Season 2 Episode 8 – Alex Edmans Edited Transcript

Conversations on Climate – Season 2 Episode 8: Alex Edmans – Edited transcript

Section one: Alex’s personal mission

Chris: First off, I’m curious as to what drives you; about your passions and way of framing the conversation. I understand that one of your favourite books is Seven Habits of Highly Effective People. And from that you’ve taken inspiration to develop a personal mission statement. Could you tell us what that personal mission statement is and how it feeds into your work?

Alex: Absolutely. So Seven Habits is a book, which is known to be about time management, but time management with respect to a given set of objectives. One of the principles is, ‘to begin with the end in mind.’ So before coming up with the time management plan, think about what the objective of your life or career is.

It’s like knowing how to get to a destination; we need to know where to go to first. So I define my personal mission statement as, ‘to use rigorous research to influence the practice of business.’ 

There are two aspects to it. First, you do want to make sure that whatever you are stating is based on research. Really important topics like climate change attract a lot of people with very good intentions; given climate change is so important, people do want to contribute to it. But sometimes you might be contributing without some research behind it. This might lead to shooting from the hip rather than saying what’s based in evidence. The second part is to use research for the practice of business. That highlights that the research I want to do is not purely for academic purposes, not just to be published in the top financial and academic journals, but to be attuned towards real world problems. Which is why I very much appreciate interviews like this one. 

Section two: who should we listen to on climate?

Chris: Tying just a couple of those kinds thread together; one is your wish for rigor, and another is your most recent TED Talk entitled, ‘What to Trust in the Post-Truth World.’ So why we should be trusting you today? 

Alex: What do we want to trust to begin with? Normally a TED Talk is a great platform to market your own research, but I wanted to talk about the importance of research in general, because often how people respond to research is whether they like the findings or not, rather than actually whether it’s rigorous.

So rather than just giving a particular talk on a topic where the response to that talk would depend on whether people like the findings, I thought to make a case for research in general. I think for something like climate or sustainability, it is important to make sure that the person has done a lot of work on it for a while. I first started working sustainability in 2006-2007, when I was finishing my PhD at MIT. And why that’s interesting is back then there was not so much of an interest in sustainability or ESG. In fact, my paper on it didn’t mention the phrase ESG even once. I didn’t write that paper in order to satisfy some demand for doing work in ESG; it was just something I cared about and I wanted to research. That also meant that I was not under pressure to find a particular result. Nowadays, if you show that ethical companies perform better, then yes, you are going to be more likely to get coverage than if you showed the opposite result. Back then, because it wasn’t something where there was a strong view, there was no pressure to find something one way or the other. 

That being said, it’s quite nice of you Chris to ask why people should listen to me; but there’s certain things that people should not listen to me about. So in particular for climate science, there are some questions around it which a climate scientist or an engineer might know better than me. Is carbon sequestration going to be effective? I just don’t know. Is it going to be possible to fire pellets into the atmosphere to reflect the sun’s rays? That’s not something that I’m an expert in. I do understand the financial limits of it, but the climate is unfortunately such a big problem that we need a diversity of perspectives. And I understand one of the great things about your series is you are trying to look at people across different areas of business – not just finance, but even beyond business. There’s so many other aspects of knowledge and science that need to be learned from. 

Chris: Absolutely. The series is no solo voice. It’s all an orchestra; lots of people talking about their own individual areas of expertise and trying to put it all together. There is no one solitary answer, and no one person can possibly embody all of the different questions and perspectives.

Could you give us a bit of advice on how we can be trusting better, and what type of frames should be looking at to try and make better decisions in terms of who we trust? 

Alex: I think there are a couple of things that you can look at. Firstly, in terms of something that is a written paper or a study; and second in terms of the authors, the actual people if you are choosing to interview somebody rather than read an academic paper. First in terms of papers and studies, it is to ask: are these published in the top peer reviewed journals? Why is that interesting? In order to be published in something like Science or Nature or the British Medical Journal, or in my field the Journal of Finance, you have to be peer reviewed. What this means is that the editors of a journal – and I was the editor of a journal for six years –asked the leading experts of a field what they think about it to make sure that the actual study is rigorous, that the claims were fully backed up by the analysis which was done. 

