Each year when fall comes, I teach finance ethics to bright new postgraduate students in finance. After introducing ethical investing – i.e. the practice of integrating ethical criteria such as environmental, social, and governance performance (ESG) in investment decisions – I ask them a question: “Who believes that ESG investing generates higher financial returns?”
This year, about half of them raised their hand. This is unsurprising, given how widespread this belief is in business. The Davos Manifesto (2020) now claims that business “performance must be measured not only on the returns to shareholders, but also on how it achieves its environmental, social and good governance objectives”. To convince investors and businesses, advocates often claim that integrating ESG criteria in investment or business decisions can reduce (long-term) risks and generate higher returns. Slightly caricaturing, a vegan restaurant chain in Canada faces lower regulatory, reputational, and environmental risks than a corrupt and polluting mining company in a politically unstable country (see examples here).
Case in point, Laurence Fink, CEO of BlackRock (a $6 trillion investment firm), sends an annual letter to the C.E.O.s of companies it invests in asking them to serve a social purpose because for him, “profits and purpose are inextricably linked” (2019). McKinsey Quarterly also published an article outlining “five ways that ESG creates value” (2019). Market actors seem to have noticed, because S&P500 companies increasingly mention ESG in quarterly earning calls and the worldwide ESG assets under management have grown to $2.72 trillion in 2021.
No empirical evidence
The first problem is that there is no solid empirical evidence demonstrating a systematic link between ethical behavior and higher profits, as long-time critics underline (Vogel 2006). Most recently, The Economist offered a damning account: “ESG has become a gravy train for the investment industry… In marketing, they claim that ESG funds outperform mainstream ones, even if this does not stand up… empirically.” Indeed, if ethical businesses were more profitable, ESG-focused investment funds would be expected to consistently outperform standard funds ignoring ESG, but this has not been the case empirically (Vogel 2006, The Economist 2022).
Take a recent study by McKinsey (2018) claiming to demonstrate that “gender and ethnic diversity are clearly correlated with profitability”. In fact, the study merely shows that companies in the top quartile for gender or ethnic diversity on their executive teams are 15-35% more likely to outperform the national industry median in profitability than companies in the fourth quartile. But there are a few problems with this result.
Assuming agreement on the method to measure diversity (vague, inconsistent, or self-serving measurement of ESG performance plagues the industry), the results do not demonstrate that diversity causes financial performance. Instead, businesses that are already financially healthy may simply have more spare money to monitor and invest in ESG objectives such as improving diversity. As the study itself admits: “correlation does not demonstrate causality”.
Moreover, McKinsey’s study does not show that diverse firms are more performant than non-diverse ones, it shows that they are more likely to outperform the national industry median. This result is compatible with a world in which some businesses in the bottom diversity quartile outperform the industry median while some diverse businesses underperform. More generally, despite anecdotal, company-specific examples where ethical strategies have delivered financial returns, ESG objectives can fail to pay off and bad practices can still deliver high profits (Vogel 2006).
Missing the ethical point
Even if one concedes that ethical behavior is not systematically linked to higher profitability, but merely claims that they do not always conflict, this is missing the ethical point. Business leaders and investors should care about environmental protection, diversity, or fraud prevention because it’s the right thing to do, not because it is good for business.
One issue if businesses only valued ESG objectives strategically is that market incentives are structured to encourage these objectives only up to the point necessary to reach strategic goals, not further. They would stop investing in environmental protection, social responsibility, and good governance as soon as it stops being profitable, which would lead to watered-down ambitions (The Economist 2022).
This means that there is always a point where ESG objectives and profitability are in conflict. Sweeping such conflicts under the rug by focusing on cases where they align omits the hard but important question that business leaders and investors must ask themselves: are there cases where they must sacrifice profitability to respect their ethical obligations?
A convenient belief
Conflicts between our own values are uncomfortable. They impose difficult trade-offs that we, or the people around us, may find controversial. When our personal gain conflicts with our social values, it can also reveal selfish tendencies in ourselves that we prefer to ignore. Observing discrepancies between the values we affirm and the actual choices we make can lead to cognitive dissonance. This is perhaps one reason why it is so tempting to believe that ethical behavior is also good for business: it would be so much easier if it was! We engage in motivated reasoning: we believe that ethics is good for business because we want to believe it.
Business ethicists may also be partly responsible for this belief’s popularity (Vogel 2006). In the urge to encourage best practices, it is tempting to take the path of least resistance: the easiest way to convince business leaders to pursue ESG objectives is to tell them it is profitable.
But the time has come to be honest. There are specific cases in which ESG objectives can be strategically useful but this is not always true and it provides a poor reason to adopt better business practices. While market competition can be beneficial (it lowers prices and drives innovation), it often limits businesses’ capacity to pursue ESG objectives. This is why business incentives are insufficient to motivate best practices and why David Vogel concludes that “governments remain essential to improving corporate behavior” (Vogel 2006).