FCA has published a collection of ESG/sustainability thought pieces

Recommended ESG reading. FCA has published a collection of ESG/sustainability thought pieces. I’ve had a first read today. You are unlikely to agree with all the pieces, but they argue for nuanced views and hit right at the tip of cutting edge debates in this area. So, I am going to suggest this is recommended reading for all those interested in ESG, sustainability issues, long-term investing and governance thinking overall. As part of a FCA consultation. Articles are:

  • Taking a holistic and purpose-led approach to net zero (Tayler, Aviva)

  • Using pay to create accountability for ESG goals (Gosling, LBS)

  • Transitioning to net zero: increasing investor confidence in corporate carbon Commitments (LSE research)

  • Adding purpose to principles and products (Eccles, Oxford) 

  • How to build an effective culture to support climate and sustainability-related objectives in the financial sector (Deloitte)

  • Board-level governance of climate-related matters (Chapter Zero)

  • How a Chief Sustainability Officer can most effectively support a firm in achieving its climate and sustainability-related objectives (Martindale, Cardano)

  • Governing climate transition implementation at banks (Mavraki)

  • Effective governance of investor stewardship to support net zero: a practitioner’s view (Chow, ICGN)

  • Preventing greenwashing: time to stop marking our own homework (Thompson, FCBI) 

Downloadable here and link to splash page here.


George Serafeim podcast transcript, Citywire with Algy Hall | Fix the Future

I made a transcript of the George Serafeim and Algy Hall (Citywire) podcast on ESG. Algy doesn’t challenge George on the push back on one of his key co-authored papers: Corporate Sustainability: First Evidence on Materiality (a summary commentary on the critique with links to it here - the comments are from noted statistician Andrew Gelman, but the orginal critique is from Luca Berchicci and Andy King). This was for many years a well quoted piece of evidence for ESG materiality. The case from academic papers is now more mixed with some of the strongest evidence (IMHO) remaining from the Alex Edmans employee satisfaction work and related work on “human capital” (a term that many non-accountants don’t like!), Caroline Flammer’s work on incentives, long-term, and CSR/ESG (using regression discontinuity design) and some of the work on material transparency.

Still, George is a leading business school voice on ESG/Sustainability and his comments on “Purpose and Profit” and the extra-financial factors that can drive business are useful to know.

(While I podcast myself, I find it much quicker to read transcripts more than listen when I’m going through a lot of work).

Podcast available at link here and below:

Fix The Future Show: ‘ESG was Never Meant to Save The World.’

George "There is a misperception about what ESG is as a management concept, as a governance concept, as an investment concept in business. ESG, at least in my mind, was never meant that it would save the world."

Algy (00:17):

That was George Serafeim, the Charles M. Williams Professor of Business Administration at Harvard Business School, who I'm talking to on this month's Fix The Future Show; the podcast where we explore ideas about how investors can do good in the world while making good money. I'm Algy Hall, the investment editor of Citywire: Fix the Future. Over the last decade, George has been a pioneer in developing the common sense ideas that underpin ESG. He has also been involved with much of the most influential research in the field and continues to push the subject forward including through his work on impact weighted accounts which we'll hear more about later. He's also the author of the recently released book, “Purpose and Profit: How Business Can Lift Up the World.” It's a book I can highly recommend. Hello, George.

George (01:10):

Hello. It's a great pleasure to be here with you.

Algy (01:12):

It's a great pleasure to have you here. I've been a huge fan of your work for many years.

George (01:19):

Thank you.

Algy (01:20):

Well, thank you, I should say. I thought a good place to start was just with your interest in transparency and where that came from in terms of your work. It seems to be a common theme which runs through everything really; this ability just to provide transparency on what's actually going on in companies.

George (01:46):

Yes. For me, that idea is an extremely important one. I like to take people back on the journey that we have traveled over the last hundred years. So if you think about it, the world that we have created, the economic system that we have created, and the society that we have created, a hundred years ago we didn't even have some basic financial reporting and control systems in markets. So if you wanted to get information about the profitability, the sales of a company and so forth, you would be getting very little information, if any information. So things that we take for granted right now were just not there a hundred years ago and a few decades ago in most markets actually around the world. Over time, what we decided as a society is that in order to have accountability over the management of financial resources inside that organization, it would be a good idea to create transparency and to have consistent comparable accounting standards. Then all the mechanisms around the production of accounting numbers, such as, for example, auditing of those, analysis of those and so forth in order to create an accountability structure that then what are the effects of that? Well, it can lead to better resource allocation, decisions, and management of those resources.