There were times when as an author myself, I had to tone down some claims which might have been striking, might have grabbed attention, but they were not fully nailed by the analysis. Now I have to admit that peer review is not perfect. There are some times when papers can get published and then are later found to be overturned. For example, I’m sure many of the listeners would’ve known Amy Cuddy’s TED Talk on ‘power poses’ that was published in an academic journal, but it was later found not to be replicable. This is also why the idea of scientific consensus is useful. It’s often not that one paper will have the last word; it may well be that the body of evidence, where you take lots of papers published in top journals, will form consensus. So the journal that published Cuddy’s initial research were good enough to publish the replications, which actually weren’t supporting it.

So yes, we do want to look at papers published in a top journal, but not just one paper – the body of knowledge. One thing that I try to do is to convey what I believe the scientific community views about sustainability in general. 

Chris: When we were organizing this chat you started a really interesting conversation about people’s positions to be able to talk and educate on important issues like climate. It seems to me that you thought that something as serious as climate change should be left to the experts, and non-experts shouldn’t be deeply engaged in the conversation? 

Alex: Let me clarify. I don’t think that I, or anybody else, should be a gatekeeper who can say, ‘you are allowed to say something, and you are not allowed to say something.’ This is absolutely not to exclude people from conversations, but when people are giving insights, then it’s to make it clear what your expertise is based on. So for me, my expertise is based on finance, but not on climate science. So there are certain things which I don’t think I have expertise in. 

Then if you think about some of the biggest voices in climate right now, you might have say Noam Chomsky, who I greatly respect. He’s a professor at MIT where I did my PhD, but he’s mainly known for his expertise in linguistics. That’s not to say that he can’t say things about climate, because an intelligent person could well read up about climate science and re-tell this intelligently. But it may well be that others who’ve worked on the issue more deeply, and for a while, might be good authorities.

So I recently read Vaclav Smil, who wrote How the World Really Works. There’s somebody who has worked in science for a while and so he understands that there’s trade-offs here. There are certain industries where it’s going to be really difficult to wean ourselves off. What that means is the idea that we can just suddenly stop using energy is going to be unlikely. This is why it might be adaptation, unfortunately, which will be more the focus of efforts than purely mitigation. 

Chris: I just had a conversation with your colleague Rajesh Chandy a couple of weeks back, a really interesting conversation. One of his great sources of hope in the whole climate change discussion was a part of his specialization which is entrepreneurship, particularly entrepreneurship in emerging markets and the developing world.

He expected to see quite significant amounts of change and innovation coming from the Global South, from people who are having to deal with the effects of climate change on a day-to-day basis. But I also understand your need and desire for academic rigor.

How do we include the information and knowledge that’s will come from parts of the world that might not have the same levels of education and access to that type of rigor that you’re talking about? How do you balance rigor versus entrepreneurship in different parts of the world? 

Alex: I don’t see any conflict between those, actually. I don’t think innovation is based on academic research. People innovate because they have great, inspiring ideas. You don’t innovate because you read academic papers. Why I say academic papers should be used is if you want to make statements such as, ‘what is the effect of carbon emissions on the cost of capital.’ That’s a statement where you can do an academic study on it. But I think innovation is a quite separate thing. So I absolutely would think that the Global South has just as much ability to innovate as other peoples.

How do people come up with these great ideas? It’s not through looking at the academic evidence. The academic evidence is instead to say, what is the cause-effect relationship between a couple of variables? But that’s not what innovator does. I think the people who are closest to the problem are probably best placed to come up with these innovations.

Section three: economics vs gut feel

Chris: Tying this discussion into one of your recent papers, ‘Applying Economics – not gut feel – to ESG.’ Can you explain the premise of that paper and what it might suggest for climate change?

Alex: Absolutely. One of the big pressures nowadays is to teach as much ESG and sustainability-related content as possible. The new Financial Times rankings, for example, grade business schools on the percentage of core hours that you use for sustainability teaching. That’s self-reported, and that’s a separate issue. But let’s assume we take the data as given. Why I think that is somewhat problematic is it tries to divorce and pigeonhole sustainability and climate content from mainstream business content.

