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Alex Edmans

"You don’t need to have ESG (environmental, social and governance) in your title, you don’t need to be a sustainable fund manager. If you’re a CFO, you should take ESG into account, because it affects the long-term financial performance. And if you are a mainstream fund manager, you should also consider these factors very seriously, because they will affect long-term investment returns."

Myles Corson

That was Alex Edmans, Professor of Finance at London Business School.  And I’m Myles Corson from Ernst & Young, host of the EY Better Finance podcast, a series that explores the changing dynamics of the business world and what it means to the finance leaders of today and tomorrow.  I’m delighted to share this special episode as part of our ongoing ESG series. Brian Tomlinson, an EY Managing Director focused on ESG reporting, spoke to Alex about how ESG has moved from the periphery to the heart of business discourse. This is due in part to investor pressure, in part to finance leaders understanding that good ESG practices can drive financial performance and in part to the work of regulators in key markets around the world. Brian digs into Alex's research and publications, including a paper he recently published, intriguingly titled "The End of ESG," which argues that ESG is both extremely important, but should also be on equal footing with other factors, such as management quality, corporate culture and innovative capability. Investors should look for great companies, not just companies that are great at ESG. I’ll hand over to Brian now to get started.

Brian Tomlinson

My name is Brian Tomlinson, Managing Director at EY, focused on ESG, delighted to welcome you all to this episode of the Better Finance podcast, where we’ll be talking about the current state of development of ESG. We’re at a remarkable time, as the ESG space has developed from being a fairly peripheral part of corporate and capital markets discourse to being part of the mainstream.

There’re lots of trends that have been driving that: market participants making commitments around ESG, large corporations embracing aspects of ESG disclosure, and in recent years, the thing that’s really driven this to the center of the discourse has been the ESG disclosure ecosystem being adopted by regulators in key markets across the world.

In the US, through the SEC’s climate proposal and its expected proposal on human capital, all of the adjustments in the EU around the implementation of the EU’s green deal, 

it’s really a high watermark for ESG now. It’s interesting for us to talk about this as being the end of beginning of ESG. ESG has risen from obscurity very rapidly. I think people spent a lot of time over the last few years talking about the ways in which good ESG practices can drive financial performance. There’s often skepticism around the solidity of some of those claims. Concerns around green wash, and whether companies and investors have wittingly or unwittingly made a slightly misleading claims around how sustainable or how green or how ESG-aligned their business practices are. 

ESG is a somewhat fuzzy label. It has slightly different meanings, depending on who you speak to, and a fuzzy label is slightly ripe for misinterpretation. One of the things that many ESG practitioners have focused on is the notion that ESG is moving from being a peripheral aspect of business discourse into being part of the mainstream. And as it becomes mainstream and is no longer niche, the relevance of a very specific label, of ESG perhaps becomes lower. There is some commentary as well around ESG slightly being a part of putting new wine in old bottles or applying new labels to old themes, as many people over time will have said, “We’ve often considered ESG type issues, we often just haven’t applied an ESG label to them.”

The way in which you think about value and the way you think about investing is developmental. It changes over time. The way institutional investors think about the valuation of a company today uses a much broader set of data than it maybe did 20, 30, 40 years ago. I think ESG is part of that. We also, at the moment, alongside some of the skepticism, have some of the politicization of ESG. I want to have a conversation about how real that is, where does it come from and what is some of that informed by and what does it tell us about ESG space. 

It’s a broad set of themes in ESG and who better to talk to about these themes than Professor Alex Edmans. Alex Edmans is a thought leader in this space. He’s a professor at London Business School. He is an author of a really terrific book called, Grow the Pie, which addresses many of these themes around corporate purpose, ESG and creating value. And he’s a leading finance researcher, including on ESG themes. A brief look at the number of downloads that his papers have will indicate the extent to which his insights are very much in demand. 

It’s great to have you with us today, Alex. 

With that introduction, I wanted to talk about your paper, which has this terrific title called, “The End of ESG.” And with that preamble, we’re talking about a period where many people would say we’re in a peak-ESG phase, so a title which says end of ESG seems somewhat counterintuitive. Can you perhaps say what you mean by the end of ESG in the context for ESG development now?