If you take that paradigm and apply to what is happening right now in terms of sustainability, you can ask the question, "What are those resources that then we're interested in to understand the efficient and effective management of those?" I think the world has changed and now more and more of the competitors of organizations depend on the management of human capital, intellectual capital, social capital, natural capital, and so forth. So I think we're asking the same basic question which is, "How can we create an accountability structure and a governance structure around the proper management of those resources?" And what I always say is that without transparency, you're not going to get there. It's not a sufficient mechanism, but it's a necessary mechanism for us to be able to get to that accountability structure.

Algy (04:15):

It's the kind of first step on the journey, but vital to get on that journey. I'm going to say you've been at this a long time, but actually it's probably only just over a decade you've really been devoting yourself to this. In terms getting that message across and getting people to understand that idea that there are things which just aren't being measured which are really important to investment, and ESG can do that, or non-financial metrics can do that or play a role in it. How has that evolved from not being listened to early on to suddenly the huge interests that we saw kind of from around 2019, I guess? That's what it felt like to me.

George (05:07):

I think there is a very interesting reframing perspective that I think has happened and it's happening and will continue happening. So I think if you say-- And I have been saying that for a very long time, Algy. Which is if you actually say to a lot of people, "Should you care about ESG issues and sustainability issues and so forth?" Some people might say yes, some people might say no because they have their own interpretation of what that means. So I think you need to make it to people very, very specific. I will give you a very simple example of that. How much money firms are spending on actually hiring, retaining, and growing human capital inside the organizations? Then when you ask that question and you say, "How much actually do we know about how effective that process actually is other than getting one financial statement item in the income statement which says how much money you have spent on this?" But then when you look at it you say, "Well, actually there are organizations--" When you're actually observing what's happening inside organizations-- “There are organizations that are spending an enormous amount of resources to actually screen and hire the right type of people inside organizations. They spend an enormous amount of resources that are spending to actually grow people internally and promote people internally inside the organization.” 

Now, there are other organizations that are following a very different model and a very different strategy which is they primarily hire externally, especially for more senior positions. As a result, they're much less likely to internally promote people. Now, these are two different models. This is a fundamental aspect of what I would say ESG under the S which is the development of human capital inside organizations. It has tremendous implications we're finding in our research in terms of the future financial performance of organizations because it relates to the ability to be productive inside organizations, to be innovative inside organizations, and the cost structure of inside organizations. But when you put it in this context where you say, "Actually, how do you create value? How do you drive performance? How do you get the necessary talent side organization and how the organizations have different models that have fundamental implications for how much you are paying for the talent? It has fundamental implications for employee turnover, for ability to create a strong culture and alignment inside organizations and drive productivity innovation." That is actually something super important. You can actually ask the question, "Do we have the data to do this analysis?" Again, the answer goes back and says, "No, most organizations actually don't provide."

So for example, what we have been doing, we have been using big data and machine learning and artificial intelligence to construct very large data sets that allows us to understand the internal promotion versus external hiring patterns across thousands of organizations. Now, I can apply the same exact topic to, for example, decarbonization. Do you actually know apart from the high level statement of two organizations saying, "We'll get to net zero?" Okay, that is a good intention and a very aspirational intention. But do you have actually good information about how effective and productive those organizations are at actually navigating that journey? How much is coming from energy efficiency? How much is coming from energy substitution? How much is coming from circularity? How much all of those things are costing and which ones are actually leading to product innovation that might lead to revenue growth by greening your products, for example, and green product innovation?

The answer, I guess, is that we have very little information about this. So we are in the early stages of understanding those things. But I think when you're actually reframing them around how they're actually affecting risk and growth inside organizations, and future revenues, and costs inside organizations which goes to the idea of how those issues are becoming financially material and how those issues are likely to have different strategic relevance across different industries, geographic context, and firm specific strategies, then people are actually starting to develop an analytical model of how those issues are actually relevant for the competitive organizations.

Algy (09:56):

It is fascinating because there's just so much we don't see from the accounts. Investors understanding of capital seems to be developing massively with this realization that so much is intangible. Also, which goes hand in hand with the fact that tangible assets don't have the same relevance anymore, I guess. I suppose just in terms of them talking about materiality, I think one is fair to describe it is a kind of landmark piece of research which you were responsible for two colleagues. Look to that issue in, I think 2016, on the materiality of ESG and just that question of, "If people are doing the stuff that matters, does it matter to their share price and does it matter to their performance in the business?" This sounds from what you're saying you are doing now, that idea seems to be in a real genesis in terms of your work.