Mainstream financial principles are always about the long-term to begin with. What does Finance 101 teach you? The present value of an investment is the present value of all future cash flows from now, right into the future. Now maybe when these frameworks were first developed, that might have been to value a car factory, which involves huge upfront investment and long-term payoff. But absolutely it will also apply to renewable energy or other sustainability topics such as investing in a more diverse and inclusive workforce. 

Why I wanted to write that paper is people think we should now just scrap existing business textbooks and do something new, because what we’ve been teaching for the last few decades is just not fit for purpose in 2023. And I have an incentive to argue that, because the textbook Principles of Corporate Finance by Brealey, Myers and Allen, which I’m sure many people learnt from, I’m now a co-author of that in the 14th edition and I have tried to incorporate sustainability content. so I should say I’ve completely rewritten the book, but I haven’t. What I’ve done is I’ve taken the book, many of the existing tried and tested finance principles can be applied and adapted to issues such as climate and sustainability more generally. I think this is important, because the reason the title of the paper is, ‘Applying Economics – not Gut Feel…’ is that people shoot from the hip, and say stuff which sounds good when that might not actually be correct. 

Let’s just give some concrete examples. I know I’ve talked in abstract terms. So the first of them is this concept of shareholder value. So there are concerns that shareholders only care about the short term. And if that’s the case, then we should completely change the way that companies are run. So how can companies run? Directors are elected by investors. Their fiduciary duty is to investors in many countries. But if investors are short term, we don’t want that; let’s instead have workers or somebody else elect the directors. But shareholder value, as I mentioned, is inherently a long-term concept; the shareholder value of a company is the present value of all future cash flows. That is true; not just in theory, it’s true in practice. Why are companies like Tesla valued so highly? It’s because of the long-term prospects. And this is why it’s often investors who are persuading companies to go faster and further on climate and other sustainability issues. So I don’t think there’s so much of a problem with shareholders. Now, there might be particular types of shareholders who are short-termist and there should be things done to address that, but we shouldn’t throw the baby out with the bath water and say let’s completely get rid of shareholders having a say in who the directors are. 

Another issue which often people think about is how sustainability affects the cost of capital. So there are people who argue that traditional approaches to valuing investments, like net present value, are all automatically biased against risky projects like climate change, like renewable energy. Why? Because the risk affects the discount rate. The greater the discount rate, the lower the net present value, the less likely you are to take a particular investment. So let’s not use net present value, let’s just invent some other way to value an investment. 

But finance 101 tells you there’s two different types of risk. There’s idiosyncratic or specific risk, which is unique to a company, and there’s market-wide systematic risk. Developing climate technologies, let’s say carbon capture technology, that is risky. We don’t know whether the technology will work or not, but that is probably not correlated with the rest of the economy. So whether the technology works or not, that’s not going to be linked to whether the economy is in a boom or recession, and that will be linked to many other sustainability issues. For example, if you were to invest in a cancer cure, you might succeed or you might not; but that again, is not correlated with the state of the economy.

On the downside, if you fail to invest in sustainability issues and you have problems like Wells Fargo and fake bank accounts, or Rio Tinto and Juukan Gorge, again those are idiosyncratic factors. They’re not necessarily linked to the stage of the economy. So why is all of this important? If indeed these projects are risky, but the risk is diversifiable and it’s idiosyncratic, it should not affect the cost of capital. So actually, net present value should give a big green light in order to support these projects, because as long as your shareholders are diversified, then they’re not actually worried so much about the risk that this technology does not work. What I try to teach in the textbook, and I try to teach in my LBS classes, is that the correct application of these finance principles is that it should only be systematic risk that goes in the denominator. Therefore, if you are a financial manager or an investor trying to value the company, you should not penalize a project like a carbon capture technology for having idiosyncratic risk that can be diversified away. 

Section four: growing the pie (and taking climate seriously)

Chris: That brings us neatly to your book, Grow the Pie the Financial Times’ Book of the Year, which has been phenomenally successful. Would you tell us about the underlying premise of it?

