As GreenFin Weekly readers know well, the rapid rise of sustainable finance and its associated "ESG" moniker in civil society and the economy has proven complicated.
But political ESG theater aside, there are good-faith questions as to the merit of the finance sector’s pursuit of sustainability thus far — both on financed emissions and social topics such as diversity and human capital — and what it’s capable of achieving in the near future.
Some are fundamental questions, like whether voluntary, non-binding sustainability initiatives have served as a profitable distraction from necessary climate policy action — "wheatgrass for a cancer patient," as former BlackRock chief investment officer for sustainable investing Tariq Fancy describes it.
Or, as another example, if one of the most powerful lobby groups for American CEOs proclaimed that its member firms are redefining the purpose of corporations to serve all Americans, why did so many of those who say they’re committed to stakeholder capitalism almost entirely avoid federal tax on corporate profits the following year?
I checked in with Alex Edmans, professor of finance at London Business School and managing editor of the Review of Finance, to gather his thoughts on some core questions thought leaders in the sustainable finance industry are grappling with.
Economics is all about the long term. Even Milton Friedman argued that companies should invest in stakeholders.
Edmans’ work digs into myriad topics related to the social responsibility of business, including "Pieconomics," his radical rethink of how companies operate and why they exist, which he covers in his influential book "Grow the Pie."
His thoughts and writing on the subject are highly influential among sustainable finance professionals and academics. I hope you enjoy some of what Edmans and I discussed in this interview, which has been edited for clarity and length.
Grant Harrison: Tell us about Pieconomics. What is it, and why does it matter to sustainable finance professionals?
Alex Edmans: The pie represents the value that a company creates, and it can be divided between profits to shareholders and value to society (wages to workers, fair prices to customers, preservation of the environment). Many CEOs think that the pie is fixed. Thus, the only way to increase profits is to take from society.
Pieconomics is the idea that the pie can be grown, at least in the long term. For example, investing in worker training may be costly in the short term, but in the long term it makes the workers more motivated, more productive and more likely to stay — growing the pie and ultimately making shareholders better off. The case for responsibility isn’t just moral and ethical, but commercial and financial.
Harrison: What does Pieconomics address that garden variety "economics" doesn’t?
Edmans: I’d love to claim that Pieconomics is a cutting-edge innovation that radically reforms garden-variety economics and topples the statue of Milton Friedman, but that wouldn’t be true. Economics is all about the long term. Even Milton Friedman argued that companies should invest in stakeholders. This is why he argued that the social responsibility of business is to increase its profits; because the only way to do so, at least in the long term, is to take society very seriously.
So what’s the contribution of Pieconomics? First, it provides a useful mental model and practical tool. People don’t go about their jobs making every decision based on a net present value calculation, but they can think, "Does this decision create value for wider society?"
Second, the heartbeat of Pieconomics is evidence. It shows that many investments in wider society do lead to financial returns, at least in the long term. But equally importantly, I highlight the investments that don’t. Pieconomics highlights the social investments that deliver financial returns and those that don’t.
Third, it highlights the importance of long-term horizons. In the short term, the pie is fixed; in the long term, the pie can be grown. To get executives to care more about wider society, we need to give them longer-term incentives.
Harrison: I’ve often heard from sustainable investing leaders that delivering sustainability in the real economy requires a rewiring of the financial system. That is, from one mired in "short-termism" to one centered on long-term value. How does that rewiring get done? Is that change already in motion?
Edmans: There are several levers. The first is the evidence, and that’s one of the reasons why I wrote "Grow the Pie" — to highlight how decisions that involve short-term sacrifices can pay off in the long term. This is why I earlier referred to the business case for responsibility rather than the moral case. Some people like to enact change by guilt-tripping CEOs to "do the right thing." But that’s problematic, because different people have different views on what the right thing is.
And companies need to make money to survive, as well as to deliver returns to shareholders such as pension funds. Thus, providing rigorous evidence that certain investments in stakeholders deliver long-term financial returns is key to rewiring executive thinking.
The second is to lengthen the horizon of CEOs’ incentives so that they think for the long term. Often reformers of CEO pay want to cut the level of pay, the idea being the less you pay the CEO, the more you can give to workers. But that’s the fixed pie mentality. Instead, a plethora of evidence in Chapter 5 of the book shows that long-term incentives encourage the CEO to make long-term investments that grow the pie, benefiting shareholders and stakeholders alike.
Companies should pay close attention to relevant drivers of long-term value even if they’re not required to by an ESG framework.