George (11:05):

Yeah. This is an important idea for several reasons. The first one is that organizations cannot do everything. I always like to say that because it's that much that you can actually do inside organizations. You cannot spread your organization very thin trying to actually satisfy everybody. So what we say is that the classic old return on management is a very, very important idea which is you really need to actually allocate management attention to the most critical issues that the organization is facing. So for example, if you are a mining firm, you really need to pay attention on health and safety inside the mines and community relations around the mines that are fundamentally giving you the ability and the license to operate. So as a result, for example, if you're running a gold mine, waste issues that are huge actually around mines are also very, very critical.

If you are actually running a pharmaceutical firm, for example, access to health and access to innovation and how you are thinking about access issues are becoming very, very important. If you are running basically very high carbon emitting industrial and manufacturing processes and so forth, those issues are becoming very, very important with increasing basically carbon regulation, awareness in society, customers demanding lower carbon products to satisfy their own aspirations to lower the carbon footprint and so forth. So there is actually a systematic process through which you can go and say, "Hey, what is it really that is likely to matter here and why?" I think that is also an important question. Is it that regulations are changing and the environment as a result is changing? For example, you can look at it and you can say, "Okay, I'm running or I'm investing in a steel or a cement manufacturer and now there might be an EU carbon border adjustment mechanism." What are the implications for that because of that change in regulation? Or you might have actually export, for example, to the United States and now you have the inflation reduction act for battery manufacturing or for ingredients that go into batteries. Well, obviously that is actually changing the competitiveness of your product. So regulatory changes is one of them.

The other one is legal changes that might be happening. Increasing litigation, for example, in the context of climate change and carbon. That is another mechanism. Of course, changes in the competitive environment and new entrants that might be competing in the industry. So if you are actually, for example, Volkswagen or if you are General Motors and now you're competing in China with BYD and Nio and you're competing globally with Tesla and so forth, that is actually changing the competitive landscape for you and of course changes in buyer's requirements. So if you're actually a supplier in large consumer goods companies or in large retailers such as Walmart or Tesco and Sainsbury and so forth, well, actually you need to comply with your buyer's requirements. So that is actually becoming a core competitive issue. So it goes back to really trying to understand how the world around us is changing because of changes in regulatory mechanism in terms of product markets, labor markets, capital markets, and so forth. Then tighten that back and saying, "How is the organization likely to respond? And critically from that perspective how the organization can develop new processes in order to be able to innovate?" I think that is also an important point because many times we tend to view the world in a static way and we say, "Oh, I will try to do that but it's so expensive."

I like to say that the best organizations view the world in a dynamic perspective, meaning that what is costly today might not be costly tomorrow. And you're observing that, for example, in many markets around the world. So for example, we have brought the cost of batteries very, very significantly down. So everybody that 10 years ago would have said, "Look, I wish I could develop, for example, electromobility but the batteries are just so high.” Then you had different organizations that had a very different attitude to that. They saw that actually as an opportunity. Instead of saying, "The battery cost is so high, I just can't develop that," they said something very different which was, “Actually because the battery cost is high, I will bring it down and because I can bring it down, I will wait."

Algy (16:13):

There's a story which I think you have right on the front of your book “Profit and Purpose” actually, which is about-- I think it's Daimler; an executive from Daimler kind of essentially mocking Tesla. I thought that story captured so well some of the things you were touching on there. One is that static thinking which I think is the outsider, is investors. That's one of those things investors fight against because things are as they are until they're not. But also, it strapped me as kind of telling a story about the way we understand risk and idiosyncratic risk which is a lot of what you are talking about. It's just very hard to actually imagine a world where certain changes have happened.

George (17:04):

Yes. It's human nature I would call it. So it's almost like it's hard for us to imagine things before they happen, and then once they happen, we cannot imagine in the world that those didn't exist. You think about it, it's this kind of conundrum that we face as humans where actually, if I would tell you that we would have a world where we wouldn't even have basic financial information for organizations around the world, you would say, "George, this is impossible. This just cannot happen." I can tell you that before, for example, the Securities Exchange Act in 1933 and 34 and so forth, people actually pushed back against that idea that we would have accounting standards and financial reporting. They said, “This is never going to happen because every organization is very unique. You cannot do that and so forth.” So it's this weird thing that we cannot imagine the world before we experience it in most cases. But once we experience it, we cannot imagine the world without it. The same thing, a classic example of that is also the iPhone. Before the iPhone came actually, so much in the telecommunication space, so much thinking was about how you will just be putting basically a phone right next to your ear. And once they came up with this giant screen on the phone, people were confused. They were like, "Why would I want the giant screen to be next to my ear?" Obviously, the innovators at Apple said, "You're actually missing the point."

Algy (19:01):

Yeah. Then we all got the point.

George (19:03):

Exactly.

