March 13, 2024 • 31 mins
ESG has become an important part of the investment landscape. But some critics say the term may be overly broad, conflating a number of topics that may or may not be financially material for different issuers. In this episode of ESG Currents, BI analysts Eric Kane and Rob Du Boff are joined by Alex Edmans, a professor of finance at London Business School, who recently authored a paper advocating the concept of “Rational Sustainability” as a worthy replacement. This episode was recorded on Feb. 13.
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Speaker 1 (00:09):
ESG has become established as a key business theme as
companies and investors seek to navigate the climate crisis, energy transition,
social mega trends, mounting regulatory tension, and pressure from other stakeholders.
The rapidly evolving landscape has become inundated with acronyms, buzzwords
and lingo, and we aim to break these down with
industry experts. Welcome to ESG Currents, brought to you by
(00:32):
Bloomberg Intelligence, your guide to navigating the evolving ESG space,
one topic at a time. I'm Rob Duboff, senior ESG analyst.
Speaker 2 (00:41):
And I'm Eric Kane, Director of ESG Research for Bloomberg Intelligence.
Speaker 1 (00:45):
It's no secret that ESG has become a bit controversial
in recent years. From the left, it gets accused of
being overused to greenwash concerns that companies are not doing
enough to address some of the critical issues of our time.
And from the right, it gets accused of forcing a radical,
woke agenda on the corporations whose so focus should really
be on making money for shareholders. So as a time
(01:07):
to just scrap the whole endeavor and move on, today's
guest certainly has some thoughts on this. He recently put
out a paper proposing an alternative concept, which he calls
rational sustainability. Joining us today to discuss is Alex Edmunds,
Professor of Finance at London Business School. Alex has a
PhD from MIT, is a Fulbright scholar and was previously
(01:28):
a tenured professor of Wharton. An investment banker at Morgan Stanley.
He's spoken at the World Economic Forum in Davos, testified
in the UK Parliament and given the Ted talk What
to Trust in a Post truth World. And he's author
of a Financial Times book of the year, Grow the Pie,
How great companies deliver both purpose and profit.
Speaker 3 (01:48):
Thanks for joining us, Alex, Thanks so much for Robin Erik.
It's great to be here.
Speaker 1 (01:52):
Great. So let's get to it, as you see, what's
the problem with ESG as it's currently understood in the market.
Speaker 3 (01:58):
I think the problem is misunderstood by the market on
two main grounds. So the first is what is it,
what's the ultimate goal? And the second is how to
do it? What's the approach? And this misunderstanding is from
both sides. So skeptics of ESG the arguer ESG is
only done to impose political beliefs that you couldn't get
by the ballot box. This is necessarily at the expense
(02:21):
of financial returns, and therefore there's proposals to ban the
consideration of ESG risks. But in many cases ESG risks
are financial risks. You would want to take them into
account even if your only objective is financial returns. So
often ESG can boost returns rather than being at their expense.
(02:41):
And then if you look at the proponents of ESG,
their goal is sometimes thinking that more ESG is always better.
Let's invest in as many ESG stocks as we can,
not recognizing that for some companies actually traditional factors like
productivity and innovation and profitability might be more important than ESG. Also,
(03:01):
ESG has diminishing returns. More was not always better, And
in terms of the approach, they often might think that
in order to do ESG, let's divest from all companies
and the fossil fuel industry. Let's try to vote for
every shareholder proposal, even if this might be micromanaging the company.
So I think there's an extremism and misunderstanding f on
(03:22):
both issues, and so this is why I wanted to
put out an alternative approach.
Speaker 2 (03:26):
So, Alex, you mentioned the misunderstanding from both sides and
the new approach. So this is where the idea of
rational sustainability enters. Can you tell us what it is
and why you think it's a better alternative?
Speaker 3 (03:38):
Certainly, And so the two words in turn, one of
them is on the goal and the other is on
the approach. So the goal is sustainability. And what does
sustainability mean. Now, often it's seen as something which is woke,
but if you go back to what it means in
the English language, sustainability means creating long term value. So
(03:58):
a self sustaining system is which is there for the
long term. Sustaining ecosystem or even organism, that's something which
will be there for the long term. So sustainability is
creating long term value. So those who are skeptical about this,
do we not want companies that are there for the
long term that manage their sustainability risk, not because of
(04:19):
any political agenda, that because these things are ultimately important
for the company's long term success. And for those who
are proponents of what's currently called ESG, sometimes they go
after short term easy wins. So again this might be
voting for every shareholder proposal, even if this micromanagers of
the company at the expense of long term value creation.
(04:44):
So vindee, the goal is creating long term value. Hopefully
that's something that everybody can align behind, both those on
the left and those on the right, and we forget,
we lose, and we reduce some of the politicaliization that
has led to the muddled views on this topic. So
if the goal is sustainability creating long term value, the
(05:04):
approach is rational. So what does an irrational approach mean.
It means being based on evidence, not ideology. So certainly
ESG factors do pay off, but others don't. And that's
to recognize this, and it also is to recognize trade offs.
More is not always better. So let's achieve this goal
in a way which takes into account evidence and trade
(05:25):
offs rather than going head in or completely ignoring it
because you're just resistant to it.
Speaker 1 (05:31):
Great and your approach. In your paper you outline ten
features of rational sustainability. Can you rock us through what
those are?
Speaker 3 (05:38):
Sure? Rather than going through all ten a big laundry lists,
let me just focus on four. Let me think about
two on the sustainability aspect and two on the rational aspect.
So on sustainability, one of the principles, actually principal number
one is rational sustainability is about value creation, not politics.
(05:59):
So this links to my earlier response. The idea of
sustainability is creating long term value, and that's something that
everybody should be aligned behind. But also it suggests that
we don't do things that don't create long term value.
So if it's something in order to move up the
league tables of asset managers voting for shared proposals even
(06:21):
if they don't create value, that's not something that we
should be getting behind. It's about outcomes, not box sticking.
But the second feature of rational sustainability I'd like to
highlight is that it's enabling, not prescriptive. So what do
I mean by this. I've used the term long term
value many times so far in this conversation. Now some
people think that means only financial value, and they might say, well,
(06:45):
Alex has completely missed the point of a ESG, which
is not just to create financial value. We also care
about social outcomes. Now, sometimes those social outcomes will manifest
in financial value, but sometimes they won't. They are pure externalities.
