ESG Conflicts? What Would Adam Smith Say?

ESG Conflicts - What Would Adam Smith Say

A respected idea in economics, known as the “universal ownership theory,” states that some actions that could maximize value for an individual company may not be optimal for its shareholders. Huh? Stick with us – we’ll explain, and show why this is relevant in the ESG arena.

The whole is different than the sum of the parts

The source of this paradox is that investors typically hold positions in hundreds of companies (through mutual funds and/or ETFs). So, if an individual company profits from actions that threaten the health of many other companies its shareholders also hold in their portfolios, the overall economic harm to those shareholders may significantly outweigh the gain each of them realizes through his or her exposure to that one company.

As explained in this recent article from the Harvard Law School Forum on Corporate Governance, prominent economists Oliver Hart (Nobel prize winner) and Luigi Zingales state that “the shareholders of one firm may be concerned about the impact of that firm’s externalities on the profitability of other firms the shareholder owns.” As a result, those shareholders might not want that one firm to focus solely on maximizing its own financial returns. 

It is rational to pursue the goal of optimizing the value of a portfolio – and we can think of an entire economic system as a “portfolio” – rather than an individual company. And, it is rational for investors who seek to optimize the value of their overall portfolios to use their shareholder rights (such as proxy voting) to pressure a company to reduce or stop an activity that generates harmful externalities, even if that reduces the value of that particular company.

Universal Ownership Theory and ESG

Therefore, policies that reject ESG considerations are against the best interest of investors who want to optimize their returns at a portfolio level. The Harvard Law School Forum article goes on to say that “casual rejection by anti-ESG politicians ignores the data, which shows that the return of a diversified portfolio depends much more on broad market returns than on the relative performance of individual portfolio companies” (in contrast, promoting sustainability within an individual company makes economic sense for many reasons). 

The same article from Harvard Law notes that policies that interfere with, or even prohibit sustainability-oriented stewardship are not only bad for individual investors, they are also bad for capitalism. By interfering with the rights of shareholders to direct their own capital in a way that produces the highest value for their investments overall, such policies directly conflict with the core principle of free market economics. That’s particularly hard to swallow when the policies are clearly political. What is that principle? That the owners of capital, by pursuing profits, create market forces that efficiently allocate resources (think Adam Smith and the Invisible Hand).

In a recent survey  of more than 4,400 CEOs around the world, PwC found a majority expect climate change to have a moderate, large, or very large impact on costs and supply chains within the next twelve months. So, under the universal ownership theory it is absolutely rational for shareholders in firms in, say, the energy and utility sectors to want those firms to pursue ways to reduce greenhouse gas emissions and increase their involvement in renewables. Even though that would reduce profitability for those who invest in energy and utility companies in the near-term, it would improve profitability and reduce risk for most of the other companies in those same investors’ portfolios.

Maximize shareholder value and sustainability at odds?

We appreciate the clear thinking from The Shareholder Commons (TSC), whose mission is to address social and environmental issues from the perspective of shareholders who diversify their investments to optimize risk and return. TSC focuses on another type of conflict in the “how to maximize shareholder value while pursuing sustainability” arena, namely that there is often a divergence between “a company’s interest in maximizing its cash flows over the long term and its shareholders’ interests in optimizing overall market returns.”

In this article titled “You Want Us To Ignore What? A Brief Analysis Of Anti-ESG Political Rhetoric” TSC says that because ESG issues often mirror political issues, it is “easy brush off social and environmental investment risks as leftist politics.” Echoing the central tenet of universal ownership theory, the article asks us to consider a company that lowers its costs through practices that contribute to deforestation and violates human rights. These practices boost that company’s profits but hurts its diversified shareholders, who invest in many other companies whose risks increase as a result of the first company’s actions. 

Laws that prevent shareholders from challenging such practices enrich the company’s executives whose compensation is likely driven by earnings, but damage other investments held in their employees’ pensions and 401(k) plans. In what we found to be a thought-provoking sentence worth quoting verbatim and reading more than once, TSC says it is often at odds with ESG investing as currently practiced, because “we think it is too focused on enterprise value, and thus misses the opportunity to protect critical systems from practices that are good for individual company bottom lines, but bad for the planet and its inhabitants.” 

Incongruities in pursuit of sustainability

It is not news that pursuing various ESG goals involves trade-offs and contradictions. For example, with respect to the UN Sustainable Development Goals increasing incomes above extreme poverty will increase environmental pressures. Eliminating hunger and malnutrition will affect land, water, and energy, biodiversity, and climate, because food production affects all of those things. 

Wanting energy companies to pursue a low-carbon future is not the only tug-of-war that arises in the ESG arena; other conflicts arise when pursuing both growth and environmental protections. An often-cited academic study examines conflicts between goals for transport and land use planning and reducing emissions in three cities in Norway, a country that is often seen as a “guiding light” when it comes to environmental practices. Another classic study on planning and local governance describes planning as a basic conflict between environmental protection, economic growth, and social justice.

In a separate but somewhat analogous way, we can think of ways in which ESG efforts within an individual company can conflict. Striving for the “perfect” or optimal combination of sustainability practices assumes we can define “perfect” in this context. In our own household, is it better to put our food scraps down the garbage disposal, which requires us to waste water that is a scarce resource in our drought-prone area, or dump them in the trash to be buried in a landfill and give off methane gas? 

Key takeaways: if we care about shareholders and economies overall (not just individual companies) we should not ignore externalities. And, no one ever said that deciding on and implementing rational ESG policies would be easy. Of course, in making those decisions we think starting with actual data is a wise course. Contact us to learn how OWL’s ESG data can help your analyses.