Algy (19:06):

I suppose in terms of what you are saying, I was just wondering how much-- This year, obviously there's been a lot of backlash, if that's the right words to describe it, against ESG as an idea. I was wondering how much of that is kind of to do with people not really understanding the scope of it and also just seeing things as they are at the moment where the old price has gone up a lot and a lot of those stocks have performed very well, and suddenly that's smart and ESG is dumb. Also, maybe the perception is that ESG has been marketed as having a moral high ground which perhaps is not quite how it should be thought of in terms of it's beyond risk and opportunity.

George (19:58):

It's a really good question and I think it deserves almost a decomposition to the various themes. The reason why I'm saying that is because there are different layers here that need to be analyzed. The first one is that sometimes it's because there is a misperception about what ESG is as a management concept, as a governance concept, as an investment concept in business. And ESG, at least in my mind, was never meant that it would save the world. There are several people that think that, "Oh, this is a mechanism or it has been advertised as a mechanism. That it will save the world. That it will solve basically poverty and inequality and climate change and waters, cars, and so forth." And it cannot do that. It wasn't meant to do that. It is a framework through which organizations are trying to measure, analyze, drive performance, and communicate key performance indicators that are actually relevant for them. Why? Again, because of going back to what we're saying about how the world is changing, and that's it. So I think there is sometimes a misalignment of expectations compared to the people that see it as a save the world type of tool which is not what this is.

I think the second one has to do with the fact that because ESG has become more important in how organizations are being managed and governed, it has started having more real implications. It starts to have more [meat]. A couple of years ago we published a paper where we looked at the stock market reaction to the passage of the non-financial reporting directive in the EU. One of the things that we found was this very interesting result that in the announcement of the regulation, the stock prices of companies that tended to have both good disclosure and good underlying performance or key performance indicators on ESG issues, in general, they show a small stock price increase in short term, and the organization that had poor disclosure and relatively poor expectations of bad performance on those key performance indicators, they show a negative stock price reaction on those.

The reason why I'm mentioning that is because for me, that paper is a perfect illustration of the point that not every organization will win from this as ESG is becoming more important. There are going to be some organizations that will experience an increase in their competitiveness and some organizations that will experience a decrease in their competitiveness. You would expect that naturally as these issues are becoming more important, the organizations that will see that as the threat to their identity, to their competitiveness and so forth, they will push back. So there is a natural pushback that is happening because of the underlying competitiveness that is happening there.

I think the third reason why it is normal to expect that is because basically sometimes it's misapplied as a concept what it is. And as a result, because there are bad or suboptimal applications of it, people are experiencing not the intended outcomes that they had expected either in terms of the impact that it might be generating or because it actually doesn't create value, it doesn't reduce risk, it doesn't open up new opportunities for innovation and so forth. So people are looking back and they say, "Oh, as a result, it didn't deliver on its promise." I always like to say that because there is a big difference and a big distinction between strategy development versus strategy implementation. I always say that. Every organization now that I know of has an ESG plan. But that doesn't mean that the plan is a good plan or that the plan is going to be implemented the right way. I think it's in that step of implementation where you observe many organizations actually failing. They cannot get the type of cultural transformation that is needed to really drive performance. They cannot get the incentives to be aligned. They cannot credibly communicate what they're doing.

As a result, all kinds of bad outcomes are happening which is happening also in any strategy that they're trying to implement. Not all mergers and acquisitions work. A lot of R&D that organizations is doing is failing. A lot of capital expenditures are going to zero. There are a lot of things that are successes and a lot of things that are failures. I think when you're decomposing ESG to the types of things that you are trying to drive basically; decarbonization versus human capital related issues versus product safety related issues versus supply chain related issues, you would naturally expect to see some successes but also some failures. And really, that's what I'm trying to emphasize in the book as well; that it is not all good and great. It's actually a lot, especially for organizations that are trying to do ambitious things with their products and services, there is a lot of failure and a lot of experimentation as well.

Algy (26:16):

Yeah. In your book you make that point, you really kind of drive that home that this isn't a magic wand. I'd like to come back to that actually. Also, just in terms of when you were talking about competitiveness because one of the things which I-- I love numbers. I've just got a natural affinity for anything you can quantify.

George (26:43):

Me too. Anything that makes [ ]

Algy (26:45):

I can tell from your work, obviously. It is the impact way to the accounts that I wanted to talk about because you talked about the underlying competitiveness of businesses seen through this prism of what are the real risks and real rewards. The impact way to the accounts try to put the external benefits companies have and also the kind of free ride, the external costs that they enjoy back into the accounts.

