Milton Was Right, Corporate Governance Matters

Many observers point to a 1970 New York Times magazine article by Friedman[i] as arguing against ESG investing. That is a mistaken view. In that article Friedman pointed out that the primary and over-riding responsibility of corporate executives is to the shareholders of the business; that is simply a matter of law. And he argued persuasively that the main objective of shareholders in a business is to make as much profit as possible. In such cases, the primary and over-riding responsibility of corporate executives is to make profits for shareholders. But Friedman also granted that investors may “establish a corporation for an eleemosynary [i.e. philanthropic] purpose – for example a hospital or a school.” What Friedman was railing against in his famous article was the use of a corporation, established by shareholders for the purpose of making profits, to achieve broad social ends instead of, or at the expense of profits.

Friedman’s clear-sighted analysis offers a useful basis for assessing ESG investing. Essentially, it enables us to differentiate three types of such investing: First, there is what might be called philanthropic ESG investing, which does not seek necessarily to make a profit per se but instead has other purposes. Second, there is ESG-screened investing, which seeks to impose ESG criteria on all investments without regard to the effect on profitability. Third, there is profit-seeking ESG Investing, which seeks to incorporate ESG criteria into investment processes and decisions in order to make a profit. Let’s consider each of these in turn.

Philanthropic ESG Investing

Philanthropic ESG investing seems perfectly consistent with Friedman’s prescription, as long as the residual claimants of such investments are copacetic with such an approach. This is likely to be generally the case for closely held private companies, although there may be circumstances under which a majority of shareholders choose to make investments in such eleemosynary purposes against the express wishes of a minority, in which case they might violate the company’s articles of association or statutory investor protection laws.

Problems are more likely to arise, however, if the executives of a public company choose to interpret its purpose as philanthropic rather than profit-seeking. In this case, while the executives may claim to be following ESG, they are actually in violation of good corporate governance practices. In such circumstances, it is likely that arbitrage opportunities will arise wherein activist investors either short the stock, based on the assumption that it will underperform, or if the stock is already underperforming buy a controlling stake and seek to replace the management. In this case, it is the activist investors who are actually practising sound ESG investment, not the corporate executives.

ESG-screened Investing

The basic idea with ESG-screened investing is that qualifying investments must be meet certain ESG criteria, typically defined by one of the now-many ESG consulting firms, which have developed their own indices. The big question for ESG-screened investing is whether it is capable of achieving returns that are equal to or greater than the returns that can be achieved without such a screen.

Early individual studies came to mixed conclusions. For example, a 2012 study by researchers at the University of New South Wales compared the financial performance of companies listed on the Australian Stock Market in 2009-10, which were rated for “sustainability” by consultancy CAER, and found that ESG “laggards” outperformed ESG “leaders”.[ii] By contrast, a 2014 study by researchers at Harvard Business School and London Business School compared returns of matched pairs of large listed companies that differed according to whether management had voluntarily adopted “sustainability” policies by 1993. They found that by 2009, “high sustainability” companies significantly outperformed “low sustainability” companies both in terms of stock price and accounting performance.[iii]

In an attempt to resolve the apparent contradictions thrown up by such individual studies, researchers produced numerous meta-analyses. And, in 2015, researchers at Deutsche Bank and the University of Hamburg undertook what might best be described as a “meta-meta” analysis, combining the results of over 2,000 individual studies they found that ESG investments outperformed conventional investments.[iv] One might be tempted to conclude, on the basis of this apparently authoritative study, that ESG-screened investing offers superior profitability. But one would not necessarily be correct.

Most of the earlier studies looking at the effect of ESG on performance (a) use composite ESG metrics and (b) assume the relationship between ESG and performance is linear. The use of composites is problematic because of the possibility that some components might positively influence financial performance, while others negatively affect it. (If this sounds a bit academic, it is not. Stay with me and I’ll explain.) Meanwhile, the assumption of a linear relationship is just that – an assumption; what if, in reality, the relationship were U-shaped?

A 2016 paper from group of researchers from the European Parliament and Bournemouth Business School sought to look more deeply at the relationship, using disaggregated data from Bloomberg’s ESG Disclosure form for the S&P 500 for the period 2007 to 2011.[v] The researchers found that the relationship between ESG and financial performance in general was indeed U-shaped. However, they found that the environmental and social components were linearly negatively related to performance. It was only the governance component that drove the U-shape relationship.