Alex: Let me explain what the pie is to begin with. Why does a finance professor write a book with pie in the title? The pie is the value that a company creates. We think about the pie being divided between investors in the form of profit, and society in the form of fair taxes, fair wages, and also lower carbon emissions. Anything you can do, it can go to society or investors. And often people have what’s known as a pie-splitting mentality or a fixed-pie mentality. If the pie is fixed, the only way that you can increase the slice to investors is if you reduce the pie that goes to society. So what does this mean? It means that if you want to maximize profits, then pay workers as little as possible; you learn in an economics 101 class during your PhD that you maximize profits by holding the workers down to the outside option. You never pay them more than the outside option. Similarly, you might maximize profits by polluting as much as you can get away with without having a fine and so on. 

What I wanted to highlight in the book was the idea of the pie growing mentality: that the pie is not fixed if you are investing in your stakeholders. Ultimately that will benefit shareholders. So in terms of employees, while investing in them by providing them more pay than you can get away with – and not just pay, but meaningful work skills development, mentorship etc. – they become more motivated and more productive and more likely to stay. Therefore shareholders can be better off in the long term.

The whole idea of win-wins might sound nice and too good to be true. So that’s why the heartbeat of that is evidence suggesting that might be the case. That is the case for employee satisfaction. That was the study I alluded to which I started in 2007. The same principles could also apply to climate. If you are decarbonizing before you need to, because there’s not full government intervention, that does leave you well-placed if there is the hoped-for government response. Then you don’t need to suddenly adapt to it because you already adapted. Your competitors who just waited until the last minute can’t suddenly adapt, and you’re going to be beating them.

The evidence on that is still relatively mixed because we haven’t yet seen the government response. We would like it to be that when there is a carbon tax, then the emitting companies are actually going to be doing worse. But actually right now, the evidence we have so far suggests that if anything companies that emit more carbon deliver higher long-term returns, which I wish it was not true. But that might be because they’re able to get away with the pollution that they’re undertaking, which again, highlights the importance of government action as Stuart Kirk and many others have said. 

Chris: There’s also the historic and deep-rooted advantages that the high-carbon, the old-world companies have; they’ve got more money, they’re better organized and they’re better able to influence governments.

Alex: Why I wanted to write that book is I think for far too long, people have thought about sustainability issues as nice-to-have, as moral and ethical issues just for ESG people within a company; for an ESG specialist within a fund; for an ESG investor. But mainstream, hard-nosed capitalists like a CEO or a Chief Investment Officer shouldn’t care about this.

I wanted to highlight that actually this is not just a moral and ethical issue. This is a business and financial issue. So even if you do not care at all about society, and you only care about maximizing profits, you should take these issues really seriously. If you are a car company, you’d like to move from petrol cars to electric cars. Now most people want to do that because they care about climate change. But even if you don’t care about climate change, this is the economics of the way the world’s working. In many cases, what is good for society is actually good for the company. Not true in all cases – and unfortunately, the lack of a global carbon tax means that with climate, sometimes there is a way of maximizing profits by exploiting society. But on other issues, particularly the employee issues, these are things which are aligned and I wanted to give the business case for sustainability, not just the moral and ethics case.

So morals and ethics are really important, but when the rubber hits the road, it may well be that morals and ethics sometimes are seen as second order compared to the importance of profits, particularly in a downturn where you might need to survive. But what I want to highlight is that there’s actually commercial reasons behind this. It doesn’t matter what your political persuasion is. What really makes me unhappy in the US is this polarization, the idea that it’s something that Republicans should oppose and Democrats should support, but I think everybody should support something which is going to increase the long-term success of a business.

Section five: the end of ESG?

Chris: I’ve been working in and studying ESG for a long time – and I don’t have a clue what it means. There are so many different measures and matrices of ESG, but break down each of the E and S and the G and there’s so many different subsets.

You can have two funds doing fundamentally opposite things, but both call themselves ESG funds. You can understand why there’s confusion. 

Alex; I think the term ESG is really puzzling to begin with. So how did the term come to be? It’s not really clear, because you think the environmental and social sides are to affect wider society, whereas governance is often to improve shareholder value. So often people use the term ESG, but they often just refer to the E and S to begin with. And even within the E and S, there are potentially trade-offs as I discussed. It might be that you’re doing something like shutting down a polluting plant, which is good for the environment, but it might be bad for workers, which is the S. Even within the environmental issues, we think electric cars are going to be a solution to greenhouse gas emissions, but they require lithium batteries and that requires mining. So there are some potential trade-offs there. 