George (27:21):

We started this project about three years ago and we incubated it as a research project here at Harvard Business School in collaboration with many external partners because we were trying to understand how we can actually think about a holistic performance measurement and evaluation system inside organizations that doesn't only reflect right now, the financial performance of the organization in terms of the profit that is generated based on a transaction based system of double entry bookkeeping of resources going in and going out inside the organization and so forth. But actually reflecting and asking the question that if both the positive but also the negative impacts that organizations are having, if they were quantified and they were valued, what would that performance of the organization look like? For me, that journey of measuring impact and valuing impact that then can be reflected in pounds and in dollars and in yen and in euros and so forth, is a fascinating journey.

For me, it has revealed several key insights. The first one is how different actually your evaluation system might look like when you're measuring inputs versus when you're measuring outcomes. And because in the impact way the account system we're actually concentrating on measuring outcomes, meaning not the intentions and the targets and the efforts that you're pursuing, but what are the actual impacts and outcomes that you're achieving? We're getting at a very, very different assessment of which organizations are leading and which organizations are lagging. And because in the ESG space we have been measuring to a large extent what I would call inputs, meaning policies and principles and disclosures and targets and investments that we make and so forth, and much less the outcomes and the impacts that we're achieving, then you actually find that sometimes what we celebrate as leaders might not be actually leaders in terms of outcomes. Some other organizations that are really actually delivering much better impacts and much better outcomes wouldn't necessarily be the ones that you would find them being the most highly ranked in ESG evaluation systems. I think that is a very, very important distinction.

The second one is that I think for me, sitting here at Harvard Business School, I have always been trying to think about ways that you can actually engage with business managers and leaders in business in a way that they can associate with that and they can actually start getting their arms around some of those issues. Always a challenge has been that if you tell a leader, "Hey, you're consuming 300,000 cubic meters of water or you're having basically 0.002 carbon intensity or like a hundred times of that. Or if you say lost time injury rate of 005 and all of those things, it's just hard to grapple with." So the question is how can we actually translate things in a way that it is easier to actually embed in business planning? Because if you want people to actually make improvements in a real way, you need to actually translate and create a management system that allows for people to understand what are the consequences of action and what are the consequences of inaction? And as a result for us being able to say, "What would it mean if you had a hundred dollars or a $50 carbon tax or carbon border adjustment mechanism in your business, and how much of that would be your profit? How might your profit look like in a carbon adjusted earnings per share system or in a safety adjusted carbon per share system? Or if you're a consumer’s good company, in a shelf and wellbeing adjusted earnings per share system."

That actually translates very, very interesting insights. When you actually look at some organizations and you say, "25% of your EBITDA might be wiped out by this." But there are other organizations that are having tremendous positive impacts, actually. One of the things that also illustrated that whole analysis was how big is the difference between the strategies that different organizations are having? For example, when we analyze consumer goods companies and we said, "Okay, if we take the six basic ingredients that are affecting human life basically from a health perspective when you're consuming those products, such as, for example, fat that you might be consuming but also whole grains and so forth. There is tremendous difference actually across consumer good companies in terms of how much sugar they're selling versus how much whole grains they're selling.”

Those are having vastly different consequences on people in terms of cardiovascular disease, diabetes, obesity, and so forth. So when you're asking that question and you're saying-- Well, actually, again, going back and saying, "How is that important to me?" Well, if consumer preferences are changing, how the different organizations might be coping with this? If regulations might change, were they're actually forcing you to make those impacts more visible in your product labeling? Or if you might have a soda tax, for example, as it has been introduced in multiple jurisdictions around the world and so forth, how is that going to actually affect you? So for us, that whole journey has illustrated the value of measuring outcomes, the value of translating those outcomes into something that can be compared with existing financial measures that managers understand, and then the idea that it really actually illustrates the fact that within industries, there are very significant differences in the strategies that different organizations have adopted.

Algy (34:24):

Also, in terms of talking about consequences and the measures like the adjusted EPS and things like that. How much of that is something that an investor could use as a real basis for investing or is it more just to show actually what these companies are doing and less of a practical tool?

George (34:49):

This is my expectation that actually five to 10 years from now, this is what actually investors interested in applying some type of ESG analysis are going to be doing. They're actually going to be using a research and data infrastructure that looks into outcomes, that looks into the value of outcomes, and then is actually modeling the internalization process of those outcomes into basically growth, risk, future revenues, and costs. Because it is a more, I would say, robust and systematic process and scientific process of actually looking at what the actual outcomes are and asking what is actually really important and what is less important from the perspective of what's the value of those outcomes. So I expect that this will happen moving forward. The reason why I'm giving a timeframe is because it is a very challenging process. It is not easy. There are elements of that analysis that are easier to be done such as, for example, in our environmental impact pillar. I would say that it is easier to be done. It doesn't mean that it's easy, but it's much easier to be done relative to, for example, assessing product level of impact which is like the impacts that you're having on the actual customer and the consumer and so forth.

