Sustainable Investing & The Chase For Profit: Friend or Foe?

“It is difficult to get a man to understand something when his salary depends upon his not understanding it.” (Upton Sinclair, 1994)

Since the dawn of capitalism, businesses have sought to fulfil only one specific goal: maximise profit. In one of his essays (1970) Economist and Nobel prize winner, Milton Friedman, shares that corporate executives are employees of the owners and that their primary duty is to create wealth for these shareholders. Consequently, businesses supply, organise and execute operations with that sole purpose in mind. Employees are also directly and indirectly incentivised for their ability to successfully contribute to this goal through monetary or social rewards. Unfortunately, what is good for individuals is usually not what is best for the environment or society. Environmental and social factors such as water & air pollution, child labour, deforestation and animal extinction have all accelerated or resulted from businesses chasing the highest profit margins. In economic terms, these factors represent negative externalities and lead to a market failure as the price businesses charge for these products fail to accurately represent the true cost of production. This blog post will discuss how the quest for profit has a significant impact on the world’s ability to deal with future environmental, social and governance (ESG) challenges and how it all connects to current trends in sustainable investing.

The Business Judgment Rule

Before addressing any issues related to profits or ESG, it is important to be familiar with the concept of the Business Judgment Rule (BJR). This rule provides company executives with the ability to make decisions that may affect the business negatively (especially in the short-term) if it can be proved that the decisions of the director were made “(1) in good faith, (2) with the care that a reasonably prudent person would use and (3) with the reasonable belief that the director is acting in the best interests of the corporation” (LII, 2021). This ruling is a significant one as it implies that any decision that has the potential of affecting the bottom-line of a company must have sufficient grounds (scientific; legal; data-driven) in order to be considered justified. For example, a director of a company cannot decide to increase wages for its employees in poor countries because it’s the “moral” thing to do, irrelevant as to whether that is true or not. The director must prove that they would be acting in favour of shareholder interests, which as mentioned earlier, is linked to maximising the return on their investment. With the BJR in mind, one can imagine how difficult it may be to push a sustainable agenda to shareholders in a capitalist and profit-driven economy.

Shareholder’s Present Bias

In the field of behavioural finance and psychology, human behaviour is known to be influenced by present bias. This concept refers to the tendency of people to prefer short-term immediate gratification over future, longer-term preferences (Xiao, 2019). In the context of business, an example would be that although shareholders would prefer that their company invests in ESG initiatives and contributes to a more sustainable future, they are not willing to sacrifice a blow to their immediate earnings (quarterly dividends, EPS, stock price, etc). In 2014, Emmanuel Faber became CEO of Danone and publicly voiced his advocacy for environmental matters and centred core business units around ESG (Gansbeke, 2021). In his last 5 years at the company, Danone underperformed relative to its competitors and saw a negative share price performance whereas competitors such as Nestle had seen increases upwards of 30% (ibid). This was despite, Nestle being identified in 2017 as the worst plastic polluter in the Philippines by NGO Greenpeace (Wheeler, 2018). Nonetheless, in those 5 years, Danone’s ESG initiatives achieved the following:

“Danone was recognized by the referential NGO CDP as a global environmental leader, becoming one of only ten companies with an ‘AAA’ score in 2020.

Introduced a Carbon Adjusted EPS (Earnings Per Share) concept which is a modified profitability metric that accounted for the offset cost of its entire carbon footprint.

Signed the New York Declaration on Forests and endorsed the Consumer Goods Forum (CGF) resolution, aiming to yield zero net deforestation in crucial commodity sectors.

Danone joined the RE100 initiative, a collection of companies committed to using 100% renewable electricity. Danone aimed to reach 50% of renewable electricity by 2020 and 100% by 2030.”

(Gansbeke, 2021)

Although Fabian’s tenure of 7 years may seem like a long time, research has shown that it will take millions of years to overcome the damage of freshwater pollution if current trends continue (Neubauer et al.). Also, the return on Danone’s ESG investments is not one that shareholders are likely to profit from in terms of capital gains (at least in the current economic climate), however, its return for the world is undeniable. Unfortunately, due to short-termism and present bias, most people are unable to see past their own lifetimes, let alone the generations to come. This may be a reason that led to Fabian’s dismissal in 2021, as shareholders grew weary of underperforming sales and growth.

Sustainable Investing

It has been established that company executives have a lawful duty to serve in the best interest of their shareholders. This has shown to be directly linked to realising profits in what has now become a highly competitive economy. Furthermore, the present bias implies that on average investors are likely to prefer earnings in the short-term rather than higher potential returns in the future. It should be noted that in the context of investing, the short-term usually refers to investments that typically last under 5 years. Nevertheless, the general public has also become more aware of ESG issues in the last decade and shareholders are putting pressure on their companies to become more ‘eco-friendly’ as a way to remain competitive. The product of this shift in mindset is sustainable investing, which refers to investors considering ESG factors when building their portfolios (OECD, 2021). The rationale is that investing only in companies that have a lower carbon footprint would make it more difficult for their highly polluting counterparts to gain financing, which would incentivise them to lower their emissions. Sustainable exchange-traded funds (ETFs) provided by large asset management firms such as Vanguard or BlackRock offered investors the possibility to invest in such funds at a slightly higher management fee as they require more intensive research. Well, everything is fixed then, right?