Edmans

I can. But before I do that, I just want to say thank you so much for having me, Brian. It’s really nice to be here. You’re right, it does seem counterintuitive, given that a lot of my work is on the benefits of ESG, why am I writing a paper called The End of ESG? But it’s actually more nuanced than what might seem the case from the first reactions. 

So, by the end of ESG, I mean the end of ESG as a niche field, the article is trying to highlight how ESG should be mainstream. Why? Because if one of the key arguments for ESG is these are important risk factors and opportunities that affect the long-term valuation of the company, then any executive and any investor should take this into account. You don’t need to have ESG in your title, you don’t need to be a sustainable fund manager. If you’re a CFO, you should take ESG into account, because it affects the long-term financial performance. And if you are a mainstream fund manager, you should also consider these factors very seriously because they will affect long-term investment returns.  

This is why the politicization of ESG is somewhat surprising to me, because it doesn’t matter what side you are on the political spectrum, everybody should want companies that create long-term sustainable value and are profitable in the long term. But there’s also a flip side to “The End of ESG”. On the one hand, I’m arguing that it should be mainstream, it shouldn’t be niche, so I want to elevate ESG to everybody’s discourse. But on the flip side. I don’t want ESG to be seen as a magic word. The ESG label seems to suggest that this is something magic which defies the laws of gravity.  What are the laws of gravity? They are the laws of basic economics. There are some people who argue more ESG is always better, so companies should invest without limit in their workers and reducing their carbon footprint and so forth. But one of the basic laws of economics is you have diminishing returns.  Investment is good, but after a point, investment might not be worth its cost. And similarly, the ESG word puts it on a pedestal compared to all the factors that drive long-term value. 

So, I’d stress, yes, ESG does contribute to long-term value.  But other things also contribute. If you have a great management team.  If you have good productivity, good innovation, good capital allocation, those are all good for long-term value. But the ESG special label means that if you’re a company and you improve your ESG, then you get more brownie points than including all of those other long-term dimensions. ESG is important, but I wouldn’t say it’s definitely more important than other drivers of value, it should be put at the same level. 

Tomlinson

Terrific commentary Alex, and I really want to pick up on a couple of themes there. In the pre-regulatory space around ESG, there was a lot of focus on the persuasion of companies and investors to engage on ESG in a constructive way. A lot of that persuasion was built around this notion of selling ESG as a universal win/win. Doing ESG investments will always be good for the bottom line. It’s presented as almost as if it was a tradeoff free set of investments, which is a highly unrealistic way of talking about a complex, highly intermediated capital markets environment, where there’s always tradeoffs between different actors, with different interests and over different time horizons. So, it’s always really important to think about ESG as being subject to the same sort of tests that you apply to other business approaches, particularly with the regulatory push, the relevance of ESG is being universalized across functions. Whether or not you’re in the finance function, treasury, the corporate sustainability function or procurement, you’re going to have significant ongoing interactions with ESG issues that are relevant to that function. And so essentially, it’s spreading out across the organization. 

And this is, I think, the way in which many ESG practitioners saw ESG as developing from being a niche and peripheral aspect, often siloed, to being something which is a whole firm concept. As it becomes a whole firm concept, you have to subject it to challenge. One of the things that’s interesting about the ESG space is it’s a relatively new set of concepts to a relatively new set of audiences. Often people talk about ESG in a slightly misleading way. I thought we could use some of your great commentary around talking about ratings to illustrate some of the issues around the way people talk about ESG. Credit ratings, which are about the likelihood of the default of a corporate issuer. And ESG ratings, which are often talked about in similar ways. It would be interesting to have you illustrate your points on ratings.                                                

Edmans

What are ESG ratings trying to do? On the face of it, they seem like a no-brainer benefit.  They’re trying to look at the effect of ESG on the company. They will look at various ESG risks or opportunities, such as, say, climate change or other environmental issues, and they will rate a company based on whether they’re managing the risks or exploiting the opportunities as best they can. 

But notice that this is a subjective opinion. Why is it subjective? You can agree or disagree as to whether a company is on the front for some certain issues, although ESG comprises lots of different issues and it’s not clear how to weight them. If you’re an electric car company with questionable governance, maybe the G is going to be low, but the E is going to be positive, because you have one of the world’s greatest challenges or perhaps the greatest challenge in terms of climate change. And you might put different weights on these different issues, but there’s no one clear way to do that. So as a consequence, people look at ESG ratings, they see that they disagree with each other and they say well, ESG ratings are not doing what they’re supposed to, which is to tell me whether a company is good ESG or bad. 

