Cross-posted from the Effective ESG blog.
Thoughtful trade-offs: models for going beyond profit maximisation
There is lots of talk about whether incorporating ESG factors could help improve profitability or returns.
This post is not about whether or not this is true.
Instead, I claim that this is missing the point.
- I’m sure there will be times when ESG thinking can lead to improved returns/profitability.
- And there will be times when ESG factors are profitability-neutral.
- And I expect there are also times when there’s a tension or trade-off between ESG factors and profitability.
For examples of trade-offs, I’m sure we could come up with strategies for e.g. a fossil fuel company, a tobacco company or an arms manufacturer which will be better from an ESG perspective but suboptimal from a profitability perspective.
It’s all about the trade-offs.
To judge whether ESG investing is actually having an impact, we need to look at scenarios where there is a tension between ESG factors and profitability factors. If ESG factors aren’t winning over profit at least some of the time, then ESG thinking isn’t having any impact beyond the raw profit-oriented mindset which existed anyway.
Note that I don’t want ESG factors to always win over profitability.
To illustrate this with an example from consumerism rather than investment: I recognise that a flight from London to New York has many externalities, but that doesn’t mean that I want every flight from London to New York to be cancelled.
Which is why we need models.
The world of finance is used to using models. In particular, if we think about asset owners such as pension funds and life insurers, they are constantly having to make trade-offs, such as whether funds should be allocated to cover the pension scheme liabilities (i.e. more confidence that the scheme will be able to make payments to pensioners in retirement) or should be made available to the company.
For this sort of important trade-off, they inform their decision-making with models.
I believe that the trade-offs between profit and ESG factors are at least as important, and therefore deserve the same level of effort and modelling.
I believe that naive dichotomies won’t help us. I believe that simplistic slogans like “planet good, profit bad” don’t lead to outcomes that anyone believes — I don’t want us to destroy the economy.
Instead I want us to have thoughtful trade-offs — trade-offs where we apply models to make better decisions.
Thanks, Sanjay, I’m sharing a basic model I’ve written that highlights the trade-off for impact investments that seek both social impact and financial returns. This isn’t specifically about ESG but the key ideas still apply. The upshot: the investment must produce annually one percent of a same-sized grant’s social benefit for every one percent concession on its financial return. I construct impact investing’s version of the Security Market Line and quantitatively define what ‘impact alpha’ means.
This model was written a couple of years ago but since then, I actually haven’t applied it much. That’s because it’s hard to quantify impact, which is a key input that the model requires (and an input that any model will obviously require). There’s no established and easy way to monetize impact, especially given impact's tremendous heterogeneity. Comparing the value of a year's education versus a year's health is hard enough. What about quantifying the counterfactual impact that a business has? Or that of the investor investing into the business? So modeling is helpful but at this stage, I think data is what we actually need most.