either with goodness or, for that matter, finance. This is the idea of sustainability and the (not unreasonable) proposition that we might be well advised to organise our lives and institutions in a way that is compatible with this principle. Viewed from that perspective, ESG’s value becomes clearer.

We can debate to the nth degree what exactly sustainability itself entails, but, as I have said before, a sensible starting point is the UN criterion set out in Our Common Future – The Brundtland Report. This defines sustainable development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”. This is neither moral cant nor financial wizardry. It is a practical compass to ensure the survival of our species through time, or in more familiar parlance, to secure the lives of our children and grandchildren.

Sustainable development is defined as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”.

An example relevant for both Boardrooms and Investment Committees comes from the topic of environmental liability. Just because any such potential liability is not currently recognised by taxes does not imply we should assume it offers a free lunch to be exploited in current cash flows. Turning a blind eye to a pricing vacuum today may simply lead to long term pain, not gain, for individual companies (in future impairments), stock portfolios (underperformance), and for society more generally (for example, climate damage – a theme central to COP26, or more generally biodiversity loss, threatening our very existence).

There is a deeper argument implicit in Damodaran’s rejection of ESG. Debt providers, employees, suppliers and other stakeholders are protected by explicit contracts in their dealings with companies. Shareholders are not – they bear the ‘residual risk’ embedded in this set of contractual obligations and are therefore defined in terms of ‘ownership’. On this basis, he sees shareholders as the rightful moral arbiters of how investment should flow through an economic system over time.

Shareholders do provide critical capital to absorb the risks of enterprise, but we should not be so naïve to think this implies rights that are supreme or unique in a modern economy. At least some corporates already openly acknowledge this – think of Alibaba’s hierarchy of first customers, then employees, then shareholders. Moreover, the recent pandemic has re-iterated the umbilical link between private and social capital required to buffer some risks - government (society) capital is the ultimate shock absorber when the train comes off the track.

In the end, we are all part of a more general ‘nature’, a theme central to the Scottish Enlightenment. From there, sustainability follows as a natural guide to business and government. Indeed, a refresher course for COP26 participants in Glasgow on Adam Smith’s The Theory of Moral Sentiments or David Hume’s A Treatise of Human Nature might aid the overall dialogue. Ovo’s Plan Zero captures the required mindset “what’s good for the planet is good for us”.

As for Damodaran’s view, his pure valuation work is rightly recognised globally for its clarity and has helped generations of finance students. However, he has missed a signal change and on the ESG issue, he is on the wrong track. Only a broader definition of corporate purpose, assets and risk embracing both nature and human capital makes any sense in the world we now inhabit. That requires a re-writing of the textbooks and auditing manuals. Otherwise, finance will merely become GIGO, waste we need not bother to recycle in future.

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Disclaimer: The blog does not aim to give investment advice, but is designed to afford relevant longer-term context to investors, encouraging a broad perspective where uncertainty is high and a spirit of learning is important. The views expressed are those of the author, not those of Investec.