It is almost 50 years since Milton Friedman declared social responsibility ‘unadulterated socialism’. The primary responsibility of a company board as he saw it was to its shareholders measured purely by return on investment, anything else was not a market mechanism but a political one. This is fine if shareholders judge success based on financial return alone, but what if they now want a non-financial return in the form of social or environmental improvement?
The rise of ESG funds, and growing demand for ESG performance metrics, has moved the goalposts. There are now two types of investment risk where in the past there was just one. The original one remains the risk of failure to deliver a financial return on investment. The newer type of investment risk is the failure to deliver non-financial returns in response to shareholder expectations regarding environmental, social and governance issues, for which there are no universally agreed metrics.
In short there are now two types of investment risk: financial and moral. The new moral risk comes from shareholders demanding non-financial performance in line with ‘social responsibility’. This is not the ‘socialist agenda’ so feared by Friedman fifty years ago, but a growing concern among investors for a performance to be expressed in non-financial terms. This raises the question about what these investors seek if not monetary gain.
History tells us that those who invest for social, moral, ethical or religious reasons want to provoke change. In the 18th century Quakers used financial muscle to protest against slavery. In the 20th century, during the 70’s the anti-war movement pushed for disinvestment in arms suppliers to protest at the Vietnam war, in the 80s’ the target was big pharma for pesticides and food contamination, and in the 90’s it was fashion retailers for labour exploitation. Values based investing seeks to promote behaviour change. However this rarely makes sense financially and change, if achieved, is usually slow to materialise.
The drive for demonstrable ESG behaviours is more than a fashion, it is becoming mainstream and the investment risk is real. Major pension funds are beginning to disinvest from oil, gas and mining corporations because they see that continuing with non ESG investments as a risk not worth taking. Blackrock announced in January and Nest announced recently that climate risk also represents an investment risk. In the long term disclosure liability could become costly under international accountancy regulations.
A major investor is quotes a saying: ‘We see climate risk like the tobacco industry in that, at some point, class action lawsuits and punitive damages will become probable’. It is major investors like pension funds who are demanding social responsibility, not socialist governments as Friedman feared. They are doing this not only to bring about change in corporate behaviour, but also to protect the value of their own investment pot in the long term.
Corporate boards need to understand why the risk of failing to respond to investor sentiment will soon become as critical to their survival as the risk of failing to deliver profit.