This governance-dominated U-shape relationship between ESG and financial performance has since been confirmed in other studies. But what is one to make of it? It seems to suggest that good corporate governance adds value only if a certain threshold is reached. Alternatively, since the scoring for corporate governance includes numerous elements, some may simply offer the superficial appearance of good governance, while adding costs; if firms generally prioritise those superficial governance measures, perhaps because they want to attract ESG investments, it is only firms that check a larger proportion of governance boxes that actually have more robust governance.

Second, the dominance of corporate governance in driving financial performance–and the generally negative effect of environmental and social indicators—suggests at the very least that the current model for ESG-screened investing should be revised. One approach would be to switch to a screen that was narrowly focused on corporate governance. Alternatively, further research is needed to identify which if any of the numerous factors that make up “environmental” and “social” criteria actually contribute positively to superior financial performance.

It is worth noting that in spite of a lack of robust evidence to support ESG-screened investment, the decision to do so is not necessarily inconsistent with Friedman’s prescription, especially if that decision is taken by individual investors—who should be free to invest their own money as they see fit. Problems may arise, however, when fund managers, who are operating as fiduciaries on behalf of others, choose to apply an ESG screen. In such cases, fund managers may be adversely affecting the performance of their fund, to the detriment of the beneficiaries. This is of particular concern given the large proportion of investment managers that have signed up to the UN’s Principles for Responsible Investment.

Profit-seeking ESG Investing

The idea behind profit-seeking ESG investing is that it may be possible to increase the profitability of one’s investments by identifying and seeking out certain ESG characteristics. Rather than using a screen, however, such investments seeks to delve more deeply into the modus operandi and governance of individual companies. Given the importance of governance as a driver of ESG investment, profit-seeking ESG investing might well focus narrowly on the ‘G’.

But beyond corporate governance, there are almost certainly opportunities to profit from investments that provide social and environmental benefits and are currently being overlooked by most traditional ESG funds. Consider companies that produce alternatives to cigarettes, for example. There are currently approximately 1.1 billion smokers in the world, spending around US$800 billion/year on their habit. But about half of all long-term smokers die from smoking-related diseases. Epidemiologists estimate that if trends continue, over the course of the 21^st century, a billion people will die from smoking related diseases. But alternatives already exist, such as e-cigarettes and snus (a low-nitrosamine oral tobacco) that are at least 95 per cent safer than smoking.[vi] So, if these products were to replace cigarettes, hundreds of millions of lives would be saved – and the manufacturers would be worth billions.

If more individuals and funds were to switch away from check-box ESG-screened investing to profit-seeking ESG investing, with a focus on corporate governance and more in depth understanding of the potentially transformative effects of the investments, the benefits to society might be enormous.

The author is Director of Innovation Policy at the International Center for Law and Economics, a Senior Fellow at Reason Foundation, and Director of Morris Strategies Ltd.

Footnotes:

[i] Milton Friedman (1970) A Friedman doctrine – The Social Responsibility of Business is to Increase its Profits, The New York Times, September 13.

[ii] Maria. C. A. Balatbat, Renard Y. J. Siew and David G. Carmichael (2012) ESG Scores and its Influence on Firm Performance: Australian Evidence. School of Accounting and Centre for Energy and Environmental Markets University of New South Wales.

[iii] Robert G. Eccles, Ioannis Ioannou, George Serafeim (2014) “The Impact of Corporate Sustainability on Organizational Processes and Performance,” Management Science, Vol 60 (11), iv-vi, 2381-2617.

[iv] Gunnar Friede, Timo Busch & Alexander Bassen (2015) “ESG and financial performance: aggregated evidence from more than 2000 empirical studies,” Journal of Sustainable Finance & Investment, 5:4, 210-233.

[v] Joscha Nollet, George Filis & Evangelos Mitrokostas (2016) “Corporate social responsibility and financial performance: A non-linear and disaggregated approach,” Economic Modelling, Vol 52 (B), 400-407.

[vi] Ann McNeill, Leonie S Brose, Robert Calder, Linda Bauld, & Debbie Robson (2018) Evidence review of e-cigarettes and heated tobacco products 2018: A report commissioned by Public Health England, London: Public Health England.

Julian Morris FRSA
Julian Morris has 30 years’ experience as an economist, policy expert, and entrepreneur. In addition to his role at ICLE, he is a Senior Fellow at Reason Foundation and a member of the editorial board of Energy and Environment. Julian is the author of over 100 scholarly publications and many more articles for newspapers, magazines, and blogs. A graduate of Edinburgh University, he has masters’ degrees from UCL and Cambridge, and a Graduate diploma in law from Westminster. In addition to his more academic work, Julian is an advisor to various business and a member of several non-profit boards.