Can ESG replace the state? Some dissenting thoughts

Today the state fails to provide many of the social functions it is constitutionally responsible for. How can the asset management industry and corporate South Africa (SA) be most effective in this vacuum?

What should a Board prioritise? Without an adequately functional state, what is even possible? And is an ESG framework with an emphasis on the Social even fit-for-purpose in framing this?

The debate around whether asset managers, and corporates more generally, should explicitly take “social issues” into account in terms of their investment decision-making, is not without its controversy, partly because such a discussion is inextricably tied to the underperformance of the SA state, but also because the conclusions drawn might come across as out-of-touch with the modern zeitgeist.

For what it is worth, I am a strong believer in the need to tackle the challenges facing our society today, and like many South Africans deeply sceptical about the ability of the state in its current guise to do much about it.

However, I am also realistic about what the asset management industry and private sector can do to drive change, and why its incentive structure is not necessarily aligned to resolving many of our pressing social challenges that I believe are linked to state rather than market failure.

In saying this I risk upsetting both those in our industry who maintain the state must simply stay out of our industry and all will be well, as well as those that perhaps naively believe we can fundamentally shift the incentive structure that applies to our industry if we just will it.

For the purposes of this discussion, I think it is useful to distinguish between market failure and state failure and in what way the two fundamentally differ.

The classic textbook example of market failure is a factory polluting the lake that a town relies on for drinking water. To frame this through an ‘S’ lens one could perhaps say child labour is banned because while it may be in the interest of a private company to employ cheap and dextrous labour, it is not in the interest of society to have children out of the education system.

So far so good, perhaps. This is the classic framing of the negative externality problem where a private company is incentivized to over-supply something with a negative externality unless prevented from doing so.

Importantly, this is not because the private company is bad or hasn’t fully integrated ESG into its decision-making, but rather because unless the state regulates it, it remains in its financial interest to persist with the behaviour.

Most private companies, to the extent that they frame their investment decisions through an ESG lens, have tended to see the state (or regulator) enforcing rules that the private sector needs to jump through, to mitigate some of the negative externalities mentioned above.

And asset managers assess these companies in terms of their expected future cash flows, and only in highly unusual circumstances (e.g., mining safety deaths, CEO sexual harassment lawsuits) do ‘S’ issues predominate.

Typically, their focus is on the ‘G’ (e.g., independent boards, alignment of remuneration policies, protection against fraud) and possibly the ‘E’ (e.g., pollution lawsuits, catastrophic climate risk) as impacting on their confidence in the future success of the investment.

Importantly, as long as companies abide by the legislation, the firms remain open for business and respectable for asset management firms to invest in, no matter what a particular interest group may think.

This is not necessarily a bad outcome, after all these asset management firms are almost exclusively focused on delivering investment returns for you!

So, what happens when there is state failure?

Importantly when I refer to state failure, I do not mean the inability of the state to mitigate market failure, although this is a real issue too. State legislation is often poorly framed, subject to unintended consequences beholden to vested interests and it even may be legitimate to question whether it does more harm than good.

Most of the pressure companies find themselves under from public interest groups today is often because of the state’s failure to legislate in response to pressing societal and environmental issues.

Let’s go back to the child labour example. Assume the child is not allowed to work and the public sector school system is broken. State failure here refers to the inability of the state to provide the public good with a positive externality.

Will embedding ‘S’ in the decision-making calculus on the private company make any difference in whether the company funds the kid (and all the other children who can’t get a decent education) through school? And should it? No matter its incentive, the private sector will not be able to supply this good up to the marginal benefit to society because (by definition) society values education more than the individual person receiving it is willing to pay for it.

What does this mean then if we define state failure as the woeful under-provision of public goods with positive externalities? In my view, quite a lot, especially if we consider the private sector response.
It is perhaps worth unpacking this further. Despite government intervention in the lake or underage labour market, with negative externalities, the private sector will still have an incentive to pursue its prior behaviour unless the costs imposed on it are so draconian it shuts down. Even then, it may have the incentive to pivot to a related but less harmful pursuit where government intervention is less onerous.

Most “social issues’ like decent education, citizen safety, and adequate infrastructure are public goods where the benefit of providing it is shared more broadly than the individual who directly benefits from it or would be willing to pay for it. Here the incentive for the private sector works in the opposite direction, and the private sector structurally undersupplies the public good, no matter the legislative pressure which consequently is usually unnecessary or ineffective.

Crucially, with negative externalities the private sector will often still be incentivised to supply the good despite government intervention. The opposite takes place when there are positive externalities. Here maximum allocation rules would simply be ignored, and minimum requirements circumvented as best as possible, as there would be no price incentive to encourage behaviour.

Does this mean all is lost? Not necessarily.

Asset management firms that have traditionally focused solely on investment returns and narrowly defined their financial interest have also started to shift in response to investor pressure. According to Morningstar, for example, independent shareholder resolutions in the US are now more likely to raise social than environmental issues, which collectively for the first time last year outranked governance issues.

In addition, there are asset management firms set up to solve large global problems, and impact firms with a far more localised agenda. In South Africa, neither is always easily accessible to the retail investor, but we are seeing some progress, including improved reporting and transparency.

The voluntary JSE Disclose Guidelines, for example, stress double materiality and highlight areas firms should report on to stakeholders and if adopted provide a consistent framework for investors to assess, as well as global organisations that firms can join that signal their commitment to sustainability, and UN SDGs that firms can commit too.

There are also asset management firms that from the outset were founded with the view that there is no trade-off between impact and return, and firms not explicitly driven by the profit-motive.

However, I don’t think we should overstate this or think the private sector response can possibly be on the scale that society needs. In my view, it is only because the state has provided so little of public goods, that it is on the margin now in the self-interest of many private companies to supply them.

Much of the muddle we have with ESG, and especially with ‘S’, are based on arguments around the obligation of the private sector to provide public goods with positive externalities in sufficient quantity despite them not being incentivised to do so.

I think we are on equally shaky ground where the rules are not legislated, but companies are expected to comply, due to societal pressure from certain interest groups. This debate is arguably most advanced in the United States where there has been a pronounced backlash from certain interest groups to companies embarking on a more progressive agenda.

The backlash is not necessarily a bad thing. It could indeed be argued that the appropriate corporate response is to remain focused on its core business and comply with any prescribed requirements imposed by the state. At best, the corporate might embrace the concept of double materiality where it looks past its narrow financial interest and considers the broader impact its business might have on its wider stakeholders, and where possible limit any adverse consequences.

I have argued here that it is only because the South African state has failed so spectacularly that we are even contemplating the importance of private companies investing in public goods with positive externalities. Given a private company will only supply a public good up to its own marginal benefit, it is not realistic to see it replacing the role of the state, even if the firm’s marketing department implies it could, or the state would allow it.

The failure of the SA state to supply public goods is uncontroversial to all but the most blinkered cadre. It should be equally obvious to all of us that the private sector cannot solve the failure of the state and nor should it be expected to.