The third is to reduce the emphasis on short-term metrics so that CEOs have freedom to think for the long term. The most obvious is quarterly earnings, but it’s important to note that many ESG metrics could encourage short-termism as well. A company can cut its emissions by selling a polluting plant to a competitor that cares even less about emissions, so total pollution rises. Or it could decrease the CEO-to-worker pay gap by offshoring its low-paid work. It might increase diversity of senior management by recruiting minorities from the outside, at the expense of employee morale as it reduces the opportunities for home-grown talent to rise and develop.
Harrison: Some in the climate community are dubious of "stakeholder capitalism" — that it’s merely an opportunistic commitment to appease stakeholders whose sentiments affect corporate reputation. Is stakeholder capitalism becoming institutionalized beyond statements and commitments? If so, how, and if not, why not?
Edmans: It’s first critical to define what stakeholder capitalism means, as a co-author and I highlighted in an earlier article. This term is bandied around with no clear definition, which makes it hard to argue whether we should be dubious of it or embrace it.
One view is grounded in the pie-splitting mentality — that it’s the pursuit of stakeholder value at the expense of shareholder value. If so, then we should indeed be dubious of it.
But if stakeholder capitalism involves growing the pie — making investments in stakeholders that ultimately increase long-term returns — then companies will follow through on these commitments. A car company has financial incentives to develop electric cars. Even if executives are entirely money-motivated and have no concern for the environment, they’ll do so because there’s a business case (as long as they’re paid according to the long-term stock price, not short-term profits). An energy company should have financial incentives to develop clean energy.
Pieconomics only works if companies’ effects on wider society are internalized in the long term and feed back into profits. But that requires externalities to be priced. Without a fair carbon price, then an energy company might not have incentives to go green.
Harrison: In your paper earlier this month, "The End of ESG," you wrote: "Companies should tune out the noise created by reporting frameworks and stakeholder demands and instead ask — what are the attributes that we ourselves want to monitor, because they’re ‘measures that drive performance?" Can you share more of your thoughts behind this?
Edmans: The title doesn’t imply that ESG should be scrapped, but instead that ESG should be seen as mainstream. ESG creates long-term value for shareholders and society, but so do other intangible assets such as management quality, corporate culture and innovative capability. It’s no better or worse than these other intangible assets and shouldn’t be treated as special.
There are more and more reporting frameworks trying to get companies to report ever more ESG metrics. But, this could lead to companies hitting the target and missing the point; focusing on improving those ESG metrics at the expense of non-ESG factors that create long-term value.
For example, testing and developing a desalination device will consume significant amounts of water and energy, but such innovation will create long-term value. Companies should pay close attention to relevant drivers of long-term value even if they’re not required to by an ESG framework.
Harrison: In that same paper, you also wrote, "All externalities are a market failure, and thus are best dealt with through government intervention to correct this failure," climate change being the result of one such externality. How do you think of the limits of what voluntary market-led action from the finance sector can deliver on sustainability?
Edmans: Voluntary market-led action is limited because it can’t achieve everything all by itself. Government intervention is necessary to really move the needle. But that doesn’t mean that it’s useless.
Throughout this interview I’ve tried to highlight the dangers of black-and-white thinking. This is the same with voluntary action. Some people claim that it’s a panacea and will save the world all by itself. Others, like [former BlackRock head of sustainable investing] Tariq Fancy, claim it’s completely useless. Reality is in between. System-wide change requires both the finance sector and the government to play its part.
While a one-sided attack on capitalism may have got more sales from some audiences, it isn’t warranted by the data.
To use Fancy’s cancer analogy, it’s true that chemotherapy is needed to cure cancer, but this doesn’t mean that a good diet, exercise and stopping smoking and drinking won’t help as well. Governments can tax carbon, but the finance sector can also fund clean energy, give executives the long-term incentives needed to support decarbonization and so on.
Harrison: The phrase "research shows" gets used often to support arguments in the sustainability space, particularly around making the business case for sustainability. How would you explain the state of sustainable finance research? Any misconceptions or dogmas out there that you’d want to clarify?
Edmans: The state of sustainable finance research is also characterized by black-and-white thinking. ESG advocates claim that sustainability always pays off; critics argue that it’s a ruse that never pays off.
As I explained in my TED talk, confirmation bias means that you will only listen to research that supports your viewpoint. In reality, it’s much more nuanced — some ESG factors pay off, others don’t. And this nuance extends beyond the financial returns to ESG to other sustainability topics.
CEO pay is not as overblown as people think, shareholder activism isn’t always short-termist, and share buybacks can be good for wider society. I tried to cover all these nuances in "Grow the Pie." While a one-sided attack on capitalism may have got more sales from some audiences, it isn’t warranted by the data.