I find ESG concerns in the world of investing to be interesting, not least because they force stakeholders to ask some rather candid and introspective questions of themselves around the type of work that is being done and what sort of role they should play in the larger scheme of things. Ultimately, if you reduce these questions down to their underlying assumptions, you’ll find that there’re rooted in rather hypocritical views: A lot of ESG-related concerns will boil down to people asking you to be a better person than they manage to be themselves.

The types of ESG topics that see interest from investors and their clients often relate to issues around global warming, the impact of globalisation on developing countries, pollution, and other phenomena that are best described as externalities of economic activity. That is, they are issues that arise because of the economic activity of stakeholders and that would need internalisation for a humanitarian and economically positive outcome to result.

With regard to externalities the main question that often needs to be asked is whose responsibility it is, really, to ensure that the externalities are accounted for and rectified. Within the ESG framework, a lot of these questions are often funnelled to companies and their management teams, after the responsibility for these have been abdicated by investors and their clients (and their clients) through an industry-wide process of passing the blame. I find this unconscionable.

Let’s consider an issue like the negative externalities of something like the fast-fashion industry. Not only does fast fashion contribute to environmental issues like waste and pollution, but there are labour-related issues to take into consideration as well. This is because fast fashion is—and has to be—cheap. This allows the companies offering the fashion to sell to a large customer-base, enjoying many of the benefits of scale and large addressable markets that investors think they enjoy so much. However, the low cost of these near-disposable fast-fashion items comes at the cost of poor working conditions for the people involved in the items’ manufacture. 

Clothing requires dexterity to manufacture, making this task hard to automate and requiring an army of human hands. High wages in developed countries and the unwillingness of customers in the same countries to shoulder the higher costs have pushed fashion brands to move more of their manufacturing abroad. (This is the case also for companies that otherwise historically have prioritised local production to allow for faster turnaround times to afford leaner inventories.) In other words, the use of low-cost labour in the manufacture of fast fashion is an externality of globalisation: If low-cost labour is available and transportation costs won’t eat away at these, it makes economical sense to move manufacturing abroad, especially when customers prioritise low prices at the expense of local craftmanship. 

The markets that offer low-cost labour for manufacturing are however less well-developed socially, and workers typically suffer lower protections and greater exploitations in these markets in addition to the low pay that they typically earn. While it can be argued that this is a temporary symptom of early stages of economic development (working conditions in the industrialising West were typically not particularly rosy either), there is another argument to be made that people in the West have a humanitarian responsibility not to exploit people unnecessarily or to expect anyone—poor or not—to suffer on their behalf. (This latter point should really not have to be made; it should be obvious that anyone following classical liberal principles should strive to better the lot of their fellow humans and that international companies can have a very important role to play here.)

However, bettering other people’s lots quickly becomes complicated in practice. For companies in the fast-fashion industry, even if they might choose to pay their workers more than the average local wage, to so better their lots, this might cause local issues by artificially inflating wages (which would be economically unproductive or destabilising). In addition, the companies will also have to balance these labour and production costs with the proportion of such costs that they can pass onto their customers. 

This is where ESG-related concerns become interesting, because the end-customers are often very unwilling to shoulder the increased costs. Instead, these customers will vote with their feet and patronise brands and retailers that can offer lower prices (often at the expense of the condition of their frontline manufacturing workers and their own profit margins). This demonstrates that the customers are an important part of the ESG equation. Investors are too, however, in their strong emphasis on companies growing their margins and to so offer improved shareholder returns. Altogether, this leaves the companies themselves somewhere in-between a rock and a hard place: By passing on the costs of their labour-related externalities onto their customers they run the risk of declining sales, but by internalising these costs, they run the risk of alienating investors. 

This makes for one of the most interesting dilemmas of ESG concerns in the investment context: How can an emphasis on ESG-related issues be balanced with investor and company return requirements? While I don’t have a good answer to this question myself, it should really be one of the main questions being asked in the space to allow stakeholders to scale their expectations accordingly. 

Another question that is interesting to ask in this context is whose responsibility the solutions to these issues actually are? As discussed above, a lot of the labour-related issues that come from the fast-fashion industry have their root in the economic reality of globalisation. The strategy pursued by agents in economic systems are typically optimised for specific environments, which are themselves the result of various positive and negative incentives. Ultimately, these incentives are set by the expectations of customers, investors, and governments, and when it comes to issues caused by globalisation, I wonder if governments shouldn’t have a larger role to play here by creating better incentives that force customers to internalise the human costs of their consumption by setting things like minimum prices on one hand and minimum wages on the other, thus creating the incentives for a higher pass-through rate of customer cash to worker pockets. This is an interesting discussion that I think should be had.

