The portfolio defense of ESG

Here’s an excerpt from this article by Rick Alexander of “The Shareholder Commons”:

Let us begin with two noncontroversial observations. First, investors are likely to own positions in hundreds or even thousands of companies, either directly or through pooled investment vehicles. This diversification allows investors to increase returns with minimal risk. Second, if one company in an investor’s diversified portfolio increases its value through conduct that poses risks to the social and environmental systems that are critical to the economy, the consequent harm may cause damage throughout the portfolio, and that damage may far outweigh any gain the investor receives from a relatively small holding in the company.

By contrast, the executives who run companies are financially incentivized to care only about the value of their company, not the aggregate value of their shareholders’ portfolios. Decisions that impact these two values differently create a divergence in interest between company managers and the investors whose capital they are using.

Investors tend to ignore this conflict and treat individual companies as the critical units for measuring financial success, rather than focusing on how company decisions affect broad market returns. Executives and asset managers are rewarded for generating alpha (the difference between the returns of a company or portfolio and the average return for similarly risky investments), regardless of the impact such alpha generation might have on the systems that determine the broad market returns that matter most to diversified investors. For example, investors strongly favor equity compensation, under which managers are rewarded when a company’s share price goes up, even if its business model relies upon cost externalization that threatens broad market performance. Similarly, asset managers who pick stocks are rewarded when their portfolios outperform similarly risky portfolios, regardless of the impact that the “winners” are having on the economy and overall market returns.

Unfortunately, ESG activists tend to share this individual company bias, at least when they explain their motives. They defend their activism almost exclusively in terms of the potential to improve the alpha of individual companies by improving their social and environmental impact. The ESG movement eschews rhetoric that directly addresses the trade-offs that sometimes exist between the positive effects a company decision has on its own financial value and the threat that decision could pose to the overall performance of the market. As a result, cost externalization continues.