Unfortunately, it’s not that simple.

Firstly, choosing not to invest in a company is not the same thing as boycotting its services. The former has little to no impact, as there will always be a buyer who will own the shares and pay a fair price for them, whereas the latter will impact a company’s profitability and may result in bankruptcy or halt of operations.

Secondly, not all companies get their funding from one source. Although a company may pledge to use funds from certain investors for sustainable initiatives (think green bonds), this does not mean that it will use all sources of funding towards those initiatives.

Thirdly, most of the stocks traded in sustainable ETFs are already being traded in public stock exchanges, meaning that investing in such funds does not provide any additional capital to the ‘sustainable’ companies which are part of that fund (Fancy, 2021).

Fourthly and perhaps most importantly, none of the ESG ETFs undergo any official regulation. As Fancy shares in his essay, many firms have been rebranded as ‘green’ with no significant change in their strategy or operations (Andrews & Sheth, 2021). Furthermore, ESG ETFs are not required to publish 100% of their holdings and over 80% have in one way or another exposure to fossil fuels users and producers (ibid). In essence, there are many questionable practices surrounding these new financial instruments and whether they are as ‘green’ as they appear.

At the end of the day, everyone is incentivised by profit. Financial institutions want to diversify their products and push these sustainable ETFs as they can charge higher fees for their management. Investors want to mitigate their risk and diversify their portfolios in case ‘sustainable’ firms outperform the rest of the market. Companies will make the most cost-effective method to remain attractive in the eyes of the general public.

Yet the question remains, is this actually making any difference for the planet?

There’s no denying that the growing interest in ESG has positive implications as it encourages consumers to question where and how they spend their money. Similarly, many producers are pressured by major stakeholders to minimise their harm to society and the environment. A McKinsey Global Survey conducted in 2019 directed towards C-Suite executives and investment professionals has shown that 83% of respondents were willing to pay a 10% premium to acquire a company with a positive track record concerning ESG issues compared to a negative one (Delevingne et al.). If big players in the economy consider companies with sustainable initiatives as more valuable, then this may incentivise a more eco-friendly economy.

However, this transition is not happening fast enough. As mentioned earlier, profit-making remains at the centre of all initiatives. That’s understandable as most companies operate in a capitalistic and highly competitive industry. However, the evidence shows that seeking profit on its own has caused market failure due to negative externalities and has resulted in devastating effects on the world. What took a few centuries to destroy may take millions of years to restore. With the BJR and present bias of shareholders constricting the ability of corporate executives to make decisions that matter and last, it seems that if businesses are left on their own, they are unable to find a common ground between making a profit and not harming the planet.

Something needs to change, but what?

At least one thing is certain.

Man’s ability to cope with the long term repercussions of its centuries of environmental destruction will depend on the way businesses, financial markets and economies change in the short run.

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References

Andrews, M. and Sheth, S., Why ESG Exchange-Traded Funds might not be as green as you think Available at: https://www.weforum.org/agenda/2021/07/esg-exchange-traded-funds-not-as-green-as-you-think/ (Accessed 29 September 2021).

Delevingne, L., Kane, S., Koller, T. and Gründler, A., ESG programs and the ESG premium | McKinsey Available at: https://www.mckinsey.com/business-functions/sustainability/our-insights/the-esg-premium-new-perspectives-on-value-and-performance (Accessed 29 September 2021).

Fancy, T., 2021 The Secret Diary of a ‘Sustainable Investor’ — Part 1. Medium. Available at: https://readmedium.com/the-secret-diary-of-a-sustainable-investor-part-1-70b6987fa139 (Accessed 29 September 2021).

Friedman, M., 1970 The Social Responsibility Of Business Is to Increase Its Profits. The New York Times. Available at: https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html (Accessed 29 September 2021).

Gansbeke, F.V., Sustainability And The Downfall Of Danone CEO Faber (1/2) Available at: https://www.forbes.com/sites/frankvangansbeke/2021/03/20/sustainability-and-the-downfall-of-danone-ceo-faber-12/ (Accessed 29 September 2021).

LII (Legal Information Institute), 2021, Business Judgment Rule Available at: https://www.law.cornell.edu/wex/business_judgment_rule (Accessed 29 September 2021).

Neubauer, T.A. et al., 2021 Current extinction rate in European freshwater gastropods greatly exceeds that of the late Cretaceous mass extinction. Communications Earth & Environment, 2(1), pp.1–7.

OECD, 2020 ESG Investing: Practices, Progress and Challenges. , p.88.

Sinclair, U., 1994 I, Candidate for Governor: And How I Got Licked,

Wheeler, P., Nestlé misses the mark with statement on tackling its single-use plastics problem. Greenpeace USA. Available at: https://www.greenpeace.org/usa/news/nestle-aiming-at-100-recyclable-or-reusable-packaging-by-2025/ (Accessed 29 September 2021).

Xiao, J.J. and Porto, N., 2019 Present bias and financial behavior. FINANCIAL PLANNING REVIEW, 2(2), p.e1048.

Originally published at https://www.linkedin.com.