In the world of finance and economics, there is an ongoing whether responsible investing and the fiduciary duty asset managers hold to generate risk-adjusted returns can coexist. Responsible investing often manifests as due diligence into the Environmental, Social and Governance (ESG) factors of companies, which critics argue does not support making sound investment decisions. Proponents, however, view such analyses as a mechanism to ensure better long-term returns for individual companies, but, more importantly, greater long-term returns from a total market perspective. To truly understand the intersection of these two forces, we must examine them through the lens of ‘externalities’. These are indirect costs or benefits incurred by third parties, which are often not accounted for in the price of a product or an asset. Pricing in such externalities can alter the incentive structures for businesses and lead to a more equitable and efficient system. The classic example of an externality is a manufacturing company that pollutes a lake its factory is located by. In doing so, it not only hurts the health of the citizens (and creates an economic cost through their healthcare needs and decreased productivity), but also economic costs to local enterprises such as fishing or tourism.
Responsible Investing and the Free Market
To many, responsible investing and capitalism appear to be mutually exclusive. At the heart of capitalism is the profit motive: entities act in their self-interest, seeking to maximize shareholder returns. Meanwhile, ESG factors, by their very nature, demand a broader perspective — considering not just immediate financial returns, but the environmental, social, and governance impacts of business decisions. Some see this as a diversion of resources, but that’s a myopic view. ESG is not about undermining capitalism but refining it, as seen through the “universal ownership” increasingly expressed by many large asset managers and owners around the Globe.
The Role of Externalities and Universal Ownership
Historically, many companies thrived by ignoring external costs. Pollution, for instance, was frequently dismissed as an unavoidable byproduct of industrial progress. Societal consequences, like poor labour practices, were often buried under the rug. But as society progresses, there’s an increasing realization that such externalities can’t be brushed aside.
When external costs are not incorporated into the price of goods or assets, the market fails to operate at its optimum. The result? Overproduction of harmful goods and underproduction of beneficial ones. Consider the previous example of a company that dumps waste into a lake. These costs are not only borne by communities, but also by other business. The universal ownership view is attempting to optimize for growth among all business in a portfolio, a perspective where managing for externalities aligns closely with the primary fiduciary duty of investors.
The Benefits of Integrating Externalities
Responsible investing aligned with the universal ownership view simply becomes an exercise in “pricing in” these externalities. Some of these have a direct impact on an individual company, such as poor labour treatment increasing the likelihood of churn and introducing legal and reputational risks, while others may have indirect impacts on other companies and industries in an investor’s portfolio.
When ESG risks are expressed in financial terms, it leads investors to direct capital towards companies that are potentially better operators, carry less tail risk, and create more total portfolio value through their impact on other business. Firms that excel in ESG parameters often enjoy better stakeholder relations, more robust brand loyalty, and resilience against market shocks. This does not preclude traditional fundamental analysis of a company’s business model and future cash flows but makes these analyses more holistic and robust.
Better expressing non-financial risks also encourages transparency. When investors and stakeholders demand to know a company’s ESG credentials, it drives businesses to be more open about their practices, leading to a more informed market.
Finally, the externality view of ESG integration ensures long-term sustainability. Companies that rely on exploitative practices might see short-term gains, but they are also exposing themselves to significant risks in the future, both reputationally and financially, while potentially damaging the overall market in the process.
Aligning incentives away from creating negative externalities then helps reshape capitalism into a system that doesn’t reward myopic behaviour and individual profit, but rewards responsible profit for the entire market.
Conclusion
The dynamic interplay between ESG and capitalism is not about opposition but evolution. Capitalism, in its most unbridled form, might overlook the externalities that can adversely affect society at large. When businesses disregard the broader repercussions of their actions, they expose themselves to tangible financial risks and damage the overall market.
By integrating externalities into investment frameworks, investors do not stifle enterprise but refine it. They nudge businesses towards a future where views of profitability are not myopic and short term, as more and more players take on the universal owner view. In such a future, the markets are not just efficient but also equitable, ensuring optimal outcomes for all stakeholders involved.
As we move forward, the call isn’t for businesses to abandon the tenets of capitalism but to embrace a more enlightened, holistic version of it. By understanding and pricing in externalities, companies can truly harness the full potential of capitalism while also contributing positively to society and our planet.
By Alik Sokolov, co-founder and CEO of Responsibli
Alik’s professional background is in AI consulting as a machine learning and AI product team leader, and venture capital as a research associate in one of Peter Thiel’s funds. Alik is also leading researcher and educator in the machine learning field, having taught and developed the machine learning course at the University of Toronto Master’s of Mathematical Finance program, as well as many workshops and classes around the world. Alik is also a PhD candidate and Vanier Scholar at the University of Toronto, studying applications of machine learning in quantitative finance and he has published papers at the intersection of quantitative finance, AI, and responsible investing in leading journals. Currently, Alik serves as the co-founder and CEO of Responsibli, a company at the cutting-edge of AI and natural language processing for investment management, with a specific focus on responsible investing.