And what I'm trying to do is not be prescriptive
as to what I mean by value. It could be
(07:07):
that for some companies and some investors they care not
only about financial returns but also about global warming or diversity,
equity inclusion, or biodiversity. But what I'm saying is that
you want to be clear about that goal, and you
might be clear that there are trade ofs between them,
rather than pretending that everything is a win with And
(07:29):
also if you want to pursue this goal, which might
not only be financial value, again to make sure that
this is pursued in a rational way. So that is
the sustainability aspect. It's about value creation, not politics, and
that value can include non financial value as long as
you're up front about it and clear about the objective.
(07:49):
But then what's the rational aspect? One principle is rational
sustainability is based on evidence and analysis. So there are
some views which is ESD always pays off. Every ICJD
dimension will always manifest in high returns. Now, even though
I'd love to believe that, my book Grow the Pie
argues that some ESG factors do improve financial returns, that
(08:12):
is not always the case. There are tradeoffs, and on
the flip side, there are ESG opponents who says ESG
is always at the expense of financial returns. No, there
are some factors where long term regress evidence suggests that
they are helpful. And the second principle that I like
to highlight on the rational part is it's based on
(08:33):
diminishing returns and the trade offs. So even if you
are an ESG advocate, which I am, more, YESG is
not always better. So some of my workers on treating
employees well, this does not mean paying them as much
as possible at a certain point in time. After a
point in time, it may be that this leads to
you becoming uncompetitive. And there's also tradeoffs between financial returns
(08:56):
and social returns. Maybe up to a point there isn't
a line. But if you're investing excessively in ESG factors,
this might be the expense of long term profitability. Now again,
maybe you're happy with that because your goal is not
only financial returns, but all What I'm saying is that
we go into this with our eyes open, realizing that
(09:18):
there are trade offs, rather than thinking that everything is
a win.
Speaker 1 (09:21):
Win, got it? Now, I guess one of the first
thoughts I had was, is this really just semantics. You know,
for ASG, we had SRI Socially Responsible Investing.
Speaker 2 (09:30):
Is this just.
Speaker 1 (09:31):
Changing the name or are there are there fundamental changes
needed to the discipline of what is now ESG.
Speaker 3 (09:38):
This is about a fundamental change. It's not just a
name change or a rebranding. And so this has been
a bit surprising to me because I've seen it's great
that this paper has got some coverage on social media
and the media, but there are some who reacted and say, oh,
why is he just thinking about changing the name. But
the paper is really upfront that it is far more
than just a name change. It is about ten principles,
(10:01):
and all the principles are are practices t ESG. It's
about how we do this is being based on evidence
and recognizing trade offs, and what the goal is is
long term value creation. So I've called it something different,
but that is to emphasize that the goal is long
term value creation and that the approach is to do
(10:24):
this in a rational way, taking evidence and out. Now,
it could be that there's some people who still call
it ESG and they still do this now based on
my paper or other people based on evidence and thinking
about long term value cation. That would be absolutely fine
with me. My main focus is on how to do
this and what the goal is rather than just what
we call it.
Speaker 2 (10:44):
That's super interesting. So it's one of the other principles
that you outline in your paper is the idea that
rational sustainability is intrinsic, not instrumental. So I've often said
that the biggest success for the ESG movement, if we
can call it a movement, would be if it just
became called investing and was no longer considered a separate discipline, right,
(11:07):
and you suggested in the paper that in theory, there
really should be no need for a new acronym to
have been coined if the factors that we're looking at
an ESG lead to value. I'm just curious to hear
your thoughts on whether you think the discipline has ultimately
kind of helped us move towards these issues actually being
more intrinsic through enhanced disclosure research and analysis. Given that
(11:32):
you know, certainly when I started in the space almost
two decades ago, we didn't have any of the data,
we didn't have as much research, we didn't have as
much product or analysis related to these concepts.
Speaker 3 (11:45):
This is a great question I do think that the
movement did create a lot of value right at the start.
You are right, Eric, that in theory they should not
be the need for ESG investing. It is just investing.
And indeed, one of my recent paper's called the end
of ESG, so that we really shouldn't need that phrase,
because if these things ultimately improve financial value, shouldn't they
(12:06):
be taking an account anyway? Well, that's true in theory,
but in practice it might not be. Why because investors
have tons of things that they need to look at,
and they only have certain numbers of hours in the day,
and without any ESG acronym, it may be that people
would have not realized that these things were material. So
when the ESG acronym was coined, that could have been useful,
(12:29):
And I think it was useful because it got people
to start paying attention to factors that they didn't realize
were material previously. And you're Eric, Intrinsically they started to
recognize that these are good things to look at when
evaluating a company. But now I think it's we've moved
past the intrinsic to the instrumental, where we do ESG
(12:51):
not because we genuinely think it creates long term value
but to be seen to do ESG. So right now,
if you're an investor and you engage each with the
company on ESG factors such as the diversity of their workforce,
you get far more brownie points than if you engage
with them on productivity or capital allocation or innovation. And
(13:12):
one question that I often ask asset managers is if
you were not able to tell anybody that you were
voting in this way or engaging in this manner, would
you still do this? And I don't think the answer
is always yes. I do think that there are some
investors who do engagement or vote in a certain way
to tell everybody that they're doing this. And I think
(13:34):
this is quite different to what started the ESG movement
to begin with, which is a genuine view that these
things are financial, need material, and they need greater attention
than they've had in the past.
Speaker 1 (13:47):
Now you also no rational sustainability guards against irrationality, whether
this is companies pushing d n I messages without considering
the backlash, or overly optimistic forecast for near term evs else.
I mean, I see similar trends when I look at
some of the stories about AI replacing jobs, or the
downstream impacts of GLP one weight loss drugs. I mean,
(14:08):
I saw and Alice put out a note talking about
airlines lowering emissions simply because passengers are going to be
ten percent later. It just feels like chasing fads is
always a feature of markets. So how do you really
guard against this?