The reason for that is because those product impacts tend to be highly idiosyncratic. That's why in the impact way that accounts as well, we worked on a very industry specific pillar because you can ask the question. You can say, “How is a credit card, for example, affecting the consumers?” Well, it's fundamentally different than a car or a box of cereals as you can imagine. So these are very, very different dimensions that you're evaluating and you're constructing impact pathways and evaluation of those relative to something that is broadly standardizable and applicable, such as, for example, the measurement of nitrous oxide and sulfur oxide and water scarcity and carbon emissions and so forth that, of course, will differ dramatically across industries in terms of the magnitude. But the measurement of that KPI is exactly the same measurement of the KPI and then the valuation of it depends on the parameters that you might use.

Algy (37:25):

I suppose I kind of think of this and it sounds slightly like ESG 2.0 thing in a way. I was wondering if it did achieve that-- come into the consciousness of investors like that. Do you think it's possible that it could become a basis of regulation? When I was doing economics way back in school the externalities were one of those big things which people talked about but never thought to quantify really. Does it potentially have quite wide societal implications?

George (38:06):

I would think so that in the future as the state of those measurements improve over time, we might see actually more and more standardization and the development of specific guidelines and methodologies and even potentially disclosure regulations around what those might be. And again, I think different measurements have different attributes and they have different levels of difficulty. So I wouldn't be surprised if the first application of this will be something around the environmental domain where the state of the measurement is not perfect by any means, but it's certainly more advanced relative to other states of development. As a result you could actually do those types of calculations where somebody would say, "Well, if you would apply a certain price on carbon and a certain price on nitrous oxide and several other particulate matters and so forth, how would your profit looks like if you were actually doing that?” Much like many companies already do when they apply some type of shadow cost on the price of carbon in order to guide some of their capital budgeting process. I think it's a similar idea and we see that idea that is increasingly being used as a management tool, as a governance tool, and I think it can also be used as a transparency tool for everybody to have a common view of the underlying outcomes and how material those might be in different organizations.

Algy (39:58):

Yeah, I think it's absolutely fascinating. I suppose if we can kind of circle back. Another thing that I really wanted to talk to you about is your view on purpose. So your book is called,
Purpose and Profit.” One of the things you kind of set out how you can have an ESG policy rolling out through an organization which creates purpose, but purpose meaning a kind of innovative culture which kind of actually is responsive and dynamic unlike the German car maker who said, "Yeah. Well, electric cars, whatever." I thought it was a really interesting argument.

George (40:44):

It actually sounds funny right now when you actually say that sentence.

Algy (40:52):

Yeah. So if you could just explain this idea that actually this idea of purpose is very central to all these things you've been researching for so long.

George (41:10):

It's a central idea in my mind. The reason why I'm saying that is because I have been observing over the years more and more of my own students actually asking the question, "How can I actually find meaning in my work? How can I actually contribute and have impact from a personal perspective? Then how can I match that in a job role in an organization that is empowering me to do that, where I have actually the agency, the align incentives and the clarity about how I can contribute? That purpose can be very idiosyncratic. So your purpose might be very different than mine and my aspirations and so forth. I always like to say that it doesn't need to be that we all care about solving a really big problem and so forth.

It might mean that, “Hey, you're really passionate about building artificial intelligence mechanism that actually provides better information to consumers when they actually go to the grocery store, whatever that might be.” You're saying, "I would like to make that more broadly accessible, easier to use, less costly." Or somebody else might be super excited about going to an entertainment and media company and producing shows that really delight customers and produce happiness; the ephemeral happiness that we all live. But I think what that purpose does which is critically important is it actually allows you to drive alignment inside the organization, a shared set of beliefs about the organization that are likely to make employees more productive and potentially more innovative if that increases the level of trust inside organization. As a result, sharing information, collaborating inside organization, the reason why that is important in the context of some of the ESG related topics, and in general, some of the big challenges that the world is facing, for example, the sustainable development goal and so forth, is because many of those strategies; business models and so forth, are not easy to execute. They actually require very high levels of commitment from their organization.

