"The greatness and the genuine trait of your thought and writings lie on the fact that you positively and interestingly make use of philosophical thoughts and thoughtfulness in order to deeply and concretely cogitate about America's social issues. . . . This does not mean that your thought is reducible to your era: your thought, being inspired by issues characterizing your era . . . , overcomes your era and will still likely be up to date even after your era, for future generations." Bruno Valentin

Wednesday, June 28, 2017

E.S.G. in the Boardroom: A Recipe for Confusion

What would business do without its faddish buzzwords? Is the bottom-line really so boring? Transformational leadership was once in vague, with little actual attention to raising subordinates’ moral compasses. Decades later, everything was about drivers—a power-aggrandized version of cause. Then consultants, dreaming perhaps of their kids’ little league, turned the profession into an analogy and suddenly became coaches. One difference is of course that most actual coaches have been players in their respective sports, whereas how many leadership coaches have been business executives or sat on a board? “Leadership assistant” is better, if in-house, otherwise "leadership adviser," assuming sufficient study or experience in leadership. Then amidst global warming and activist stockholders, “E.S.G.” could suddenly be heard in boardrooms with the frequency of a trope.[1] Must business be led by a herd-mentality? Such leadership is internally inconsistent, for leaders are by definition ahead of the crowd, leading it rather than squawking like lemmings. In the case of E.S.G., which stands for “environmental, social, and governance,” the chatter eclipses recognition of the befuddled condition of the combo. With such different things in the mix, it is no wonder that a study attempting to quantify E.S.G. came up with mixed results. So the metric and purportedly related financial performance may not be very useful, after all.

E.S.G. “refers to the three main ways to measure a company’s commitments to ecological sustainability, to its community and to corporate governance.”[2] Large institutional investors, including BlackRock, the world’s largest asset manager, “have publicly declared . . . environmental, social and governance issues to be key metrics of their investment decisions.”[3] Although politically correct, this mantra has some rather severe drawbacks.

Firstly, what exactly is social? Good interpersonal relations inside a company?  Stable bilateral relations with key stakeholders (which sounds hardly social in nature)? Good relations with the towns and cities in which a company has a physical presence? Work on behalf of world peace? The term community is inherently such a vague notion, and it be applied to very different scales, from inside a factory to the world, that the social part of E.S.G. is problematic, especially when misplaced efforts to quantify “community” are involved. What may seem social could actually be economic, especially in stakeholder management. Also, having or being part of “community” is different than a corporate social responsibility program geared to alleviating a problem affecting employees, stakeholders, a city, or the world. This last point also applies to ecological sustainability—does this refer to a company’s own carbon footprint, or can a company get away with making financial contributions to Green Peace?

The second major problem is how different social and even ecological matters are from good corporate governance. A company’s board could improve accountability on management by severing the CEO from also chairing the board, but this does not mean that the same board has an ecological bent or wants to create a social responsibility program or give employees a sense of community (conditional, of course, given the power to fire). In short, E.S.G. combines apples with oranges. Not unexpectedly, they can relate differently with respect to financial results. Improving accountability structures and processes on management are more tightly connected to medium- and long-term financial performance than is working on a city’s problem, for instance. Improving stakeholder relations goes to the bottom line more than working for peace in the world. To be sure, the value of working on societal or global issues is real, and investors so motivated need not be thwarted by a loose relation to financial profits. The problem lies in combing E., S., and G. into a single measure and related it to financial performance.

A study by quantitative strategists at Bank of America—that bank that showed questionable smarts in buying Merrill Lynch—found mixed results in relating E.S.G. companies and profits. On the one hand, companies high in E.S.G. tend to have less volatile stocks, yet whether those companies outperform low E.S.G. companies, the answer depends on the industry. In health-care, technology, and consumer staples, the low companies actually outperformed the high ones from 2005 to 2015. In fact, the results generally were “very similar to the performance of large versus small companies.”[4] A mere look at the grab-bag of indicators demonstrates just how meaningless an overall E.S.G. number is. The study relied on a scoring system devised by Thomson Reuters, “which graded companies based on emissions and resource reductions, human rights, community engagement, work force diversity, training and development plans, board structure and compensation policy, and shareholder rights, among other things.”[5] Imagine quantifying human rights and board structure into one number!  It is as if the folks at Thomson Reuters were trying to come up with the general equation that so eluded Einstein relating the general theory of relativity to quantum mechanics! 

I submit that E.S.G. is an unstable molecule that would better serve business and society by being broken up into its component parts—its elements, each of which could be assessed, whether qualitatively or quantitatively. Some investors may want to invest in companies with a strong human rights record, while other investors may put a lot of emphasis on qualitative strength in corporate governance. Even within the social category, institutional investors could have very different things in mind—from workforce diversity to global warming. To be sure, investors could look for companies with diverse workplaces, no corporate social programs, and good corporate governance, or good relations with cities and good governance but no CSR programs to speak of—or all three. In short, the supposed positive correlations in E.S.G. do not hold in actuality even if it can be said that environment, social, and governance all have ideals. This is perhaps the underlying problem: the fallacy that says that just because x, y, and z have top values, the three variables are positively correlated. The other fallacy involved insists that everything in or affecting business can be readily or accurately quantified as if life itself were a spreadsheet. If investors really want companies to come out of their shells, it is vital to think beyond well-hooved business metrics and fads.

1. Andrew Sorkin, “Can Good Corporate Citizenship Be Measured,” The New York Times, June 26, 2017.
2. Ibid.
3. Ibid.
4. Ibid.
5. Ibid.