This just doesn’t make sense, because if I view ESG as long-term value, is it possible to have an unambiguous measure of whether a company is creating long-term value? Absolutely not. This is subjective. This is why you have a huge profession called asset management, where lots of people have different opinions as to whether a company will create long-term value. One analogy that I often use is to equity research report. One might say buy, one might say sell, and the fact that they disagree doesn’t mean that they’re not doing their job, they have different opinions. 

But then you might think, well, why is that the analogy? People often use credit ratings as the analogy and they say, well, the correlation between ratings are something like .99. But with credit ratings, it is clear what you are trying to measure. You’re trying to measure: Can a company repay a particular loan or bond? While there might be some subjectivity as to whether you can repay, it’s clear what you’re trying to measure: Can that loan be repaid? Where it’s ESG, it’s not clear what you’re trying to measure, how much weight do we put on governance versus environmental issues, should we even consider some issues at all? So, is lobbying an ESG issue? Or is lobbying contributing scientific evidence to a government inquiry and to inform government policy? If we were to ask the governments to put in a global carbon tax, is this lobbying? One might say it is, but one might say it’s good lobbying. It’s really not clear where to put this. 

ESG ratings are useful, but they’re useful not for the overall answer. Are you Triple A or Triple B, but for the analysis that goes into the rating, just like if an equity research report saying buy, I’m not going to buy automatically. I’m going to read the report and look at the analysis underpinning that recommendation. 

Tomlinson

That makes so much sense, Alex. It really speaks to the fact that the ESG space, it has an extraordinary breadth and many of the issues under the ESG issue spectrum have a really open-textured set of interpretations. The ESG space doesn’t necessarily have an agreed set of objectives. When some people talk about ESG, they’re talking very specifically about how ESG issues drive a financial return. Some people are talking about ESG issues, how can ESG issues reduce the negative social impacts of corporate activity on the planet.

Depending on where you come out on any of those interpretations of a particular ESG issue, you might have a very different rating of a company on the basis of a very similar issue. We’ve seen all of these studies about how different ratings firms are differently weighing things. They’re using vastly different numbers of data points. There are some issues with staleness of data as well. Comparability when you have a range of different voluntary frameworks that people are reporting against. I think there are all sorts of reasons to do with the nature of ESG and then also the nature of ratings taxonomies, why they’re different. It indicates that key point that you ended on, which is the importance of expertise in the analysis of ESG issues. 

And I want to go one level down to that, which is to say so where a rating might give you sort of a high, or a series of ratings, because actually what a lot of investors are doing, they’re using several ratings to give them rule-of-thumb assessments on the basis of ratings taxonomies they like. But then ultimately, in order to really understand the business’s ESG footprint, you’re often going to look at it in a sector-specific context. ESG issues tend to vary in terms of their materiality by sectors. The issues that are material for, say, a tech[nology] company are going to be different for a car manufacturer. Do you want to talk a little bit about that sector-specific aspect in terms of the application of expertise to ESG?

Edmans

You just gave a good example. So, in tech[nology], maybe climate, which is such a major issue, is not so important, but maybe something else, like misinformation, cyber bullying or cybersecurity, that’s important. And it’s important, whichever way you look at ESG. If you think about ESG as the relevance of issues for a company’s financial performance or if you think about the effect of a company in wider society, both of those will be different for a techncompany than it would be for an energy company. What does that mean? 

What some people are trying to promote are standards, where you have a specific set of ESG metrics that every single company needs to report irrespective of the industry. So, the World Economic Forum has a list of stakeholder capitalism metrics. And how do you define victory? You’ll say, “Oh, my set of metrics is used by 68% of the S&P 500, and therefore, that seems to be a popular set of standards.” But actually, the material factors will differ from industry to industry, so some measures of cybersecurity or misinformation that would matter for one sector, but it might not matter for others. 