I also think that the other reason why ESG is a dangerous term – which is why one of my recent papers is called ‘The End of ESG’, and suggesting not to use it – is it suggests that it is just a niche thing just for ESG professionals. Whereas I believe that it should be something that all business people take into account. I don’t see these things as being ESG investing – it’s just investing. If you want to take into account the long-term potential of a company, the yes, you look into its factories and its machines and its brand, but you also look at, how is a company treating its workers? What’s its relationship with its customers? Is it actually environmentally sustainable? Because that might be something which even right now will affect customer’s willingness to buy from you, and in the future might affect your profitability if there’s government regulation on these issues. 

So I called it ‘The End of ESG,’ not because I’m an anti-ESG person, but the opposite. I believe that ESG is so important that it should not be seen as a niche issue. That led to the follow up, the ‘Applying ESG Economics – Not Gut Feel,’ paper arguing that actually mainstream finance techniques have always been about trying to maximize long-term value. So it’s a bit artificial to divvy up things into ESG content and not-ESG content. If you do that, some people will pay attention to the latter and close their ears to the former. All of these things are important content, which any business practitioner or business academic should be wary of and mindful of.

Chris: Great. I’d like to go back to an article that you referenced earlier, on ‘The End of ESG.’ There’s a nice quotation there, that ESG is both extremely important and nothing special. Now I found this really interesting because I largely agree, but I think climate, and particular parts or subsets of climate, I find really hard to say that it’s nothing special. Because it’s existential, it’s urgent. I can see the argument with governance and certain other parts of ESG; but in particular, for climate, I find it extremely important. 

Alex: I really appreciate the challenge. When you said you largely agree I thought: great, if you largely agree that means there’s something that you disagree with. And so there’s something that I can learn from in terms of your disagreement.

This article, ‘The End of ESG,’ what might jar about the title with many of the viewers is that I’m an ESG advocate. Why do I call it the end of ESG? This now dovetails with behavioural economics. So Dick Thaler, who won the Nobel Prize, wrote an article a couple of decades ago called ‘The End of Behavioural Finance.’ You might think that’s strange. Why is one of the leading lights in the topic wanting to end it? He said, now I want behavioural finance to be seen as so mainstream that it’s not a separate subfield. To understand the price of a stock, you need to understand cash flows and dividends, but also investors psychology.

It is the same with the end of ESG. I’m saying it’s nothing special because it’s something that everybody should take into account. If it’s seen as special, then it might be seen as something only for ESG investors. But as we’ve talked about throughout this conversation, it’s something that any rational business person should be mindful of.

Now your final topic is that there are certain things which do make it special. Why? Because my last statement was just from the perspective of an investor wanting to maximize value, but for society, ESG is special. Certainly climate is special because it’s existential. I agree with this, but this again goes back to my earliest statements that these are then things which need to be dealt with by governments and wider society.

There are other issues which are special: let’s say illegal narcotics, let’s say murder and crime and so on. And you’re not going to fully be able to rely on companies to address those issues. Because if companies were allowed to set up with cocaine, they would set up because the economics of that situation are there!

Section six: embracing subjectivity

Chris: One of the issues about trying to score well on ESG, is that it’s inherently subjective. If you’re just trying to measure yourself on profits, at least on its face, its objective. You can you can have a number and see whether one number is bigger than the other. But on your ESG metrics, you’ve got issues; what is the most important thing you want to be focusing on and how well are you doing on it? Trying to put numbers on these things is very difficult. How do you deal with that type of issue? 

Alex: I think the most important way to deal with the issue is to recognize and to embrace the subjectivity. So there are people who argue that ESG standards are a panacea. Once we find a unified way to measure everything, then the problem will go away. Because if we can measure ESG, we can call out the winners and call out the losers. But I think ESG is intangible. It’s inherently something which is very difficult to measure.