Speaker 3 (14:21):
I think it is to recognize what you just asked
in the question, Rob, is that chasing fads is always
a feature of markets. ESG is as prone to fans
as anything else. So this is one of the problems
with the ESG term and might be why actually a
name change might help. In addition to all the fundamental
changes I'm focusing on, the ESG term has been seen
(14:43):
as a bit of a magic word that it defies
the laws of gravity, or in this context, the laws
of basic economics. People think, let's pursue ESG without regard
for pricing, without regard for diminishing returns, because these are
good things. But the basic laws of economicsuggests that more
of anything is not always better, even if that thing
(15:04):
is seen to be good. More investment isn't always better
because there's diminishing returns. And also, as an investor. Whenever
you choose to invest in something, you always need to
compare it to the price and the excitement that we
had about electric vehicles in the early part of this decade,
particularly when we had the lockdown. This is something which
(15:24):
could have led to them being really overpriced and people
had just forgotten about. Let's relate this to fundamentals, which
is pricing. So when we think about ESG as another
set of factors rather than this special set of magic
words which is immune to the same bubbles that anything
else in business is, that will allow people to have
a more rational approach to this. And this is something
(15:47):
that I tried to highlight in this paper, but actually
a paper before this called applying economics not gut feel
to ESG argues that we should look at these things
as mainstream business issues and approach with the same riga
rather than ideology or wishful thinking.
Speaker 2 (16:04):
Super interesting. So I think one of the other topics
that has really become a flashpoint for debate within ESG currently,
if we can still call it that for the purpose
of this conversation, is the debate between single materiality and
Deublop materiality. And we've kind of touched on some of
these concepts and some of the previous answers, and we've
(16:26):
done a lot of research on our team and oftentimes
kind of view the distinction between the two as a
false dichotomy. So if we think about a real world example,
we've created ESG scores, for example, for about fifteen thousand companies.
One of the things that we do in our scoring
process is identify top priority environmental issues, top priorities social issues,
(16:50):
and that's based on financial materiality or single materiality. And
what we see when we look at all the industries
that we've identified, you know, greenhouse gas emissions as being
financially material for it represents ninety seven percent of the
indexes emissions, right, Whereas the roughly eight thousand companies for
(17:13):
which we don't think greenhouse gas emissions are financially material,
it's over half the index, but they represent only three
percent of emissions. So in my mind, you know, it
shows that the same group of companies that we ultimately
think of as having a financial exposure to the issue
are also the ones that are having the biggest impact
(17:36):
on the planet in terms of climate change. So if
one wanted to really tip the scale or move the
needle on climate change. They should be focusing their effort
on those companies for which it's financially material, rather than
that group of eight thousand companies that only produce three
percent of the indexes emission. So curious as to kind
(17:57):
of your thoughts on that debate between materiality and double
materiality and whether you know there there is a false
ecademy there.
Speaker 3 (18:05):
That's another great question, Eric, and I think ninety percent
of the time I would agree with you that there
is a fourth dichotomy. Ninety percent of the time factors
that affect society and the environment ultimately come back and
are financially material for the company. And that was the
main premise of my book, Grow the Pie Companies that
create value for wider society. You might call this inside
(18:28):
out materiality that ultimately leads to outside in materiality. This
affects the company's financial performance. But there are some ESG
advocates who argue this is one hundred percent of the time,
every single thing you do to affect the world ultimately
affects your profits. And I think this is just wish
for thinking this is too good to be true. So
(18:49):
a basic principle of economics is externalities. There are things
that we can do to affect the world that don't
ultimately affect us. So one example could be tobacco. In
nineteen fifty that was the first evidence that smoking leads
to cancer. In the intervening seventy four years, there have
(19:10):
still been outsized profits from the tobacco industry. Even if
there's negative social impact. There could be other things that
you can do, such as monopoly power or lobbying of
the government to protect your profits. And in the environmental
issue that you asked in your question is where we
also do see a trade off. So there is a
(19:33):
finding which I wish it wasn't true, but this is
just what the data says is that companies that emit
higher carbon generate higher stock returns. Now, the EESG crowd
immediately latched onto this and said, well, isn't that proof
that carbon emissions are bad? The reason why they emit
higher stock returns is they are so bad that investors
(19:57):
will only hold these companies if they're given higher returns
as compensation for the risk of, say a change in
government regulation. But if you just think about this with
a clear head, doesn't the ESG crowd typically see higher
returns as a good thing. Right, they claim companies that
treat their work as well or their customer as well
(20:18):
they have higher returns. They see this as outperformance. They
don't see this as compensation for risk. So you can't
just suddenly turn around and then when you find that
bad brown companies generate higher returns, that you interpret those
higher returns or a bad thing. And so in actually
in a recent paper which is called does the carbon
(20:39):
premium result from risk or mispricing? My course and I
analyze this and we find the reason for these higher
returns is not because these companies are riskier. They're just outperforming.
And how are they outperforming. They are able to get
away with polluting. They're not investing in emissions reduction. They're
able to pollute, and because is not a global carbon tax,
(21:02):
they are not suffering in terms of financial consequences. So
that is a case in which inside out materiality is
not currently leading to outside im materiality. Now people look
at that and they say, okay, well that was the past.
That was based in the past few decades of history.
In the future, when there will be government action, all
(21:23):
of that will change. But when I was at school,
a couple of decades ago, I already knew about the
greenhouse effect and climate change. We all learned about that,
and the intervening couple of decades we've seen some action,
but it clearly has not been enough in order to
change that result. Now, I would love it if my
result went away and that in the future companies that
(21:44):
emit more carbon have lower returns, But it may well
be because of the political difficulties of implementing a carbon
tax of the size that we think will actually fully
incorporate the externalities that we might see this trade off
going forward, and therefore there will be always some discrepancy
between financial returns and social returns, even if most of
(22:08):
the times they are aligned. There will be these inconvenient truths.
And again one of the goals of my paper is
to recognize and be upfront that there are inconvenient truths,
rather than assuming that everything is always going to be
a winner.
Speaker 2 (22:21):
That's super interesting, eles and to follow up on that,
because I think it's certainly different than some results that
we've seen in some of our research. So maybe just
a clarifying question when you do that analysis and you're
finding that those companies that ultimately are emitting more carbon
are yielding more returns. Is that in industry specific analysis
(22:42):
or are you looking across the economy and kind of
picking type admitting companies and comparing to the entire economy.
Speaker 3 (22:50):
Yeah, So this analysis has done a number of ways.
So first it's done in an aggurate way, but it's
also done on an industry adjusted basis, because you might
think there's industry effects here and I also should be
up fun. I appreciate you crediting me with this, but
the actually initial findings were done by some other researchers
which documented rigorously this link between emissions and stock returns.