Now, the response is, well, when we have a certain set of metrics, that’s only a minimum, that doesn’t prevent you from also reporting something like misinformation or cybersecurity. However, whenever there’s a standard set of metrics, we know that there’s going to be more focus on that because it’s comparable. For example, we have earnings and earnings per share — that’s standardized across companies, and therefore, equity investors will look at earnings per share, even if there might be more relevant dimensions for a company’s value, such as employee engagement or employee turnover. What this means is that this one-size-fits-all idea of just trying to reduce this rich and complex and nuanced concept of ESG to a couple of metrics is just not going to work. What is the driver behind this? As you say, Brian, it is limited expertise. 

Let’s say I have no expertise in American football, if indeed, we were to just have statistics on number of touchdowns or rushing yards or something like that, even if I can’t watch somebody play and evaluate how they are on the field, I can look at those measures. And similarly, for something like ESG, if you are late to the game but you want to, with good intentions, be an investor and allocate your funds to more ESG companies, you will just look at some simple metrics, even if those metrics might not be material or even if they’re silent on some qualitative issues. For example, with diversity, equity and inclusion (DE&I), we can have metrics for the percentage of females or ethnic minorities on the board, but that says nothing about whether your culture is inclusive or not. 

Tomlinson

A more nuanced approach to how we think about ESG, why it’s relevant to particular companies, the level of expertise that you need to bring to think about the impacts that ESG can have around things being an ESG stock. Do you think that’s a concept that makes sense or do you think that’s probably a misapplied label?

Edmans

I don’t think it makes sense. It’s just like saying is there such a thing as a good company or a bad company, not really, because people have different subjective opinions as to this, and there are lots of things to look at to determine or know whether a company is good. 

So, with ESG, there are some investors or there are some approaches which might look at your carbon footprint and say, well, if your carbon footprint is above the industry average or it’s 80%, you must be bad, if you are in the 20% or lower, you must be good. That’s problematic because that’s only one issue. Now, I clearly understand that climate is a really serious issue, but there’re other environmental issues, there’re local pollutants, there’s water usage and there’s biodiversity. There’s also social issues and also social issues might conflict. If you were an energy company and you closed down the polluting plant, well, that’s good for the environment, but that’s bad for workers. 

Why do we want to even classify something as an ESG stock? To make our lives easier, because if you were able to separate the universe into black and white, and only invest in one set of stocks, then your life would be easy. But just like anything, in business, these things lie on a spectrum. It may well be that you would want to put even more capital into a really green company than a moderately green company. But if you just define something as green or not green, then there’s going to be no difference between them. If you just discretize this and turn it into black and white, you ignore all the shades of gray in the full color spectrum of companies.

Tomlinson

I think this builds on the fact that we’re bringing in a more nuanced approach to how you think about ESG. For instance, one of the ways in which investors started to engage with the concept of kind of sustainable investment was through a notion like divestment, essentially, or negative screens, to essentially say there are certain types of industry, there are certain types of stock that we’re not willing to be invested in, driven by a set of often kind of ethical considerations. 

Whereas now, more broadly, with the ESG space, you have investors that can take a more nuanced view of how they choose to invest in a particular company. Investors may want to drive investments toward a company which has a strong transition story. For instance, it may have a very large greenhouse gas (GHG) footprint today, but it has an extremely strong story about transitioning to the low carbon future over the next ten years.  That may actually be attractive and something like a negative screen could prevent you from investing in that sort of company, whereas some investors may be investing in the best in class.  You may also want to invest in a company that you can engage with to enhance their trajectory over time in terms of prioritization of ESG issues. 

I think it’s about bringing more nuance and more consideration and more specificity to how you think about your objectives as an investor, the forward story in terms of the company, in terms of ESG and really that balance of priorities in terms of your strategy and time horizon in terms of investing.

Edmans

That’s right.  Often, investors might say oh, we’re never going to touch fossil fuel, but the harsh reality is we don’t yet have enough renewable energy sources to rely exclusively on that source. It takes a lot of energy to power manufacturing, to power food production and so forth. If you were to say let’s avoid all fossil fuels, it makes things easy, so this is what’s attractive to classify industries in good or bad. But right now, you might think it’s quite responsible in oil and gas companies, if they’re absolutely best in class and if they’re having a credible transition plan that they’re putting in practice. 