As an analogy, let’s take us education 20 years ago, where people wanted to have common standards for school performance. It was a pretty similar narrative to what we have now. If we have common measures, there’s going to be accountability for teachers. It’s also going to drive capital allocation; school districts know which schools to fund, just like now investors are saying we can put our money into the more sustainable companies, but only if we know who’s most sustainable. So what did we have? We had standardized tests. And we know the outcome – you taught to the test. You were able to deliver performance on the tested elements but not the broader aspects of teaching, such as critical thinking, a love of learning, ability to respect authority, and so on. Instead, you were able to just repeat fragmented bits of information to be tested. 

I think this will also be the case here for various ESG dimensions. For example, let’s take diversity, equity and inclusion, something I obviously care about being an ethnic minority. Now, you can do well on diversity scores by just hiring ethnic minorities or women or whatever demographic statistic is being measured, just to tick a box. But is that measuring whether you are included and are feeling valued? I don’t think so. I have a work in progress paper where we’re actually looking at true DEI and link it to diversity in a demographic sense, and these are not correlated at all. So yes, you can play to the measures in terms of, ‘we’ve got x percentage of women or minorities,’ but does that mean that you’re going to be inclusive? Not necessarily. 

One counter argument is, okay, maybe you can’t do it for something intangible like diversity, equity, inclusion, but you can do it for some things. Why don’t we do it for things that you can measure – don’t let perfect be the enemy of the good. For example, with climate change, we understand there are carbon emissions, there’s scope one and scope two and scope three. Let’s force all companies to disclose this. And indeed many companies disclose this, but actually there are still issues with the data. So if you think of some of the main data providers, such as Trucost, they actually report not just data directly disclosed by the company, but they also need to estimate the data because not all companies report it. They have to estimate the data by looking at other peers within the same industry of a similar size. There are studies showing that the link between carbon emissions and long-term shareholder returns differs according to whether you use the full sample from Trucost, or you look at only the disclosed emissions and not the estimated ones.

So even the data set that everybody thinks to be the gold standard on carbon emissions is not something which might be fully reliable, because some of it might be estimated. You might think, why don’t we just look at the ones which are purely disclosed by the company? And again, when I talk to people more on the ground level, who know the data gathering better than me, they say that actually a company disclosing its carbon emissions are making a large number of assumptions in doing that. It’s not that they look at every single factory and measure the emissions of every factory. They are sampling a couple of them and trying to make some aggregation. 

It is not profits. With profits, there’s quite an easy way of aggregating it. If you’ve got a company with lots of different divisions, they’re all reporting their profits and you are pretty sure that the overall measure is the sum of its parts. That is not necessarily the same for climate. That’s not to say that we should just ignore it – there is still some accuracy. It may be that you are correct within the range of 50 to 70 [units], but whether it’s 55 or 65, you’re not so clear.

I think we should try to measure what we can, but understand the limitations of that measure. So it’s still fine to look at diversity, just know that might not capture inclusion and equity. Let’s look at something like carbon emissions, but let’s acknowledge that might not capture the truth; even if it’s disclosed by the company, it might not capture the position accurately.

Chris: One interesting way of looking through this whole area is the idea of an augmented net present value. Could you unpack for us?

Alex: There was a sensible logic behind augmented net present value. What I claimed earlier was that NPV takes into account all the future cash flows of a company. We don’t actually need to change NPV. But one of the counter arguments is if there are things like externalities, do we need to take them into account? Because even long-term NPV will only look at the effect on the cash flows of the company. So there are some initiatives to try to quantify the externalities that you are producing, by looking at the externalities that you are creating, converting this into a dollar number and then adding that to the net present value.

For example, there might be certain products and services which extend the value of human life. So it could be drugs, it could be seat belts, it could be education about alcohol -related violence and so on. And there are frameworks which we’ll try to look at such as, ‘what is the number of lives that you will save? And what’s the value of a life?’ But this to me leads to rather uncomfortable conclusions; which is that sadly, the estimates that are used for the value of life depend on the person’s life expectancy and the person’s income. This automatically leads to the global south having a low financial value of life compared to somebody in the US, because you say the value of the life is how much money they can make. That to me is very uncomfortable. Yes, as a professor I understand the value of data. Yes, let’s quantify things when we can. 