(23:12):
The goal of my care isn't me, was to look
at the reason for that. Is it due to risk
or is this due to mispricing? But it was prior
people who had documented that link, not my co authority.
Speaker 2 (23:25):
Interesting because our colleague and is not on the call today,
has done a lot of work that he coins climate
Alpha and basically the premise there is looking across the
most carbon intensive industries, comparing companies within the industry to
industry peers based on a carbon intensity metrics. So if
we think about something like power generation O two over
(23:48):
mega wad hour generated and what he sees time and
time again across the most carbon intensive industries is that
those companies within those peer sets that you know generate
what over their product is, whether it be steel, power, aluminum,
et cetera, are actually outperforming those who are more carbon
intensive on a total return basis when you take a
(24:13):
five year review. So interesting to hear different results.
Speaker 3 (24:17):
Thanks very much for raising that. And it could be
because they're measuring carbon in a different way. So what
your colleague is measuring is carbon intensity, which presumably is
carbon emissions scale by sales or assets or something like that.
This initial paper looked at raw absolute carbon emissions, and
there have been critiques that actually intensity is the better
(24:39):
measure because you should scale it by something, and so
there is this academic debate as to what the better
measure is. But there's a critique paper saying that when
you look at intensity, the results go away. They don't
find the results flit, they just find no relationship. The
original authors responding and they said, oh, we think that
raw emissions is the better measure. The approach of my
causs and me it's quite different. Rather than arguing as
(25:02):
to what the better measure is of carbon emissions. Is
it scaled or unscaled? When you interpret high stock returns,
don't automatically say high stock returns is a bad thing.
It's definitely due to risk. High stock returns could be
due to our performance. And that indeed seems to be
the interpretation of your colleague when he finds that less
intensive companies are performing better. That is our performance, not risk.
(25:27):
And that sort of makes sense to me because if
you're emitting less carbon per unit of sales, you're probably
a more efficient company, right, You're producing in a more
efficient way, you're saving an energy costs, and so that's
something that to me just makes more intuitive sense.
Speaker 2 (25:40):
Absolutely, No, it's interesting, and just to clarify when we
do that analysis rather than using sales, which I think
is ultimately you know, has its own complications. Certainly, when
you're comparing across industries, we look at a unit of
production specifically relevant to that industry. So for power generation,
looking at two two per meg a wild hour steel
(26:02):
per ton of steel produced, et cetera, et cetera, So
lots of different ways to other suicide analysis. Super interesting
to hear those thoughts.
Speaker 1 (26:13):
Yeah, and if I can also you know it sounds
like some of the conclusion from your work is kind
of the plan on the old adage that government policies
can remain irrational longer than you can stay solvent. Right,
is that ultimately where you're you're getting at.
Speaker 3 (26:27):
Yes, and and the phase our power phase this is
as governments are people too, So governments have the same
short term considerations that companies and investors have. And some
of the policies that I think we really need in
order to ensure that these externalities are internalized, they might
just be so politically unpopular that the government, which wants
(26:47):
to ensure that it's re elected might not pass this,
and so that is I think a major concern. So
this is again why yes, I wish that my results
will go away in the future, but I view the
glasses only half full, not completely full. We've known about
climate change for decades. We haven't seen a government action
because governments are planing to the same lobbying in short
(27:09):
terms and that you think companies and investors are planing to.
Speaker 1 (27:11):
Absolutely Now, I think what you describe as rational sustainability
tracks with what I think of its just esg It's
a focus on factors maybe not found in a financial statement,
but that have material consequences on a company's launterm value.
But really ultimately that concept and its purest form has
more often to something else, right, whether it's fund managers
(27:32):
trying to oversell the concept to attract assets or politicians
weaponizing it and the culture wars as we just talked about.
Given that it's just the nature of business to make
money and the nature of politicians to make more outrage,
is there a risk that polarizing behavior will continue no
matter you know, how we conduct the analysis.
Speaker 3 (27:53):
What you said contain both a statement and a question,
and I'll respond to those in turn. First, I completely
agree with that statement. To me, rational sustainability esg. If
you go back to basics, this is the recognition that
these societal factors are ultimately material for company's long term performance.
And if we indeed need a little bit of a
(28:14):
rebranding or whatever it is to get back to basics,
I'm more for that. Then to the question, which is
potential skepticism that they will always be a polarization, I
do think that this is a risk, But here I
do see the glass more half full than half empty.
So this is why my work and it's not just
the rational sustainability paper, but the two papers before that
(28:36):
applying economics not got feel to ESG, and before that
the end of ESG. I notice the end of ESG.
That's not an anti ESG paper, but saying ESG should
be seen as mainstream because these are financial material issues.
I'm trying to highlight that the correct behavior should be nuanced,
should be recognizing the pros and cons that there are
(28:57):
sometimes trade offs. And so the work that I've been
trying to do has been to highlight the way we
do this is to consider evidence rather than being at
one extreme or the other. And you might think, well,
is this just an academic just whistling in the wind.
Is anybody going to listen to him? But the reason
why I came up with this rational sustainability to me,
But this was thought up with with a meeting I
had with an asset management firm where they were telling
(29:19):
me their approach and I said, well, this sounds like
rational sustainability. And then I decide to write it up
and I say, well, what should that approach be? And
this approach is based on the work that I do
with a lot of investors. What are the most successful
and the most effective ways in which I see investors
putting this into practice. So I'd love to say I'm
completely new and completely revolutionary and suggesting something that nobody
(29:42):
else has done before. That is not true, right, There
are things here which are probably not new. They are
just said a codeification of what I've seen the most
successful investors doing. Now, just before this interview with you,
I was another call with a US investor in a
completely differ asset class and they were saying, Oh, we
read your rational sustainability paper. This is exactly what our
(30:05):
approach is, and let me send you our ESG policy
just to show you how much alignment there is. So
while you might have some loud investors out there which
are at one extreme or the other extreme, I do
think that the silent majority are people who go around
practicing sustainability not necessarily to get media coverage, but because
(30:27):
they think this is in the long term interest of
their clients. And I do think that the middle ground
is occupied by far more people than one might think.
They might just not shout about it as loudly as
people on the extreme.
Speaker 1 (30:39):
Got it all right, Thank you so much for your
time today. Out you can find more information on topics
like ESG integration and financial materiality by going to BI
ESG go on the Bloomberg terminal. If you have an
ESG quandary or I guess now, we might call it
a rational sustainability question you would like to ask BIS
expert analysts an email at ESG currents at Bloomberg dot net.
