The Evolution of ESG: Rational Sustainability

Roman Dubczak: Hello, everyone. I’m Roman Dubczak, Deputy Chair of CIBC Capital Markets. In recent months, we’ve seen increasing critical discussion regarding the phrase ESG: Environmental, Social and Governance, namely what it is and what it can actually deliver. The topic is clearly being discussed from C-suites to trading desks. It’s also become a political lightning rod with some material repercussions now surfacing. On the one hand, we’re seeing companies resort to greenhushing to quiet down and minimize public attention to their climate pledges. We’re also seeing some companies exclude the term ESG when describing their corporate initiatives in earnings calls and in performance reports. Yet, on the other hand, corporate leaders continue to work towards implementing new and evolving sustainability reporting guidelines, the commonly referred to “alphabet soup”. These pressures will only grow as international standards become mandatory. With all of this mounting controversy regarding the phrase, not the actions, however, we’re going to explore the prognosis for the phrase ESG today. A few weeks ago, an academic paper titled: “Rational Sustainability” became public, which elevated the discussion of ESG’s application and further usage. The paper caught our attention and we decided to explore it’s ideas a bit fuller for the benefit of our clients. Here with me today to provide further insights is the paper’s author, Dr. Alex Edmans, a professor of finance at the London Business School and a widely followed and leading expert in behavioral finance. Alex has a Ph.D. from MIT, was previously a tenured professor at Wharton and also an investment banker at Morgan Stanley. He was also voted by Poets and Quants, the Professor of the Year in 2021.He’s a distinguished speaker and author on purposeful business and sustainable investing and his TED talks have had millions of views and I recommend them, I’ve watched them all myself. Alex, thank you for joining the discussion today. Let’s start with the basics: I mentioned this element of push and pull happening with ESG. In your opinion, how should ESG be viewed and why are we deviating off course, so to speak?

Dr. Alex Edmans: Well, first, Roman, thank you so much for inviting me. It’s great to be here and discuss this topic. So how do I think ESG should be viewed as a way to create long term sustainable value? And so that to me is why some of this backlash against ESG is somewhat surprising. So typically in the U.S., this backlash comes from Republicans who believe that business should be there to make money, but sustainability is about being successful in the long term. Indeed, why did ESG come to the fore in 2004? This was because there was emerging evidence that the long term profitability of a company was linked to how well you governed, how well you treat employees, how well you steward the environment. This is how I, as a professor of finance, not philosophy, not business ethics, how I, as a former investment banker at Morgan Stanley, came to be a fan of ESG, is the evidence that these are ways to improve long term value. But where some of the push and pull might come is that sometimes people swing too far the other way. So these are potentially ways to create long term value, but like anything, ESG has diminishing returns. So even if something is good, be it this diet exercise or hard work you can do too much of them to an extreme, and so ESG is not a magic word that immunizes it from the other laws of business, which are diminishing returns and trade offs. So if we pursue ESG, we need to ensure that it is a pursuit in a way which is consistent with long term value creation, rather than focusing too narrowly on it, and forgetting why it became so popular to begin.

Roman Dubczak: Alex, I’d like to dive a little deeper into what irrational sustainability is, as you mentioned. How does rational sustainability guard against this?

Dr. Alex Edmans: That there could be several different forms of irrationality. So, one form of irrationality is to forget about pricing. So again, as per my question, sustainability should be incorporated into investment decisions just like any other characteristic. If indeed a company has a great business model, this doesn’t necessarily mean we should buy it because that great business model could be in the price. And that is the same with sustainability. Yes, electric vehicles are great for decarbonization, but should we necessarily move into electric vehicles? No, there could be bubbles as there was a couple of years ago. Should we necessarily divest from all fossil fuel companies? From a purely financial perspective, even if there is climate risk, it could be that those risks are fully priced. So some of the black and white ways in which sustainability is pursued is ignoring the current price, It’s just buying companies because they are, quote, “good”, selling companies because they’re quote, “bad”, but we always want to take the price into Account. Right’s that’s point number one. Point number two is sometimes rational sustainability is pursued in a way that forgets about the evidence and goes with ideology and wishful thinking. So one example is the evidence for DEI and company performance. So ideologically, clearly as an ethnic minority, I would love to believe that diverse companies performed better, and there was indeed some research which is widely cited which claims to find that result. But unfortunately this research is relatively weak. But because of confirmation bias, we will have funds we’re not recognizing that they failed to distinguish correlation from the causation. They can set a very short time periods and so on. But because of confirmation bias, we want to accept that when in reality, if we look at this rationally, we might think, oh, yeah, there is no clear relationship between demographic diversity and stock returns, but this doesn’t mean that DEI is a bad thing. This means that if we are to pursue DEI, we want to look further than just something simple, like demographic diversity, maybe we want to take into account socio- economic diversity, diversity background, not just having finance people, but maybe engineers and scientists, and also cognitive diversity in terms of how we approach problems and try to solve them. And the third concept of rationality is the idea of diminishing returns and trade-off I alluded to earlier, but when I discussed this earlier, I talks about tradeoffs in terms of financial and social returns. And these are clearly important tradeoffs because often we say, do the right thing, let’s spend as much as we need to do to decarbonize, but notice we might be spending pensioners’ money, and so it’s not clear what the right thing is if we are to trade off a school, a planet where the fact that people are relying on these incomes for the pensions. And also, what I want to shift with, is the trade off here, not just between financial and social, but different social objectives. So when I was at the World Economic Forum a couple of months ago, we were discussing a just transition and then a lady from Africa got up and she said, in Africa, 600million people have no access to electricity. So you in the West, you talk about having a just transition in my continent, 600 million people have nothing to transition from. So, yes, it is true that climate change is a really big threat, but also electrification is necessary for economic development and also to rapid decarbonization could, within North America, lead a lot of people who rely on the fossil fuel industry for jobs being out of work with huge impact not only on them but on their families. And it is nice for the, quote, “Davos Elite”, to think about only the decarbonization issue when they might not know any 55 year old, 55 year old oil and gas worker, but we need to make sure that we take into account all of the people affected by a decision rather than just the ones that get the biggest media attention.

