(Illustration by Matt Chase)
Right-leaning US politicians such as Florida Gov. Ron DeSantis have declared war on investors who pressure companies to pay more attention to environmental, social, and governance (ESG) issues. At the same time, progressives such as BlackRock’s former CIO for Sustainable Investing Tariq Fancy criticize ESG efforts as an ineffectual distraction from the policy efforts needed to create real change.
These critiques from opposite sides of the political spectrum are buttressed by a key shortcoming of the ESG movement: It has yet to acknowledge the conflict that lies at the heart of modern portfolio investing—individual companies boost their profits with practices that threaten the systems that underlie the diversified portfolios of their own shareholders.
By identifying this conflict and extrapolating its implications, investors can explain their financial interest in stewarding portfolio companies toward accounting for their impacts on society, the environment, and the broader economy. Such systems stewardship is an essential, market-based solution that can use investors’ economic incentives to shape decisions made in C-suites and on Wall Street.
When Alpha Fails
Let us begin with two noncontroversial observations. First, investors are likely to own positions in hundreds or even thousands of companies, either directly or through pooled investment vehicles. This diversification allows investors to increase returns with minimal risk. Second, if one company in an investor’s diversified portfolio increases its value through conduct that poses risks to the social and environmental systems that are critical to the economy, the consequent harm may cause damage throughout the portfolio, and that damage may far outweigh any gain the investor receives from a relatively small holding in the company.
By contrast, the executives who run companies are financially incentivized to care only about the value of their company, not the aggregate value of their shareholders’ portfolios. Decisions that impact these two values differently create a divergence in interest between company managers and the investors whose capital they are using.
Investors tend to ignore this conflict and treat individual companies as the critical units for measuring financial success, rather than focusing on how company decisions affect broad market returns. Executives and asset managers are rewarded for generating alpha (the difference between the returns of a company or portfolio and the average return for similarly risky investments), regardless of the impact such alpha generation might have on the systems that determine the broad market returns that matter most to diversified investors. For example, investors strongly favor equity compensation, under which managers are rewarded when a company’s share price goes up, even if its business model relies upon cost externalization that threatens broad market performance. Similarly, asset managers who pick stocks are rewarded when their portfolios outperform similarly risky portfolios, regardless of the impact that the “winners” are having on the economy and overall market returns.
Unfortunately, ESG activists tend to share this individual company bias, at least when they explain their motives. They defend their activism almost exclusively in terms of the potential to improve the alpha of individual companies by improving their social and environmental impact. The ESG movement eschews rhetoric that directly addresses the trade-offs that sometimes exist between the positive effects a company decision has on its own financial value and the threat that decision could pose to the overall performance of the market. As a result, cost externalization continues.
Take climate activism, for example. While climate plays a large role in ESG strategies, investors have not effectively pushed companies to align their carbon footprint with the Paris Agreement—the United Nations-brokered international agreement to keep global temperature increases from greenhouse gases to well below 2 degrees Celsius above preindustrial levels. Companies do make operational accommodations for the climate crisis but appear to do so only to an extent that does not materially threaten their own financial returns. Yet, our research shows that the collective failure of our economy to align with Paris will mean that a typical 32-year-old worker saving for retirement is likely to have 7 to 14 percent less in retirement, with the risk of much greater losses.
The same story repeats itself for most ESG issues, including inequality, worker rights, and biodiversity. Failure to address these issues threatens economic loss that will lower portfolio values for diversified investors. The alpha that some companies can achieve by ignoring these issues cannot make up for the damage to overall market returns for which they are responsible. But even though most shareholders would benefit from directly confronting this dynamic, most current thinking about shareholder stewardship draws a line at explicitly calling for corporate decisions that might negatively impact a company’s financial value. Instead, it favors a “win-win” vocabulary that highlights overlap between improving social and environmental impact and improving individual company returns.
One reason for this failure is the contrast between the saliency of alpha and silence of beta (the average return to a diversified investor). Investors can always compare the performance of a fund with its benchmark and the performance of a company with its peers’. Thus, a fund or company that successfully creates alpha can claim success by pointing to historical returns. On the other hand, contributions to market return (and the systems that support it) benefit all diversified investors equally, and so they do not show up in comparisons among companies or funds.