(31:03):
You can also read more of Alex's work at Alex
Edmunds dot com. Thank you again
ESG has become established as a key business theme as
companies and investors seek to navigate the climate crisis, energy transition,
social mega trends, mounting regulatory tension, and pressure from other stakeholders.
The rapidly evolving landscape has become inundated with acronyms, buzzwords
and lingo, and we aim to break these down with
industry experts. Welcome to ESG Currents, brought to you by
(00:32):
Bloomberg Intelligence, your guide to navigating the evolving ESG space,
one topic at a time. I'm Rob Duboff, senior ESG analyst.
Speaker 2 (00:41):
And I'm Eric Kane, Director of ESG Research for Bloomberg Intelligence.
Speaker 1 (00:45):
It's no secret that ESG has become a bit controversial
in recent years. From the left, it gets accused of
being overused to greenwash concerns that companies are not doing
enough to address some of the critical issues of our time.
And from the right, it gets accused of forcing a radical,
woke agenda on the corporations whose so focus should really
be on making money for shareholders. So as a time
(01:07):
to just scrap the whole endeavor and move on, today's
guest certainly has some thoughts on this. He recently put
out a paper proposing an alternative concept, which he calls
rational sustainability. Joining us today to discuss is Alex Edmunds,
Professor of Finance at London Business School. Alex has a
PhD from MIT, is a Fulbright scholar and was previously
(01:28):
a tenured professor of Wharton. An investment banker at Morgan Stanley.
He's spoken at the World Economic Forum in Davos, testified
in the UK Parliament and given the Ted talk What
to Trust in a Post truth World. And he's author
of a Financial Times book of the year, Grow the Pie,
How great companies deliver both purpose and profit.
Speaker 3 (01:48):
Thanks for joining us, Alex, Thanks so much for Robin Erik.
It's great to be here.
Speaker 1 (01:52):
Great. So let's get to it, as you see, what's
the problem with ESG as it's currently understood in the market.
Speaker 3 (01:58):
I think the problem is misunderstood by the market on
two main grounds. So the first is what is it,
what's the ultimate goal? And the second is how to
do it? What's the approach? And this misunderstanding is from
both sides. So skeptics of ESG the arguer ESG is
only done to impose political beliefs that you couldn't get
by the ballot box. This is necessarily at the expense
(02:21):
of financial returns, and therefore there's proposals to ban the
consideration of ESG risks. But in many cases ESG risks
are financial risks. You would want to take them into
account even if your only objective is financial returns. So
often ESG can boost returns rather than being at their expense.
(02:41):
And then if you look at the proponents of ESG,
their goal is sometimes thinking that more ESG is always better.
Let's invest in as many ESG stocks as we can,
not recognizing that for some companies actually traditional factors like
productivity and innovation and profitability might be more important than ESG. Also,
(03:01):
ESG has diminishing returns. More was not always better, And
in terms of the approach, they often might think that
in order to do ESG, let's divest from all companies
and the fossil fuel industry. Let's try to vote for
every shareholder proposal, even if this might be micromanaging the company.
So I think there's an extremism and misunderstanding f on
(03:22):
both issues, and so this is why I wanted to
put out an alternative approach.
Speaker 2 (03:26):
So, Alex, you mentioned the misunderstanding from both sides and
the new approach. So this is where the idea of
rational sustainability enters. Can you tell us what it is
and why you think it's a better alternative?
Speaker 3 (03:38):
Certainly, And so the two words in turn, one of
them is on the goal and the other is on
the approach. So the goal is sustainability. And what does
sustainability mean. Now, often it's seen as something which is woke,
but if you go back to what it means in
the English language, sustainability means creating long term value. So
(03:58):
a self sustaining system is which is there for the
long term. Sustaining ecosystem or even organism, that's something which
will be there for the long term. So sustainability is
creating long term value. So those who are skeptical about this,
do we not want companies that are there for the
long term that manage their sustainability risk, not because of
(04:19):
any political agenda, that because these things are ultimately important
for the company's long term success. And for those who
are proponents of what's currently called ESG, sometimes they go
after short term easy wins. So again this might be
voting for every shareholder proposal, even if this micromanagers of
the company at the expense of long term value creation.
(04:44):
So vindee, the goal is creating long term value. Hopefully
that's something that everybody can align behind, both those on
the left and those on the right, and we forget,
we lose, and we reduce some of the politicaliization that
has led to the muddled views on this topic. So
if the goal is sustainability creating long term value, the
(05:04):
approach is rational. So what does an irrational approach mean.
It means being based on evidence, not ideology. So certainly
ESG factors do pay off, but others don't. And that's
to recognize this, and it also is to recognize trade offs.
More is not always better. So let's achieve this goal
in a way which takes into account evidence and trade
(05:25):
offs rather than going head in or completely ignoring it
because you're just resistant to it.
Speaker 1 (05:31):
Great and your approach. In your paper you outline ten
features of rational sustainability. Can you rock us through what
those are?
Speaker 3 (05:38):
Sure? Rather than going through all ten a big laundry lists,
let me just focus on four. Let me think about
two on the sustainability aspect and two on the rational aspect.
So on sustainability, one of the principles, actually principal number
one is rational sustainability is about value creation, not politics.
(05:59):
So this links to my earlier response. The idea of
sustainability is creating long term value, and that's something that
everybody should be aligned behind. But also it suggests that
we don't do things that don't create long term value.
So if it's something in order to move up the
league tables of asset managers voting for shared proposals even
(06:21):
if they don't create value, that's not something that we
should be getting behind. It's about outcomes, not box sticking.
But the second feature of rational sustainability I'd like to
highlight is that it's enabling, not prescriptive. So what do
I mean by this. I've used the term long term
value many times so far in this conversation. Now some
people think that means only financial value, and they might say, well,
(06:45):
Alex has completely missed the point of a ESG, which
is not just to create financial value. We also care
about social outcomes. Now, sometimes those social outcomes will manifest
in financial value, but sometimes they won't. They are pure externalities.