The bar to investment in fossil fuels will be higher than the bar to investment in, say, health care. But that bar should not be infinite. If you are never to invest in a particular industry, you are effectively saying, “I would not invest in any company no matter how good it is,” effectively, that means you think the world would be better off without the industry. One might say that you could have that position for certain industries, let’s say controversial weapons, but with energy, we just don’t have enough renewable energy to meet the world’s energy demands right now, so I don’t think it’s possible to have such a black and white position.

Tomlinson

In Europe, you have this concept of the EU’s taxonomy, where essentially sector by sector, you’re going to be able to see where companies are in terms of the alignment of their revenues with green standard and the alignment of their capex with the green standard. You’re going to be able to look at what their footprint is today and what their likely footprint is forward, and how they’re credentializing their strategy in terms of the investments they’re making in relation to transitioning to the low-carbon economy. I think the more data the market has, the more nuanced the approaches will inevitably become.  

You’ve talked many times about the importance of the generation of long-term value, you address this in your book, Grow the Pie, and this also connects to this concept of politicization around ESG. Many people would say that elements of ESG are simply synonymous with the long-term value. Well-managed sector-specific ESG issues can help with resilience and employee relations, and inevitably long-term issues. Given that, are elements of the ESG discussion and debate that are actually new, or do we think it’s more of a case of putting old wine in new bottles?

Edmans

I think it depends on what the motive is for doing ESG. Most people argue, “We’re doing ESG, because these issues affect the long-term financial performance of a company. If we don’t reduce our carbon emissions, then if there was a carbon tax, then our company will be suffering. If we don’t invest in a more diverse and inclusive workforce, then we will not have market-leading human capital.” But if that’s the case, if it’s purely for long-term financial value, that is not new at all. Like we’ve known since 1992, when the balanced scorecard first came out that the value of a company is based on both financial and nonfinancial dimensions. 

When I wrote my most well-cited ESG paper on the importance of employee satisfaction that came out in 2011, I didn’t use the phrase ESG a single time in that article. I just looked at employee satisfaction, because it’s common sense that this really matters to a company’s long-term performance. If we’re viewing ESG as a way to improve long-term performance, then it’s not new. And I do believe that that is the way that most ESG components view the value of ESG. If you look at one of Larry Fink’s letters, he argues that stakeholder capitalism is just capitalism. That is a way of making sure that a company is profitable in the long-term, he says climate risk is investment risk. Why we care about this is not for woke reasons, it’s not to change the world, but it’s to protect the value of our portfolio.

There is one new element of ESG, which is we’re going to do ESG not just to improve our long-term returns, but to change the world. For example, if we are going to engage with companies to reduce their carbon footprint or improve their DE&I, or if we’re going to withdraw capital away from polluting companies and invest it in nonpolluting companies, that might have an effect on wider society. But even though that is presented as being new, I believe that traditional investing already has that effect.  If you’re investing in the company with a great management team, great innovation, good capital allocation and productivity, that is good for wider society, because you are backing such a company and allowing it to carry on being innovative and productive.  You would like to withdraw capital away from an unproductive company where it will not be generating jobs or value for customers.  Even that aspect of ESG, the impact motive, that might not be too new, because I think just general good companies, they have positive impacts on wider society. 

That means that the subset of ESG, which is new, is a small subset, which is the idea that there are lots of investors who would sacrifice financial return to achieve those social outcomes.  Even when we go back to the old idea of long-term investing, people would not say let me sacrifice returns in order to invest in good companies with great management teams.  They would think these things are synonymous. But if there was a trade-off, there are some ESG investors who say, “Hey, I know that if I force this company to decarbonize, I will be foregoing some return, but I think private change is such an important issue that I’m willing to make that sacrifice.” 

But note of that is the one thing of ESG which isn’t new, that we’re willing to sacrifice financial returns, I don’t think ESG would be put on the same pedestal that it is right now, which is the promise of win-win, this promise that you will always improve your financial returns by taking ESG into account. In fact, you’re sacrificing them. You may be willing to pay that sacrifice because of the importance of climate change. But that sacrifice makes it far less attractive or at least moderately less attractive, compared with how it’s currently being portrayed. 