As a result, it's much more likely that we will build many climate solutions organizations around the world if those organizations and those solutions are going to be led by purpose-driven organizations where employees are more committed to it. They work very hard, they really want to solve that problem, and as a result they exhibit higher levels of productivity, higher levels of innovation and so forth because it's not easy to be done. So that's where, for me, this idea of purpose connects to some of the big challenges that the world is facing, that they tend to be codified in some of the dimensions of the ESG and why those two pieces are connecting to each other. We wrote a piece for the American Economic Association several years ago around corporate purpose and climate change where we made that point that because it's actually a hard problem to solve, you need purpose-driven organizations that are more likely to take the kinds of risk, experimentation, and introduce disruptive innovations, but also to exhibit the higher levels of productivity innovation that are able to bring some of those solutions to the market and commercialize those solutions and make them broadly applicable.

Algy (45:25):

I think it's a great message actually. Also, last month we spoke to, Dan Ariely who's behavioral psychologist. Your views on purpose kind of tallied so much with what he has found from the field of psychology and he is now working on to translate into a way of understanding companies. Yeah, the human capital is-- especially in terms of the hierarchy of intangibles, really key I suppose is maybe a message we can take from it.

George (46:03):

Yes. Very, very, very important.

Algy (46:06):

But George, it's been an absolute pleasure to have you on and thanks so much for sparing the time to talk.

George (46:13):

Thank you very much for having me. It was a great pleasure to connect and have this conversation.

Algy (46:18)

Thank you.

Net Zero thinking, investments and fiduciary duty

My friend Tom Gosling makes arguments for challenges that the GFANZ and other NZ (NetZero) alliances (particularly) financial ones face.

On the limits of GFANZ, @GoslingTj argues for the limitations of GFANZ and the problems of committing to a 1.5c world when the world is committing to (median scenario) of 2.7c. There is still much use in the planning tho. tom-gosling.com/blog/one-cheer…

His overall point that corporates can not attempt NZ by themselves without governments, policy and other supporting actors is well made and I think understood by those at the frontier. He makes other points about the compromises and difficulties of a world where the median policy scenario is looking at 2c to 3c heating (2.6c or so at latest assessment I’ve seen, but with error bounds etc.) but companies are being asked to support a 1.5 to 2c scenario.

Tom argues that for many investor mandates this would be incompatible with fiduciary duty. This is the legal concept - with variation between countries - that an investor has to act as “prudent person” would and this is typically interpreted to mean to maximise risk adjusted financial returns depending on the mandate.  Tom’s argument is that investing for eg. a 1.5c world would harm risk adjusted financial returns and not be “prudent” given the policy scenario.

To this particular argument, I believe the legal answer is “it depends” or as lawyer might say, it depends on “fact and degree” (not legal advice yadda yadda) . Certainly, (not investment advice yadda yadda) I could construct an equity portfolio that is plausibly in-line with a 1.5c to 2c scenario and that plausibly will make better or at least as good risk adjusted returns as the benchmark on a 7 year or longer horizon. 

And, in fact, the equity portfolios I manage are aligned with the Paris agreement, and I believe will produce better risk adjusted returns than their benchmarks. There are two observations and a caveat that I will make. First, the caveat. I am very of the “fair share” carbon budget analysis that determines temperature alignment at a company level. I judge there is limited \ no science basis for the estimates that go into fair share analysis. They are social-political judgements. This is less of an issue at a country or sector level, but a big problem at a company level. This was hit home to me listening to Prof Simon Dietz at the LSE, Climate Transition \ Grantham | TPI team. So when you see you a rating organization claim company X is aligned to eg. 3.2c this number has so many dubious assumptions behind it to be borderline fictional.  [The challenge is that you need to assign a company its “fair share” of the global carbon budget for a 2c world (at 66% probability)]

My first observation of why such portfolios are possible to manage in line with fiduciary duty is relatively simple maths. If the world is on track for 2.6c, (66% chance) then some companies and sectors are approximately heading to a 3.6c world and  some are heading to a 1.6c world (given ALL the massive uncertainties I briefly highlighted some of, above). It seems entirely plausible that you can construct high returning portfolios from those below average companies.

My second observation is you can plausibly see this from bottom up calculations. There are 1000 over companies with Science Based Target approvals (there is a large separate debate on how robust the SBT process is, but it is plausibly as good as other processes) and you have a good number of companies such as Microsoft which have produced good financial returns and are plausibly aligned with a NZ world.

Still, while NZ and fiduciary duty in my view is compatible. It certainly is possible to break it. Hence the answer, it depends. But, for instance, 30 to 35% of Americans do not believe in man made climate change, and many investor mandates will want asset managers to ignore climate in the way they ignore (at first order at least) poverty, pandemic risk, nuclear risk, pollution and many other negative systems risk. This does not address the complexity of systems thinking, universal ownership or a possible  systems view of fiduciary duty. But, it is certainly possible to break this in a mandate. A catholic mandate may be broken by investing in a prophylactic maker, a global mandate is broken by not investing globally. These may seem almost trivial except that it does show that the “customer” or end investor wishes in this case are primary.

