ESG is Dead, Be True and Fair Instead

ESG is dead. It failed because it didn’t serve a purpose. It was both insignificant and unworkable. In its extrinsic, single materiality form, as promoted by IFRS, it was no more than another investment risk factor. In its intrinsic, double materiality form, as advocated by the EU, it was another cost centre and form of regulation. It was neither designed to save the world nor promote growth, investment and prosperity. It should not therefore be missed.   

But do not take this as a sign that all is well without it. All is not well and will not be. It is manifestly getting worse. “Crises are increasing in frequency and growing in intensity. Their frequency and intensity will continue to increase until we solve the problem” (Colin Mayer (2024)). The problem is that there has been too much emphasis on risk, regulation and costs, and not enough on value creation and profit, and the commercial opportunity that comes from solving problems.

Profit is the fuel that lies at the heart of capitalism and the incentive that drives business. Profit comes from the Latin proficere and profectus, to advance and progress. That is precisely from where a profit should come, from advancement and progress. But too often it is also associated with disadvantage and regress.

As currently measured, a profit is simply the difference between the revenue of a business and its input costs – its labour, material and capital costs. However, that does not account for the costs of paying its employees below a living wage, suppliers below a fair-trade price, or the pollution, biodiversity loss and global warming a company causes. In other words, it does not account for avoiding or cleaning up the mess that a company creates.

A company’s measured costs are not therefore its true costs, and its measured profits are not its fair profits. Indeed, whenever the directors of a company sign off their accounts as being “true and fair”, they are doing no such thing. They are neither true nor fair. They are not true because they do not reflect their true costs, and they are not fair because they are therefore not reporting a fair profit. 

They must do both and there is one party that has a particular duty to ensure they do – their owners, their shareholders. Shareholders have many rights, but they have one overriding responsibility – to ensure they profit without harm. We are justifiably outraged when companies profit at the expense of others, as they did in the financial crisis. Profit without harm is a fundamental requirement of every business in the world and a basic right of all citizens and parts of the world. 

This is not just a moral precept but a necessary requirement for the functioning of economies. As Adam Smith noted in the Wealth of Nations, without it, markets and competition fail because good firms that incur their true costs and earn a fair profit cannot compete against those that do not. Far from encouraging runs to the top, competition creates runs to the bottom – a Gresham Law of bad firms driving out the good. 

Profit without harm is both a necessary and sufficient condition for markets to function and competition to promote social wellbeing. It is the duty of directors of corporations to ensure that they report their true costs and fair profits without harm. It is the role of shareholders to ensure that they earn nothing else. 

Corporate law should determine that corporate success derives from profit without harm. Banking and securities laws should ensure investors and investment institutions do not profit unfairly at the expense of others. Corporate auditing, reporting and governance standards should establish that companies accounts and reports are true and fair, and stewardship codes that investors’ profits are earned without harm. Together they will provide a uniform standard of performance for all businesses everywhere.

But much more significant than just avoidance of the negative is the contribution this makes to the positive - value creation. It is the source of the innovation, imagination and inspiration that allow profits to be earned without harm. Instead of risk-taking coming at the expense of other stakeholders as at present, it is solely borne by those who should bear it, namely the shareholders. Shareholders become the true residual claimants of a firm.

This is not a stakeholder proposition. Directors’ duties of loyalty remain solely to their shareholders but in the context of a recognition that the “success” and “interests” of the corporation derive from profiting without harm, in other words from value creation not value diversion or transfer from others. It is this that associates innovation and investment with advancement and progress, not disadvantage or regress. 

By aligning shareholders with other stakeholders’ interests, all parties, including governments, are encouraged to innovate and invest. Trust is created where mistrust prevails, and stakeholders are confident about investing in companies where at present they fear being exploited and expropriated. In particular, the interests of government in social wellbeing are aligned with those of business in profits without harm. 

As a result, firms are assisted by their stakeholders and governments in internalizing and capitalizing benefits conferred on others that currently remain external and unrewarded.  Mutually reinforcing interests promote partnerships between businesses, investors, governments, customers, employees, suppliers and communities in committing to a common purpose of shared prosperity.

There are two reasons why this shift from costly regulation and reporting to financial value creation from problem solving appeals to both businesses and investors. Firstly, it is about the core of what a business does, its strategy, namely problem solving, and, secondly, it is the core of financial investment, namely financial value creation.

For companies that recognize their purpose to be profitable problem solving, not creation, new problems and crises are new opportunities. They find innovative ways of solving problems profitably. In the process, they create new problems, which in turn they solve profitably, which then create further problems, and so businesses and the world progress and advance. 

This changes the focus of companies from wading in the weeds of exploitation, expropriation and unjust enrichment at the expense of others, to surfing the waves of innovation, imagination and inspiration of earning fair profits from shared prosperity.

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By Colin Mayer (Oxford University and ECGI)

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