Ultimately, these issues have grown out of the inconsistencies and conflict of customer demands and their actual behaviour. On the one hand, fast-fashion customers want low-cost clothing (which they’ve shown by supporting a large industry focussed on satisfying this demand and by prioritising low cost over local manufacturing). On the other hand, these same customers however ask of their retailers to offer more sustainable alternatives—somehow expecting the price to stay the same even as the cost will increase for the manufacturer. In other words, the customers want to have their cake and eat it too. Of course, this creates an opportunity for manufacturers that are able to satisfy both of these demands in the form of low-cost garments that are manufactured to a high humanitarian standard. This is however a very hard balance to strike, and I can think of only a handful of players able to walk this very narrow line (most of which still offer product at a higher-than-average price-point). 

Another set of issues however grow out of investors projecting their own—only partially overlapping—demand onto the companies in their never-ending hunt for yield. (Even as this, of course, is fuelled by their clients’ demands for higher and higher yield to help fund their own liabilities and obligations.) While this is understandable, it makes any investor’s emphasis on ESG-related issues a bit hypocritical. I don’t think it’s fair for investors to project these issues onto the companies they invest in, asking them to do the right thing and to pay their workers more while at the same time hungering for yield. In this context, investors are the same as the customers themselves; they want to have their cake and to eat it too. The companies themselves are stuck in the middle of these concerns, with very little firepower to actually do anything about these very conflicting demands. 

For this reason, my instinct is to side with the companies. While I am aware that there are many companies that are poorly run and that have chosen to do the wrong thing, I oftentimes think this is just one way for them to optimise their strategy according to the incentives that they’re operating under (where better incentives would lead to better behaviours across the board). This however makes the companies doing the right thing—and doing so successfully—all the more impressive as they’ve found a way to thrive under quite complicated conditions. Such companies deserve a lot of respect, not least from investors. 

This is where I find the emphasis on ESG-style investing to be very misplaced, because it creates additional incentives for companies that I’m not sure is going to be helpful or productive as it incentivises investors to ask companies of the impossible. Again, this is a version of shareholder activism, where investors are projecting their own failures onto companies and asking them to do right because the investors themselves have failed. This is wrong, as any conversation around ESG-type investing or similar concerns needs to form around an appreciation of the reality of the demands being made. For example, the only investors who could—in good faith—expect the best of companies are the ones who have chosen to internalise the cost of their own wishes by communicating to their clients that ESG-style investing comes at a price, which is the risk of a lower return.

I don’t think this attitude is common in the investment community, as you can see in the widening valuation skew between CAPEX-heavy and CAPEX-light industries and the resultant investor interest. While CAPEX-heavy industries like heavy manufacturing actively invest in their local economies and often create products with a tangible economic value, this comes at the cost of lower free cash flows and thus investor returns. Conversely, CAPEX-light businesses like software companies skim value away from global economies because of the zero-sum products they create and because of their scalable business models, this also leads to strong free cash flows and high investor returns. Given these two choices, rational investors will of course choose to invest in the higher-yielding alternative, but it needs to be recognised that this comes with negative economic externalities in the form of growing local income inequality and stunted domestic economic growth. 

What is cheeky is for such high-grossing investors to first pocket the returns from their low-CAPEX investments (on behalf of their clients) and then to turn around and ask the companies to better themselves by increasing CAPEX (or OPEX to be consistent with the labour-cost example) when they wouldn’t actually invest in such companiesbecause it’s not consistent with their investment mandate and client demands. Instead, any ESG investor worth the name would need to communicate this trade-off with their clients clearly, and to be willing to stand by and see their clients (who often are the ones pushing for ESG-type investing) to turn around and find an investor offering better returns. An ‘ESG’ investor is therefore not worth the name if—when you press them on the topic—they confess that “lower-grossing companies don’t have a place in their portfolios”. This I suspect, is however the attitude taken by the vast majority of investment professionals since ‘ESG’ is really—at the end of the day—just a marketing term. 

Altogether, this however shows that what’s really needed to get to the bottom of these issues is the recognition that if ESG investing was easy, everybody would already be doing it. But it’s not easy, and I think all stakeholders need to wake up to this fact. Good ESG investing requires honest expectations from clients, just like companies doing good requires honest understanding from their customers. While good and clear communication (from companies and governments alike) is needed to increase the recognition of this low-cost-high-wages dilemma, ultimately, it’s people like you and me who need to internalise the costs of our expectations: If we want to see a better world where companies are actively doing good and where investors reward companies for doing so, we need to be willing to pay extra for that luxury. There are no free lunches. Rather, everything comes at a price and before you ask for something, you need to look yourself in the mirror and ask if you’re willing to pay that price before you’re asking anyone else to pay it on your behalf.