Ronald Harry Coase was a fine English gentleman, an economist interested in real-world wealth creation. Early in his career he noted that, as an entrepreneur, you could buy all the goods and services you need on the market and outsource all of your business. In theory, however, things are easier than in the real world.
As an entrepreneur, you have to search for contractors, bargain with them, make sure they deliver what they promise, make sure they keep your trade secrets secret. All of these transaction costs adds up quickly; and a wise entrepreneur will start a company doing so is cheaper than all of the haggling and enforcing.
When there is one shareholder, she can steer the company as she pleases (within the law, of course). When there are more, they can negotiate and reach decisions. When you have thousands, then it gets tricky. How should you steer a public company, or a company owned by a pension fund with thousands of shareholders?
Coase’s contemporary Milton Friedman, also a professor based in Chicago, said that the only thing a company has to do is “conduct the business in accordance with shareholders’ desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”
In conducting the business operations as the shareholders desire, some of the costs associated with running the business are external to the company and negative to the environment. Factory pollutes the river. The night club is really loud at night. Your software has security bugs. It’s clearly better to have clean river / quiet streets / safe software than not have those things.
Is it best to simply remove the deficiency that gives the negative externality? Mr. Coase would not necessarily agree. According to Coase, you do not start with “Pollution is bad, remove the factory!”, but you start with weighting what you will lose without the factory, and what would you gain. Once you find the optimal policy, the economic theory further states that the party that can fix the problem while incurring the least cost should do that.
It seems reasonable to ask companies stop polluting the rivers. It is also not a huge leap forward to ask companies to also eliminate by-products of making things (reducing waste and use of resources in general). We have made that leap already. The purpose of the company might not be solely shareholder value anymore, but also generating benefit to other stakeholders including employees, customers, and the general public. Fiduciary duties evolve over time, and what was previously value driven management now becomes values driven management, for better or for worse.
While intuitively this broader definition of company purpose feels right, it opens up some questions. Beyond standard legal requirements for technology, health, and safety, how to known which interests to follow? What are we maximizing at all?
Entering the trifecta
It appears that we’re maximizing sustainability, perhaps as opposed to self destruction. Sustainability is usually defined broadly as reducing negative impact on the environment, or not taking anything away from future generations. Notably sustainability is not defined as creating wealth for the future generations. Maybe it’s so self evident that the UN, the EU, and other institutions didn’t bother explicitly writing it down, or maybe I just haven’t come across it.
As we stand now, the proxy for sustainability is the ESG trifecta: Environmental, Social, and Governance considerations. In essence, it is one of the tools to look at risk factors a company might face. If you manage environmental, climate, social, and governance risks well, chances are you have a well functioning company. By thinking about ESG you may avoid future liabilities and losses, and can also make better investment decisions.
While all of that is true, why to single out this in the general risk framework? One explicit reason is to achieve broader goals, and one particular goal is reduction of CO2 emissions. The EU is quite explicit that it wants to check how companies comply with the 1.5 degree Paris Agreement target, which is a bit tricky because it is impossible to achieve. In any case, some companies do go above and beyond the regulations, which is a good thing.
The other broader goal is to make sure that some standards are extended abroad as well: workers’ rights, safety, and other things that cost real money which you can save by outsourcing. It is harder to produce t-shirts in Indonesia if you have a factory full of children workers, and you have to disclose that in your annual review.
The third goal is to direct investment to sectors and firms that are more sustainable. And here we have two problems. First, investments related to ESG are by definition long term and it’s too early to measure the impact, although some people tried. Second, the “inferior” sectors and companies still need investment and can be easily deprived from that, even if they in fact invest billions in green energy.
You get what you measure
EU will come up with a list of items to disclose and measure in the next few years. Some private companies (S&P, Moody’s, Refinitiv, and others) created proprietary indices to track ESG performance. Those indices agree on about half of the 709 things they measure. Each item has its own weight, and the jury is still out on how to say which ones are the most important. This is the complexity you get as you move from shareholder value to stakeholder value.
Many companies will become ESG compliant, at a significant cost. I wonder what Mr. Coase would say about that.