And what I'm trying to do is not be prescriptive
as to what I mean by value. It could be
(07:07):
that for some companies and some investors they care not
only about financial returns but also about global warming or diversity,
equity inclusion, or biodiversity. But what I'm saying is that
you want to be clear about that goal, and you
might be clear that there are trade ofs between them,
rather than pretending that everything is a win with And
(07:29):
also if you want to pursue this goal, which might
not only be financial value, again to make sure that
this is pursued in a rational way. So that is
the sustainability aspect. It's about value creation, not politics, and
that value can include non financial value as long as
you're up front about it and clear about the objective.
(07:49):
But then what's the rational aspect? One principle is rational
sustainability is based on evidence and analysis. So there are
some views which is ESD always pays off. Every ICJD
dimension will always manifest in high returns. Now, even though
I'd love to believe that, my book Grow the Pie
argues that some ESG factors do improve financial returns, that
(08:12):
is not always the case. There are tradeoffs, and on
the flip side, there are ESG opponents who says ESG
is always at the expense of financial returns. No, there
are some factors where long term regress evidence suggests that
they are helpful. And the second principle that I like
to highlight on the rational part is it's based on
(08:33):
diminishing returns and the trade offs. So even if you
are an ESG advocate, which I am, more, YESG is
not always better. So some of my workers on treating
employees well, this does not mean paying them as much
as possible at a certain point in time. After a
point in time, it may be that this leads to
you becoming uncompetitive. And there's also tradeoffs between financial returns
(08:56):
and social returns. Maybe up to a point there isn't
a line. But if you're investing excessively in ESG factors,
this might be the expense of long term profitability. Now again,
maybe you're happy with that because your goal is not
only financial returns, but all What I'm saying is that
we go into this with our eyes open, realizing that
(09:18):
there are trade offs, rather than thinking that everything is
a win.
Speaker 1 (09:21):
Win, got it? Now, I guess one of the first
thoughts I had was, is this really just semantics. You know,
for ASG, we had SRI Socially Responsible Investing.
Speaker 2 (09:30):
Is this just.
Speaker 1 (09:31):
Changing the name or are there are there fundamental changes
needed to the discipline of what is now ESG.
Speaker 3 (09:38):
This is about a fundamental change. It's not just a
name change or a rebranding. And so this has been
a bit surprising to me because I've seen it's great
that this paper has got some coverage on social media
and the media, but there are some who reacted and say, oh,
why is he just thinking about changing the name. But
the paper is really upfront that it is far more
than just a name change. It is about ten principles,
(10:01):
and all the principles are are practices t ESG. It's
about how we do this is being based on evidence
and recognizing trade offs, and what the goal is is
long term value creation. So I've called it something different,
but that is to emphasize that the goal is long
term value creation and that the approach is to do
(10:24):
this in a rational way, taking evidence and out. Now,
it could be that there's some people who still call
it ESG and they still do this now based on
my paper or other people based on evidence and thinking
about long term value cation. That would be absolutely fine
with me. My main focus is on how to do
this and what the goal is rather than just what
we call it.
Speaker 2 (10:44):
That's super interesting. So it's one of the other principles
that you outline in your paper is the idea that
rational sustainability is intrinsic, not instrumental. So I've often said
that the biggest success for the ESG movement, if we
can call it a movement, would be if it just
became called investing and was no longer considered a separate discipline, right,
(11:07):
and you suggested in the paper that in theory, there
really should be no need for a new acronym to
have been coined if the factors that we're looking at
an ESG lead to value. I'm just curious to hear
your thoughts on whether you think the discipline has ultimately
kind of helped us move towards these issues actually being
more intrinsic through enhanced disclosure research and analysis. Given that
(11:32):
you know, certainly when I started in the space almost
two decades ago, we didn't have any of the data,
we didn't have as much research, we didn't have as
much product or analysis related to these concepts.
Speaker 3 (11:45):
This is a great question I do think that the
movement did create a lot of value right at the start.
You are right, Eric, that in theory they should not
be the need for ESG investing. It is just investing.
And indeed, one of my recent paper's called the end
of ESG, so that we really shouldn't need that phrase,
because if these things ultimately improve financial value, shouldn't they
(12:06):
be taking an account anyway? Well, that's true in theory,
but in practice it might not be. Why because investors
have tons of things that they need to look at,
and they only have certain numbers of hours in the day,
and without any ESG acronym, it may be that people
would have not realized that these things were material. So
when the ESG acronym was coined, that could have been useful,
(12:29):
And I think it was useful because it got people
to start paying attention to factors that they didn't realize
were material previously. And you're Eric, Intrinsically they started to
recognize that these are good things to look at when
evaluating a company. But now I think it's we've moved
past the intrinsic to the instrumental, where we do ESG
(12:51):
not because we genuinely think it creates long term value
but to be seen to do ESG. So right now,
if you're an investor and you engage each with the
company on ESG factors such as the diversity of their workforce,
you get far more brownie points than if you engage
with them on productivity or capital allocation or innovation. And
(13:12):
one question that I often ask asset managers is if
you were not able to tell anybody that you were
voting in this way or engaging in this manner, would
you still do this? And I don't think the answer
is always yes. I do think that there are some
investors who do engagement or vote in a certain way
to tell everybody that they're doing this. And I think
(13:34):
this is quite different to what started the ESG movement
to begin with, which is a genuine view that these
things are financial, need material, and they need greater attention
than they've had in the past.
Speaker 1 (13:47):
Now you also no rational sustainability guards against irrationality, whether
this is companies pushing d n I messages without considering
the backlash, or overly optimistic forecast for near term evs else.
I mean, I see similar trends when I look at
some of the stories about AI replacing jobs, or the
downstream impacts of GLP one weight loss drugs. I mean,
(14:08):
I saw and Alice put out a note talking about
airlines lowering emissions simply because passengers are going to be
ten percent later. It just feels like chasing fads is
always a feature of markets. So how do you really
guard against this?