Tomlinson

I think the one thing that I’d maybe add to that as well is those institutional investors, particularly who have begun to take something of a system-level view rather than looking at the individual impact of a portfolio company. You’re going up to the level of your portfolio and thinking about the portfolio impacts in terms of ESG issues. That, therefore, may influence the way in which you think about the risk and reward matrix that you apply to a particular company by having that reference to your broader concerns. One of the system-level issues, for instance being hitting that zero by 2050 and thinking about how that impacts the way in which you might engage with, for instance, an oil and gas company. 

Your point about the different ways in which ESG is discussed, you see that being picked up in the way in which some of the regulators are talking about this. For instance, in the EU, under the Corporate Sustainability Reporting Directive (CSRD), the EU uses what’s called a double materiality standard, namely they’re asking companies to think about ESG both in terms of its impacts on the company itself. That is like the outside-in concept of sustainability and financial impact, how are sustainability issues impacting the performance of the issuer. But then you also have this impact notion of materiality, which is the impact of the issuer on the world around it. This is called the double materiality standard.  

These are often highly interrelated issues, because ultimately, if you are having a significant negative impact on your communities, that’s going to relatively rapidly migrate into very clear financial impact, bottom line impact. The nature of these issues changes over time and have to be monitored by companies. I think that shows you that even in

the regulation, there is some attempt to try to capture some of that impact element of ESG issues in addition to the purely financial lens. It’s something of a blend, which has its own implementation challenges for companies thinking through these issues. 

Alex, I think we’ve had a great conversation today and I want to end by giving you a chance to really double down on your end of ESG thesis. I’m taking away a couple of points, one of which is that a monolithic approach to ESG is going to be highly inappropriate. ESG is highly expertise-driven. Metrics are going to be important but ultimately the qualitative aspect of ESG is going to be really important. That means that a sector-specific focus is often going to really help reflecting the way in which the analyst community engage with portfolio companies, so it’s about using data, using expertise to really think about how ESG issues affect the companies and not taking a kind of one-size-fits-all approach. With that summary, is there any final thoughts you have in terms of key takeaways?        

Edmans

Whenever I hear any statement about ESG, I remove the word ESG and see does the remaining sentence make sense. If people say, “Oh, is it consistent with fiduciary duty to take ESG risks into account?” Well, let’s remove ESG, is it consistent with fiduciary duty to take risks into account? Absolutely. And again, this is why I view some of the politicization as being rather bizarre, because any investor should take into account risks that affect the long-term returns to the company. 

But then on the converse, we would also want to use that approach to get rid of this magic word and pedestal that ESG is sometimes put on. Does ESG investment always pay off? Well, does investment always pay off? Not necessarily. Is more ESG always better? No, because more of anything is not always better, due to diminishing returns. I think if you forget that label, then we are going to be using standard mainstream good economic thinking, rather than wishful thinking or politicization. But then you might think about saying get rid of ESG, what do I replace it with? I would call it just long-term value or intangible assets. Now, that might seem a little bit less catchy than ESG, but those are things which people have looked at for a very long time, for decades, people looked at how to create long-term value. For decades, people have realized the importance of intangible assets, as well as tangible ones. 

I think the ESG label was useful for a couple of decades, just to draw people’s attention that when you look at intangible assets, it’s not just your brand, it’s not just the management quality, but also environmental, social and governance factors. But I do think we’re now at a point that value is recognized, that is respected and having too much of a focus on that label can do more harm than good for the reasons that we’ve discussed. Now, it’s actually past its time, let’s just think about long-term value or intangible assets.  

Tomlinson

That’s a terrific note to end on. Alex Edmans, thank you so much for being with us on the Better Finance podcast today, very much appreciated it.

Edmans

Thank you very much, Brian. It was great to be here.

Corson

The value of a company is based on both financial and nonfinancial dimensions, so only viewing ESG as a means to improve long-term performance discounts other critical business drivers that can create long-term financial and social returns. 

Thank you to Alex and Brian for sharing your perspectives on this important topic and discussing the different ways people view the wide ESG spectrum.  

If you’ve enjoyed this or any episode, please leave a rating or review. And don’t forget to subscribe so you can catch future episodes in our ESG series and in the core Better Finance podcast.  

You’ll find related links in the show notes or at ey.com/betterfinance. 

As always, thank you for listening and I look forward to speaking to you next time on the Better Finance podcast.

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