I find the debate around SRI/ESG (socially responsible investing/environmental, social, and governance) to be largely artificial and somewhat distracting. It seems to me that, given the difficulties we face measuring CSR (even defining CSR), identifying correlations between some set of compromise variables and firm performance is spurious (to put it generously). In other words, the filters that structure these investments (such as low pollution levels, or director diversity, or employee pay ratios, or whatever measure you like) miss the point. Primarily this is because, in my mind, CSR is everything the firm does (not easily identifiable parts), but also because this research suffers from omitted variable bias. That is, it is the progressive executive team that adopts good environmental practices (or diverse directors or equitable pay practices), so it is the progressive executive team that predicts performance (not the various practices they adopt). With this in mind, the article in the url below adds another important (and rational) explanation for why much of the discourse around SRI/ESG is misleading. In particular, it identifies a flaw in the argument intended to legitimize this industry—that investing in social responsibility need not compromise performance:
"The trouble is, even badly run companies, big polluters or terrible employers have some price at which they will be profitable investments. A recent example is the rebound in the sector environmentalists love to hate: Coal miners globally have returned almost 20% in the past 12 months in dollar terms, double the world market, according to Datastream indexes."
Beyond the challenges associated with measuring social responsibility, whenever you constrain choice there is a good chance you will affect outcomes. Similarly, if a lack of demand pushes the price of one stock down, that only makes it a more attractive investment (presuming it is an ongoing, profitable business). It is this same logic that undermines much of the oil and gas divestment activism:
"Lower stock prices mean a higher cost of capital for the company, which should hurt. But cheaper shares in the same business mean buyers should expect higher returns in future than they did before. If the do-gooders are successful in driving down stocks, the new shareholders in the badly behaved business should outperform, and the do-gooders underperform."
The Figure in the article that shows total returns of the coal sector relative to all stocks is enlightening. The article also has another Figure showing how much individual firms have varied in ESG ratings—reinforcing the idea that we really have no idea of how to measure CSR. But, none of this means that SRI/ESG products are not viable. It just means that, if the industry is to be successful, it has to be more honest with potential customers/investors. Just like there is a cost to purchasing a higher quality product (expressed in terms of a price premium), there is a cost to investing using one or more SRI/ESG filters. Given that reality, customers can choose. The added value comes from knowing that certain firms and industries are being avoided—that investments are aligned with values. But the cost, over the medium to long term, almost by definition, is likely to be lower returns.
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If You Want to Do Good, Expect to Do Badly
By James Mackintosh
June 29, 2018
The Wall Street Journal
Late Edition – Final