Speaker 3 (14:21):
I think it is to recognize what you just asked
in the question, Rob, is that chasing fads is always
a feature of markets. ESG is as prone to fans
as anything else. So this is one of the problems
with the ESG term and might be why actually a
name change might help. In addition to all the fundamental
changes I'm focusing on, the ESG term has been seen
(14:43):
as a bit of a magic word that it defies
the laws of gravity, or in this context, the laws
of basic economics. People think, let's pursue ESG without regard
for pricing, without regard for diminishing returns, because these are
good things. But the basic laws of economicsuggests that more
of anything is not always better, even if that thing
(15:04):
is seen to be good. More investment isn't always better
because there's diminishing returns. And also, as an investor. Whenever
you choose to invest in something, you always need to
compare it to the price and the excitement that we
had about electric vehicles in the early part of this decade,
particularly when we had the lockdown. This is something which
(15:24):
could have led to them being really overpriced and people
had just forgotten about. Let's relate this to fundamentals, which
is pricing. So when we think about ESG as another
set of factors rather than this special set of magic
words which is immune to the same bubbles that anything
else in business is, that will allow people to have
a more rational approach to this. And this is something
(15:47):
that I tried to highlight in this paper, but actually
a paper before this called applying economics not gut feel
to ESG argues that we should look at these things
as mainstream business issues and approach with the same riga
rather than ideology or wishful thinking.
Speaker 2 (16:04):
Super interesting. So I think one of the other topics
that has really become a flashpoint for debate within ESG currently,
if we can still call it that for the purpose
of this conversation, is the debate between single materiality and
Deublop materiality. And we've kind of touched on some of
these concepts and some of the previous answers, and we've
(16:26):
done a lot of research on our team and oftentimes
kind of view the distinction between the two as a
false dichotomy. So if we think about a real world example,
we've created ESG scores, for example, for about fifteen thousand companies.
One of the things that we do in our scoring
process is identify top priority environmental issues, top priorities social issues,
(16:50):
and that's based on financial materiality or single materiality. And
what we see when we look at all the industries
that we've identified, you know, greenhouse gas emissions as being
financially material for it represents ninety seven percent of the
indexes emissions, right, Whereas the roughly eight thousand companies for
(17:13):
which we don't think greenhouse gas emissions are financially material,
it's over half the index, but they represent only three
percent of emissions. So in my mind, you know, it
shows that the same group of companies that we ultimately
think of as having a financial exposure to the issue
are also the ones that are having the biggest impact
(17:36):
on the planet in terms of climate change. So if
one wanted to really tip the scale or move the
needle on climate change. They should be focusing their effort
on those companies for which it's financially material, rather than
that group of eight thousand companies that only produce three
percent of the indexes emission. So curious as to kind
(17:57):
of your thoughts on that debate between materiality and double
materiality and whether you know there there is a false
ecademy there.
Speaker 3 (18:05):
That's another great question, Eric, and I think ninety percent
of the time I would agree with you that there
is a fourth dichotomy. Ninety percent of the time factors
that affect society and the environment ultimately come back and
are financially material for the company. And that was the
main premise of my book, Grow the Pie Companies that
create value for wider society. You might call this inside
(18:28):
out materiality that ultimately leads to outside in materiality. This
affects the company's financial performance. But there are some ESG
advocates who argue this is one hundred percent of the time,
every single thing you do to affect the world ultimately
affects your profits. And I think this is just wish
for thinking this is too good to be true. So
(18:49):
a basic principle of economics is externalities. There are things
that we can do to affect the world that don't
ultimately affect us. So one example could be tobacco. In
nineteen fifty that was the first evidence that smoking leads
to cancer. In the intervening seventy four years, there have
(19:10):
still been outsized profits from the tobacco industry. Even if
there's negative social impact. There could be other things that
you can do, such as monopoly power or lobbying of
the government to protect your profits. And in the environmental
issue that you asked in your question is where we
also do see a trade off. So there is a
(19:33):
finding which I wish it wasn't true, but this is
just what the data says is that companies that emit
higher carbon generate higher stock returns. Now, the EESG crowd
immediately latched onto this and said, well, isn't that proof
that carbon emissions are bad? The reason why they emit
higher stock returns is they are so bad that investors
(19:57):
will only hold these companies if they're given higher returns
as compensation for the risk of, say a change in
government regulation. But if you just think about this with
a clear head, doesn't the ESG crowd typically see higher
returns as a good thing. Right, they claim companies that
treat their work as well or their customer as well
(20:18):
they have higher returns. They see this as outperformance. They
don't see this as compensation for risk. So you can't
just suddenly turn around and then when you find that
bad brown companies generate higher returns, that you interpret those
higher returns or a bad thing. And so in actually
in a recent paper which is called does the carbon
(20:39):
premium result from risk or mispricing? My course and I
analyze this and we find the reason for these higher
returns is not because these companies are riskier. They're just outperforming.
And how are they outperforming. They are able to get
away with polluting. They're not investing in emissions reduction. They're
able to pollute, and because is not a global carbon tax,
(21:02):
they are not suffering in terms of financial consequences. So
that is a case in which inside out materiality is
not currently leading to outside im materiality. Now people look
at that and they say, okay, well that was the past.
That was based in the past few decades of history.
In the future, when there will be government action, all
(21:23):
of that will change. But when I was at school,
a couple of decades ago, I already knew about the
greenhouse effect and climate change. We all learned about that,
and the intervening couple of decades we've seen some action,
but it clearly has not been enough in order to
change that result. Now, I would love it if my
result went away and that in the future companies that
(21:44):
emit more carbon have lower returns, But it may well
be because of the political difficulties of implementing a carbon
tax of the size that we think will actually fully
incorporate the externalities that we might see this trade off
going forward, and therefore there will be always some discrepancy
between financial returns and social returns, even if most of
(22:08):
the times they are aligned. There will be these inconvenient truths.
And again one of the goals of my paper is
to recognize and be upfront that there are inconvenient truths,
rather than assuming that everything is always going to be
a winner.
Speaker 2 (22:21):
That's super interesting, eles and to follow up on that,
because I think it's certainly different than some results that
we've seen in some of our research. So maybe just
a clarifying question when you do that analysis and you're
finding that those companies that ultimately are emitting more carbon
are yielding more returns. Is that in industry specific analysis
(22:42):
or are you looking across the economy and kind of
picking type admitting companies and comparing to the entire economy.
Speaker 3 (22:50):
Yeah, So this analysis has done a number of ways.
So first it's done in an aggurate way, but it's
also done on an industry adjusted basis, because you might
think there's industry effects here and I also should be
up fun. I appreciate you crediting me with this, but
the actually initial findings were done by some other researchers
which documented rigorously this link between emissions and stock returns.
(23:12):
The goal of my care isn't me, was to look
at the reason for that. Is it due to risk
or is this due to mispricing? But it was prior
people who had documented that link, not my co authority.