Also, broad index funds eg representing the 2,000 largest companies in the world. Those type of funds are likely not aligned to a 1.5c - 2c world currently (they are likely to be aligned to board where the world is heading if govts make good on their commitments), and their mandates may well not be suited for a NZ commitment. 

In any event, Tom’s blog makes several noteworthy points for climate and Net Zero thinkers to ponder, even if the legal nuances of fiduciary duty, in my view (not legal advice, yadda yadda) simply depends on the actual circumstances. Subscribe now

David Wallace-Wells raises the challenge of the fact that the median science now points to a 2c to 3c world and not a 4c+ world. 

Five years ago, scientists talked about 'business as usual' warming between four and five degrees celsius. Now they talk about two to three. What does that jagged new world look like? A tour of life at 2C. (1/x)

The New World: Envisioning Life After Climate Change. Scientists increasingly agree on how much warming the planet will experience. This is what it might look like.

That this is progress, but that damage will still arise. Some activists advocate for representing a more alarmist world in order to garner more action. Others believe sticking closest to the median science is more truthful.  This is not only a challenge for climate but crosses into pandemics and other areas.

Is it better to be Straussian or “on the nose” ? (Do you even know what I mean by that?) My moderately held belief is that truthful is mostly better, but there are definite counter examples.  (It is possible that Utilitarian thinker Peter Singer is purposefully not advocating views he holds because he believes this will produce more utility, consequentialist second order thinking for those who might follow such things)

Noted libertarian leaning, conservative leaning thinker, Bret Stephens has an essay on changing his mind on climate. He now views it as definitely a problem, and one that “markets should solve.”

“A trip there changed my mind about climate change while reinforcing my belief that markets, not government, provide the cure.”

Opinion | Where My Climate Doubts Began to Melt. A trip to Greenland changed my mind about climate change but reinforced my belief that markets, not government, provide the cure.

But a careful reading of even just this opinion piece shows that these are not quite “free markets” as such, or at least as interpreted by the 1000+ comments on the article. They are markets that are created, incentivised (or not) by government and NGO actors. This is where a reading of Jacob Soll and his history of free market ideas I think is useful. See my previous blog here.

“Most of this innovation will be driven by free-market capitalism, with important incentives from government and NGOs.” (quoted in the essay).

Stephans argues:

1) Engagement with critics is vital.

2) Separate facts from predictions and predictions from policy.

3) Don’t allow climate to become a mainly left-of-center concern.

4) Be honest about the nature of the challenge.

5) Be humble about the nature of the solutions.

6) Begin solving problems our great-grandchildren will face.

7) Stop viewing economic growth as a problem.

8) Get serious about the environmental trade-offs that come with clean energy.

9) A problem for the future is, by its very nature, a moral one. A conservative movement that claims to care about what we owe the future has the twin responsibility of setting an example for its children and at the same time preparing for that future.

I would say the above sums up a possible centre-right manifesto on climate.

I think, perhaps, the simplified debates over “free markets” vs state control are unhelpful in the abstract. In the abstract, society typically at the nation-state level (but it can be at higher or lower levels at times) decides through a political process where the state should have skill\capacity (with classical liberals and conservatives cautious about the states ability to act, and (what we now view) as left leaning liberals and social democrats more optimistic about government’s ability), and then the state though policy, incentives and regulation develops markets or systems to meet society’s chosen needs usually [today] with a welfare security element (smaller for conservatives, and larger for others).

But the details really matter, most libertarians still advocate for defence, police, justice, basic science research and some other areas all to be done at the government level but they disagree even amongst themselves as to how much regulation there should be on finance or the environment. 

Re: environment, two ideas potentially compatible with classical liberals or libertarians would be a carbon tax\price (with neutral redistribution) and relaxed permitting for new energy infrastructure eg wind farms and solar panels. 

I currently view the permitting challenge as one of the main shadow battle ground taking place across most developed nations. Certainly in the UK where permitting ends up will set the medium term direction of much more than perhaps the average person realises.

Permitting for new energy infrastructure should also be a cause for leftist supply-side policy people (eg.Ezra Klein in the US). Let’s see where that develops.

The left view is - more easily understood - for more government actions possibly across all of regulations/standards, innovation direction and infrastructure and less reliance on mobilisation from the private sector.

Some thinkers here, go so far as to argue that company pronouncements on eg NetZero are a dangerous placebo that is slowing government action.

I circle back to Jacob Soll and examining the economic history work of Mark Koyama (also see previous podcast). Many solutions have been a blend of government or nonprofit actors in market formations although within this you have examples across the spectrum.