Interpreting ‘S’ in ESG – turning a mule into a zebra?

16 Apr 2020

Harold Hutchinson

Head of Research

The S (standing for ‘social’) in ESG elicits a significant diversity of viewpoints – what role should social factors play in investment decisions by corporates and investors?

In 1916, in a dispute between Henry Ford and the Dodge brothers, the Michigan Supreme Court ruled that ‘a business corporation is organised and carried on primarily for the profit of the stockholders’. No room for social objectives there. Yet, just over 25 years later, Peter Drucker’s classic, the Future of Industrial man, argued that companies had a social purpose every bit as much as an economic one. So, what is going on?
 
In an earlier post, I contrasted the views of Friedman and Stiglitz on economics. According to Friedman and our Michigan judge, the relationship between shareholders and the company is one of ownership, to reflect the fact that shareholders have the residual claim on the company’s cash flows after its various legal contracts have been honoured.
 
An alternative view follows naturally from Stiglitz. Shareholders are just one of a number of stakeholders in the company, a list that includes all of its contractual counterparties - workers, suppliers, bondholders, and the tax authorities. This perspective implies a company has a social purpose beyond its shareholders.
 
Investors embracing this latter world-view usually follow one of three portfolio approaches, each potentially at odds with classical views of asset management. A first group look to exclude companies from their portfolios that follow questionable social purposes. The straw men here are often the tobacco and arms industries, but there are others. One potential problem with this approach is that it breaks the basic rule of the Capital Asset Pricing Model – by excluding investments, the remaining portfolio is a sub-optimal risk/return mix. Moreover, in ethical terms, one man’s vice may be another’s virtue.
the S in ESG argues for a corporate purpose that recognises an inescapable mutuality between corporates and society. 
A more promising second route for ESG investors is to engage with corporates, promoting and integrating social purposes in boardroom decisions while maintaining a commitment to the primacy of shareholders. This methodology enjoys growing support across several large asset management groups. However, Warren Buffett would not agree. Even if Berkshire Hathaway’s management magically knew what was best for the world, it would be wrong to invest on that basis, because asset managers are just agents for the company’s shareholders, in his view.
 
That leaves the third group – impact investors, committed to social projects even at an explicit cost to future investment returns. For such investors, the second ESG approach may simply turn a mule into a zebra by painting stripes on its back, as Sir Keith Joseph, Margaret Thatcher’s former adviser, might have put it. This more radical view re-writes the shareholder value maximisation axiom, demoting it to a broader economic and political context.
 
In conclusion, the S in ESG argues for a corporate purpose that recognises an inescapable mutuality between corporates and society. Whatever one’s opinion, with issues such as COVID-19 in the headlines, ESG is likely to be an important global theme in the years ahead.

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