Speaker 2 (23:25):
Interesting because our colleague and is not on the call today,
has done a lot of work that he coins climate
Alpha and basically the premise there is looking across the
most carbon intensive industries, comparing companies within the industry to
industry peers based on a carbon intensity metrics. So if
we think about something like power generation O two over
(23:48):
mega wad hour generated and what he sees time and
time again across the most carbon intensive industries is that
those companies within those peer sets that you know generate
what over their product is, whether it be steel, power, aluminum,
et cetera, are actually outperforming those who are more carbon
intensive on a total return basis when you take a
(24:13):
five year review. So interesting to hear different results.
Speaker 3 (24:17):
Thanks very much for raising that. And it could be
because they're measuring carbon in a different way. So what
your colleague is measuring is carbon intensity, which presumably is
carbon emissions scale by sales or assets or something like that.
This initial paper looked at raw absolute carbon emissions, and
there have been critiques that actually intensity is the better
(24:39):
measure because you should scale it by something, and so
there is this academic debate as to what the better
measure is. But there's a critique paper saying that when
you look at intensity, the results go away. They don't
find the results flit, they just find no relationship. The
original authors responding and they said, oh, we think that
raw emissions is the better measure. The approach of my
causs and me it's quite different. Rather than arguing as
(25:02):
to what the better measure is of carbon emissions. Is
it scaled or unscaled? When you interpret high stock returns,
don't automatically say high stock returns is a bad thing.
It's definitely due to risk. High stock returns could be
due to our performance. And that indeed seems to be
the interpretation of your colleague when he finds that less
intensive companies are performing better. That is our performance, not risk.
(25:27):
And that sort of makes sense to me because if
you're emitting less carbon per unit of sales, you're probably
a more efficient company, right, You're producing in a more
efficient way, you're saving an energy costs, and so that's
something that to me just makes more intuitive sense.
Speaker 2 (25:40):
Absolutely, No, it's interesting, and just to clarify when we
do that analysis rather than using sales, which I think
is ultimately you know, has its own complications. Certainly, when
you're comparing across industries, we look at a unit of
production specifically relevant to that industry. So for power generation,
looking at two two per meg a wild hour steel
(26:02):
per ton of steel produced, et cetera, et cetera, So
lots of different ways to other suicide analysis. Super interesting
to hear those thoughts.
Speaker 1 (26:13):
Yeah, and if I can also you know it sounds
like some of the conclusion from your work is kind
of the plan on the old adage that government policies
can remain irrational longer than you can stay solvent. Right,
is that ultimately where you're you're getting at.
Speaker 3 (26:27):
Yes, and and the phase our power phase this is
as governments are people too, So governments have the same
short term considerations that companies and investors have. And some
of the policies that I think we really need in
order to ensure that these externalities are internalized, they might
just be so politically unpopular that the government, which wants
(26:47):
to ensure that it's re elected might not pass this,
and so that is I think a major concern. So
this is again why yes, I wish that my results
will go away in the future, but I view the
glasses only half full, not completely full. We've known about
climate change for decades. We haven't seen a government action
because governments are planing to the same lobbying in short
(27:09):
terms and that you think companies and investors are planing to.
Speaker 1 (27:11):
Absolutely Now, I think what you describe as rational sustainability
tracks with what I think of its just esg It's
a focus on factors maybe not found in a financial statement,
but that have material consequences on a company's launterm value.
But really ultimately that concept and its purest form has
more often to something else, right, whether it's fund managers
(27:32):
trying to oversell the concept to attract assets or politicians
weaponizing it and the culture wars as we just talked about.
Given that it's just the nature of business to make
money and the nature of politicians to make more outrage,
is there a risk that polarizing behavior will continue no
matter you know, how we conduct the analysis.
Speaker 3 (27:53):
What you said contain both a statement and a question,
and I'll respond to those in turn. First, I completely
agree with that statement. To me, rational sustainability esg. If
you go back to basics, this is the recognition that
these societal factors are ultimately material for company's long term performance.
And if we indeed need a little bit of a
(28:14):
rebranding or whatever it is to get back to basics,
I'm more for that. Then to the question, which is
potential skepticism that they will always be a polarization, I
do think that this is a risk, But here I
do see the glass more half full than half empty.
So this is why my work and it's not just
the rational sustainability paper, but the two papers before that
(28:36):
applying economics not got feel to ESG, and before that
the end of ESG. I notice the end of ESG.
That's not an anti ESG paper, but saying ESG should
be seen as mainstream because these are financial material issues.
I'm trying to highlight that the correct behavior should be nuanced,
should be recognizing the pros and cons that there are
(28:57):
sometimes trade offs. And so the work that I've been
trying to do has been to highlight the way we
do this is to consider evidence rather than being at
one extreme or the other. And you might think, well,
is this just an academic just whistling in the wind.
Is anybody going to listen to him? But the reason
why I came up with this rational sustainability to me,
But this was thought up with with a meeting I
had with an asset management firm where they were telling
(29:19):
me their approach and I said, well, this sounds like
rational sustainability. And then I decide to write it up
and I say, well, what should that approach be? And
this approach is based on the work that I do
with a lot of investors. What are the most successful
and the most effective ways in which I see investors
putting this into practice. So I'd love to say I'm
completely new and completely revolutionary and suggesting something that nobody
(29:42):
else has done before. That is not true, right, There
are things here which are probably not new. They are
just said a codeification of what I've seen the most
successful investors doing. Now, just before this interview with you,
I was another call with a US investor in a
completely differ asset class and they were saying, Oh, we
read your rational sustainability paper. This is exactly what our
(30:05):
approach is, and let me send you our ESG policy
just to show you how much alignment there is. So
while you might have some loud investors out there which
are at one extreme or the other extreme, I do
think that the silent majority are people who go around
practicing sustainability not necessarily to get media coverage, but because
(30:27):
they think this is in the long term interest of
their clients. And I do think that the middle ground
is occupied by far more people than one might think.
They might just not shout about it as loudly as
people on the extreme.
Speaker 1 (30:39):
Got it all right, Thank you so much for your
time today. Out you can find more information on topics
like ESG integration and financial materiality by going to BI
ESG go on the Bloomberg terminal. If you have an
ESG quandary or I guess now, we might call it
a rational sustainability question you would like to ask BIS
expert analysts an email at ESG currents at Bloomberg dot net.
(31:03):
You can also read more of Alex's work at Alex
Edmunds dot com. Thank you again
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