Applying Economics—Not Gut Feel—to ESG

Abstract

Interest in environmental, social, and governance (ESG) issues is at an all-time high. However, academic research is still relatively nascent, often leading us to apply gut feel on the grounds that ESG is too urgent to wait for peer-reviewed research. This paper highlights how the insights of mainstream economics can be applied to ESG, once we realize that ESG is no different to other investments with long-term financial and social returns. A large literature on corporate finance studies how to value investments; asset pricing explores how the stock market prices risks; welfare economics investigates externalities; optimal contracting considers how to achieve multiple objectives; private benefits analyze manager and investor preferences beyond shareholder value; and agency theory helps ensure that managers pursue shareholder preferences, including non-financial preferences. I identify how conventional thinking on ten common ESG myths is overturned when applying the insights of mainstream economics.

Keywords:

• CSR
• ESG
• responsible business
• SRI
• sustainable investing

PL Credits: 0.75:

Acknowledgment

I thank the Editor (Daniel Giamouridis), two excellent referees, Pierre Chaigneau, Tom Gosling and Ken Pucker for helpful comments.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 For simplicity, I am assuming an all-equity firm, so cash flows to the company are cash flows to shareholders, and that these cash flows are paid to shareholders as dividends.

2 Jensen and Meckling (1976) use the term “non-pecuniary benefits.” We use “private benefits” as it is the more common term in the literature.

3 This assumes that the capital asset pricing model is the benchmark. If it is the arbitrage pricing theory, then the discount rate is affected only by non-diversifiable risk.

4 This will lead to higher stock returns if the market was not fully aware that companies don’t bear the consequences of such externalities.

5 While ES investors should be concerned about aggregate externalities, rather than only those produced by the companies they own, some investors’ tastes may be such that they only care about the latter. For example, some shareholders exclude tobacco companies and don’t engage with the government to increase tobacco taxes as they don’t feel it’s their responsibility if they don’t hold tobacco. Even if we had a literal definition of “its” in “A company’s ESG metrics capture its impact on society,” i.e., we don’t include the pollution produced by plants outside a company’s control, this measure still does not fall. Duchin, Gao, and Xu (2022) find that the sellers don’t lose access to the divested plants, since they are typically bought by firms with supply chain relationships or joint ventures with the sellers.

6 Even though another investor buys your shares, the act of selling lowers the stock price, which makes it harder for the company to raise capital in the future and harms the CEO’s wealth and reputation. Thus, a CEO might be concerned with investor selling even though it does not directly deprive a company of capital. Even so, Edmans, Levit, and Schneemeier (2023) show that the optimal divestment strategy may be tilting (leaning away from a brown industry but being willing to hold a best-in-class company) rather than blanket exclusion. Exclusion gives the firm no incentives to reform as it will be excluded anyway, tilting incentives the company to reform and become best-in-class.

7 More precisely, higher numbers are always better for “good” measures such as diversity, and lower numbers are always better for “bad” measures such as carbon emissions.

8 In Aghion and Tirole (1997), they do this by giving “real authority” to the CEO, i.e. delegating decisions to her even though they possess “formal authority.” This is consistent with the wide discretion given to directors in practice, and the limited votes given to shareholders. In Burkart, Gromb, and Panunzi (1997), they take a small stake to begin with, reducing their incentives to interfere.

9 Note that there may be innocuous reasons for such outreach, e.g. to garner support from other investors and the public.

10 In practice, these schemes are almost exclusively linked to ES performance, but we will use the term ESG as this is how they are often described to the public.

11 The quote is “capitalism is the worst economic system, except for all the others.” This is based on Winston Churchill’s phrase that “democracy is the worst form of government, except for all those others that have been tried.”

Additional information

Notes on contributors

Alex Edmans

Alex Edmans is Professor of Finance, London Business School, Regent’s Park, London, UK.