A letter to the editor (of the Financial Times)

Misgivings about the value of ESG investing in driving change are missing the point, writes Jon Duncan

The upheaval of life as we know it as a result of the Covid-19 pandemic has escalated calls for the application of ESG principles across all industries in order to build back a better world. This has been particularly evident in financial markets, which have seen the wreaking of almost unprecedented havoc across global markets, with the interruption of global supply chains and the drying up of demand. Globally, sustainability-themed funds saw record inflows in the first quarter, while the rest of the markets were leaking hundreds of billions in outflows. The Covid crisis, it seems, has reinforced the belief among investors that ESG will have a material impact on their shareholdings over the longer term.

However, there exists increasing debate around the role of ESG investing and stakeholder capitalism in driving optimal returns for shareholders. Last week, we saw one argument in particular in an article by the Financial Times’ US Financial Editor, Robert Armstrong, titled ‘The dubious appeal of ESG investing is for dupes only’, which contends that ESG investing rests on weak conceptual foundations and should be viewed suspiciously by investors seeking adequate returns or citizens advocating change for a better world.

This kind of thinking is deeply flawed in that it fails to recognise the economy as a subset of society, which in turn is acutely reliant on the safe functioning of the global biophysical system.  Sustainability as a field sits at the intersect of complex system science and normative ethics. The systems science side of it focuses on the interplay between the biophysical, social and economic aspects of our existence. The normative ethics aspect draws our attention to issues such as human rights, earth jurisprudence, articles of religious faith, and cultural norms and practices.

In failing to acknowledge this critical systems interplay, Armstrong displays the blind spot of shareholder capitalism i.e. that it exacts a heavy price on society and environment, and often these externalities go unpriced in the markets. By taking a singular system view on the economy and failing to recognise its interconnectivity, he completely overlooks what society and science are telling the world. Similarly, he takes a narrow view of capitalism and fails to see it as an evolving set of concepts that have been shaped through time.

Armstrong’s point that stakeholder capitalism is founded on weak conceptual ideas is just plain incorrect. This is a field that has grown in its depth of research and understanding over the past 20 years. Prof Colin Mayer of Oxford, an advocate of stakeholder capitalism, frames it so: “The purpose of business is not to produce profits. The purpose of business is to produce profitable solutions to the problems of people and the planet”. In the same vein, the research of Michael Porter from Harvard provides a compelling conceptual framework for stakeholder capitalism, and importantly highlights the strategic advantage of pursuing a business strategy centered on these concepts.

The idea that corporate leaders will be forced to choose between delivering to stakeholders at the cost of shareholders is a conundrum that is not unique to “stakeholder capitalism”.  Balancing competing priorities is also a challenge for shareholder capitalism – think of the situation where a CEO has to weight short-term margins for shareholders by reducing product quality or customer service levels. What matters in these situations is the quality of the leadership, and the time horizon used for decision making. It is certainly not uncommon for shareholders to accept short-term pain for longer-term gains.

While we may not know what comes next, after the Covid-19 fallout has subsided, what we do know is that the world will be significantly altered going forward. Our sense of interconnectivity will be enhanced and we will have learnt that it is not just returns that matter. In part, this explains the growing call for post-Covid fiscal stimulus – unprecedented in global history –  to be directed to low-carbon, resource efficient and socially inclusive growth. This tail wind supports sustainable and ESG focused investing as a viable and technically sound approach to delivering competitive financial returns. This approach has the potential to shift the global economy to a path that is low-carbon, resource efficient and socially inclusive, but this is as much to do with shareholder value as it is to do with the greater good.

The junction we find ourselves at, in the midst of this crisis, is the perfect moment for all actors in the financial services sector to really realign their understanding of RI and ESG issues. It is critical that decision-makers should be clear on how ESG issues affect long-term risk and returns, and additionally how the growing trend towards ESG investing impacts the ability to attract, retain and ultimately grow capital.

 Jon Duncan is Head of Responsible Investment at Old Mutual Investment Group