Roman Dubczak: Very good. Thank you, Alex. So what I liked about your paper is that you advocated for more corporate behavioral changes, not fewer. Taking the phrase itself, but reconstructing it to trigger more change, which is excellent. What advice would you give to our corporate clients trying to deliver responsible outcomes for their for their stakeholders?

Dr. Alex Edmans: I think it’s just to go back to basics as to why ESG and sustainability became popular in the first place. And all for good reason, because these are ways of creating value for wider society, but also making for successful companies. Now, how will this is evolved and somewhat morphed, is into a box ticking exercise where we pursue ESG in order to tick the box in the previous ESG ratings. If we instead go back to the basics and say, well, can we do things which create long term value for my company, irrespective of what it does for the metric, I think we end up then pursuing sustainability in a much better way. How? Number one, we focus on outcomes, not labels. For example, let’s go back to DEI, it may well be that a white male would add more diversity to the company than say, me, because he could come from a different socioeconomic background, could have a background outside of finance. Now, that doesn’t show up in certain metrics, but what we want is true diversity of thought. That’s something that we will try to make sure that we include. Number two is to recognize that sustainability is like any other business decision. So one simple tip that I give to companies is if you have a problematic or controversial sentence in order to evaluate it with a clear head, remove the word sustainability and evaluate the remaining sentences. So, is more sustainability investment always better? No! More investment is not always better. There are diminishing returns. So sustainability is not this magic word, which means that it is immune to all of the other forces which drive business decisions. Conversely, is it consistent with fiduciary duty to take sustainability risks into account? Absolutely, because it’s consistent with fiduciary duty to take risks into account. In fact, that is an essential part of fiduciary duty. So let’s again not think about whether something fits the sustainability label or not. Instead, does it create value for wider society? Let’s try to make sure that as a board, as a company, we have on our radar screen all of the things that will matter to our company’s long term business success. Some of these will be traditional sustainability issues like environmental impact and DEI, others might be other intangible issues like innovation, which might not fit within a sustainability box. But this does not mean that they are any less valuable, and others might be traditional tangible assets like property, equipment, plants and factories and so forth, but all of these things matter for the long term value of a company, just right now if you are a company and you want to win brownie points, you would invest more in a sustainability issue rather than these other issues when I think all of them should be taken into account.

Roman Dubczak: Thank you for that. And I’m going to Alex now widen the aperture a little bit and feature what I view as a very good read. And in 2020, you published the book: “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”, which was also named to the Financial Times Business Books of the Year list in 2020, among other accolades. You’ve described it as a fundamentally optimistic book, even though it’s about the increasing polarization between business and society. What inspiration can our clients draw from the book?

Dr. Alex Edmans: Well, let me first explain what the pie is, and thank you so much for mentioning it Roman. So the pie is the value that a company creates and that can be divided between investors in the form of profits and society, in the form of value that could be fair taxes, fair wages and fair prices. And we typically think that the pie is fixed and therefore if the pie is fixed, it’s a fight between them and us. So, quote, “countless things”, let’s take as much of the pie as possible by holding down wages and raising prices and then advocate for business reforms, say, let’s try to straitjacket business with heavy regulation to give more pie to everybody else. So why this is a fundamentally optimistic book is that it suggests that the pie can be grown. And this is not based on blind faith or wishful thinking, but rigorous academic evidence show that many things that companies do to help wider society, they ultimately bounce back and improve the company’s value in the long term. And so that is the same idea of shared value creation that we’ve been talking about in terms of rational sustainability, if we instead shift the attention from pie splitting, them vs. us, or box ticking towards what can truly create value for both the company and wider society, that could then be something which not only allows a company to be profitable and sustainable in the long term, but also allows the company to address some of the biggest challenges in the future. So let’s take, for example, going back to electric cars, but using this example in a more positive light, so, why was this something which was started out because people felt passionate about the climate crisis and then this inspired them to take a crazy decision as to whether we can run a car just on batteries, which might have seemed crazy when this was first started and then, while that is highly profitable, because if you are creating value for wider society, if you are addressing society’s challenges, then ultimately you grow the pie and then you will be able to take part of that pie in the form of a greater slice in terms of long term profitability.

Roman Dubczak: Wonderful. Well, Alex, thank you for your insights, your very thoughtful insights on ESG and surfacing the phrase and directing the conversation on rational sustainability, which I find very, very interesting. And what is obviously going to be a hot button issue, namely ESG and the application of the phrase in the coming year. So thank you very much for coming to us from London, as it turns out today. So appreciate you joining us. And no doubt, the upcoming political elections in a number of key jurisdictions, coupled with increasing disclosure across different geographies and continued shareholder engagement, will all contribute to how this debate unfolds this year. Our goal is to help our clients make sense of these issues and to help them move forward. I’d also like to thank you, our clients, for spending some time with us today. I hope you enjoyed today’s topic and we’ll look forward to speaking with you again soon. Thank you.