Green Finance Advisor of Friends of the Earth (HK)
The article “Applying Economics—Not Gut Feel—to ESG” by Alex Edmans explores the application of economic principles to environmental, social, and governance (ESG) issues. While the importance of ESG has gained significant attention, the author argues that decisions in this field should be based on careful analysis rather than gut feelings. By drawing on insights from mainstream economics, Edmans challenges common myths surrounding ESG and highlights the need for a rational approach.
ESG and Mainstream Economics:
Edmans emphasizes that ESG investments should be treated like any other long-term investment with financial and social returns. He points out that conventional economic theories, such as corporate finance, asset pricing, welfare economics, optimal contracting, and agency theory, provide valuable frameworks for understanding and evaluating ESG initiatives. By applying these economic principles, the author aims to debunk several misconceptions about ESG.
Challenging ESG Myths:
The article addresses ten common ESG myths and presents alternative perspectives based on economic analysis.
1. Shareholder Value is Short-Termist:
Contrary to popular belief, shareholder value is a long-term concept. It encompasses the present value of all future cash flows and takes into account both financial and social returns. Therefore, maximizing shareholder value can support ESG projects that yield positive future cash flows, even if they have short-term negative impacts.
2. Shareholder Primacy Leads to an Exclusive Focus on Shareholder Value:
Shareholders have objectives beyond financial returns. They may also consider social and environmental impacts. Thus, shareholder primacy does not necessarily exclude a broader focus on stakeholder value.
3. Sustainability Risks Increase the Cost of Capital:
Sustainability risks, such as environmental or social risks, do not always raise the cost of capital. If these risks are idiosyncratic, they may not significantly affect a company’s expected cash flows and, therefore, the cost of capital.
4. Sustainable Stocks Earn Higher Returns:
While sustainable stocks may align with certain investors’ preferences, they do not necessarily generate higher returns. The market may already price in sustainability factors, leading to lower returns for these stocks.
5. Climate Risk Is Investment Risk:
Climate risk is an unpriced externality, meaning it is not fully reflected in investment risk. Therefore, considering climate risk separately is essential to make informed investment decisions.
6. A Company’s ESG Metrics Capture Its Impact on Society:
ESG metrics provide a partial view of a company’s impact on society. However, a comprehensive understanding requires considering the broader economic equilibrium and the interdependencies between different stakeholders.
7. More ESG Is Always Better:
ESG initiatives exhibit diminishing returns. It is important to strike a balance and recognize trade-offs between different ESG dimensions.
8. More Investor Engagement Is Always Better:
Increased investor engagement does not always lead to improved ESG performance. Investors may lack information or undermine managerial initiatives, highlighting the need for thoughtful engagement strategies.
9. You Improve ESG Performance By Paying For ESG Performance:
Paying for specific ESG dimensions may cause firms to neglect other important aspects. A holistic approach that considers multiple dimensions of ESG is crucial for sustainable performance improvement.
10. Market Failures Justify Regulatory Intervention:
Regulatory intervention is only justified when market failures outweigh potential failures resulting from regulation. A careful assessment of the costs and benefits is necessary in determining the appropriate level of intervention.
article emphasizes the importance of applying economic principles to ESG
decision-making. It argues against relying solely on gut feelings and urges for
a rational analysis that considers long-term financial and social returns. By
debunking common ESG myths, the author encourages a balanced and informed
approach to ESG initiatives. While acknowledging the need for further research,
the article highlights the value of existing finance and economics literature
in guiding ESG practices.
- Edmans, A. (2023), Applying Economics – Not Gut Feel – to ESG, Financial Analysts Journal vol. 79, 2023 Issue 4