Of course, alpha is important to investors. Holding all other things equal, increased alpha does mean increased returns. The knowledge that executives are working to optimize alpha encourages commitment of the permanent residual capital necessary to fund a complex modern society. A trust-based security like common stock that is entitled to no specific return and is subordinated to every creditor requires a promise that the interests of those shareholders come first. Delivery of alpha is the making good on that promise.
Furthermore, companies’ search for alpha serves the critical role of price discovery for our economy. Firms acquire resources for one price and use hard work, efficiency, and innovation to turn them into goods and services to be sold at the highest price obtainable. This is the primary mechanism by which we allocate scarce resources in a market economy.
In sum, alpha is (relatively) easy to measure, good for shareholders, and good for society. But all alpha and no beta is a recipe for disaster. Authentic systems stewardship can preserve the role of seeking alpha but ensure that it does not compromise beta and the systems upon which the global economy depends.
The Power of Shareholders
Ideally, laws and regulations would address the externalities that threaten beta. But, for reasons beyond the scope of this article, the global regulatory scheme leaves ample room for firms to profitably externalize costs in an economically inefficient manner. Moreover, the search for alpha by companies often leads them to interfere in the regulatory process, an aspect of profit-seeking that systems stewardship can address.
If alpha is accepted as the true measure of business success, critics can insist that ESG is anti-business and bad for investors.
The regulatory gap can be ameliorated by diversified shareholders who, unlike corporate executives, are well-positioned to limit business strategies that threaten social and environmental systems. They have the right economic motivation—protecting the intrinsic value of the economy in which they are invested. They also have the power, through a globalized capital market, to impose consistent limits across borders. As long as politicians do not interfere with investors’ rights to steward their own capital, shareholders will remain free of many of the political strictures that prevent regulators from addressing critical social and environmental issues.
A systems-stewardship lens allows shareholders to preserve the global economy and their portfolios: They can continue to insist that the firms they own pursue alpha, but do so only within boundaries that protect the systems that support our economy. Such stewardship can serve as a crucial feedback system in our complex market economy when companies are tempted to externalize costs that threaten social and planetary boundaries.
System stewards should focus on the area where shareholder voice is most needed: corporate conduct that creates alpha while undermining the beta upon which diversified investors rely. If stewardship does not address situations where surrendering alpha is necessary to protect beta, corporate executives will continue to pursue these extractive strategies. Companies maximizing their own returns will continue to reduce the value of diversified portfolios and misallocate capital throughout the economy.
By contrast, the current practice of alpha-only stewardship cedes shareholders’ authority to management. After all, while shareholders can make a case about company value to corporate management, these executives already have the expertise and motivation to build company cash flows. Only shareholders have the motivation to protect beta. Thus, while it may be counterintuitive, a shareholder’s argument that a company must change a practice to protect beta at a cost to alpha is actually much more credible and authoritative than an argument that it must change a practice simply to protect alpha—an area in which management arguably has the greater qualification.
A narrow reliance on alpha arguments also strengthens the hand of ESG opponents. ESG objectives seem to be designed to protect systemic outcomes. Critics can credibly allege that ESG alpha claims are just cover for stewardship arguments that do not truly promote company value. If alpha is accepted as the true measure of business success, they can insist that ESG is anti-business and bad for investors. By contrast, if ESG proponents clearly state their goal of preserving vital systems crucial to the overall economy in order to buttress the returns of diversified portfolios—explicitly rejecting individual company alpha as the sole measure of success—they can answer such allegations directly and provide a better case for recognizing the authority of shareholders.
Shareholder stewardship over social and economic systems creates a market-based approach to these issues that enables shareholders to ensure that their capital is employed efficiently on their behalf. Embracing systems stewardship shows that it is the anti-ESG movement that is anti-capitalist: By legislating against stewardship by shareholders, they are “picking winners” who cannot make it on their own in a market system in which investors—the actual capitalists—are able to direct how their capital is deployed.
Read more stories by Frederick Alexander.