This is why earlier I said, let’s try to embrace subjectivity. When things that cannot be valued, then just don’t try to value them. Leave that in non-financial terms. So if Project A saves a hundred lives in the US and Project B saves a thousand lives in the global south, just stop there. Don’t try to convert that into a dollar number to add to your net present value. Now, there are some people who say that unless I can convert everything to one single number, how can I do a comparison? Because it’s not apples to apples. If one project makes more money but saves fewer lives, then do I prefer that to one that makes less money and saves more lives? But throughout life, we always make decisions based on more than one criterion. 

Now, there will obviously be a value judgment there because different people will have different views as to how to trade off the money versus the effect on the environment let’s say, which are not captured in long-term value. But again, throughout life, different people will have different subjective opinions and yet they are still able to make decisions. So I think that should happen. 

How can we guide the subjectivity? What I have in chapter three in the book is a couple of principles. In order to make this not completely arbitrary, I’m not going to go through all three of them, but one of them that I’ll talk about is the idea of comparative advantage. What I mean by this is that there’s loads of problems in the world, but companies don’t have a responsibility to solve every single one of the world’s problems. They should focus on the issues that they have most expertise in solving. 

Section seven: stakeholders, shareholders, and getting Friedman right

Chris: At the hearts of economics is the dynamics and the trade-off between shareholder value and stakeholder value. What is the issue you have with that wording and the phraseology?

Alex: Yeah. So often, like right now, shareholder value is a dirty word. If you want to be accepted in polite society you need to say how much you despise shareholder value and the ideas of Milton Friedman. Why? Because number one, shareholder value is short-termist; and number two, shareholder value is at the expense of stakeholders.

I believe that both of those premises are incorrect. Number one, shareholder value is a long-term concept, as I said right at the start of this conversation. And number two, there’s many elements of shareholder value which are aligned with stakeholder value. How can a company be successful in the long term? It has to treat its work as well. It has to make great products that customers want to buy and also provide after-sales service, have a great reputation for not causing addiction and so forth. Similarly for the environment, if you have a good environmental record, people are more willing to buy from you.

Now, it’s not always the case that shareholder value and stakeholder value are fully aligned. Sometimes there might not be full government intervention. For example, tobacco companies have been successful, even though it’s clear that their product causes addiction. And to your lobbying point, why is it that this has not been regulated out? One might argue that actually they’re overly powerful. The same is true with pollution. There is not a fair carbon tax. So there are some trade-offs and there are cases in which shareholder value and stakeholder value are not fully aligned.

So it’s not always win-wins, but I think that win-wins are much more common than we might think. I think it’s 80% to 90% in terms of alignment. Which is again why I say – and you’ve also asked in your questions – it is just good business sense for a company to think about its long-term consequences and its long-term effects on society, because these are all things which will affect financial sustainability, not just your social contribution. 

Chris: 80-90% of that I do agree with, but I think there are issues with the 10-20%. In a globalized and unequal world, you can find shareholders who are stakeholders, for example, a European oil and gas company. You’ll have a shareholder who is a stakeholder by virtue of their pension, taxes and their wider society. They can play both roles. but you’re going to have other stakeholders in other parts of the world, where the materials are being extracted, the profits are being brought back to the North at a price that’s doesn’t adequately compensate for the pollution and the loss of resources back in the Global South (for example).

I know you accept that there’s 10%-20% where there is a problem, but that is a real problem, isn’t it? 

Alex: Absolutely. And this is why I think it’s important to recognize, as I’ve said throughout this conversation, that we need government intervention. We can’t just leave it for capitalism to sort out itself. There are people who promote this idea of universal ownership theory, which is not any theory I’ve seen formally proven or even formally stated. But the idea is that if there are shareholders who own stakes in every company, they will suddenly solve the problem because they will take some of these externalities into account.

For example, if you own both the energy company and the real estate beachfront company, you will tell the energy company to stop polluting so that the beachfront properties are not going to be flooded. But that just doesn’t make a full sense to me, because what is a universal owner to begin with? Often people look at sovereign wealth funds, but they might be focused on owning just things within that one country. Will they necessarily care about the effect on the Global South? No. And I don’t think there are universal owners who own every single thing in the entire world. 

Also, there are many externalities which don’t have financial consequences. Let’s say that we make a particular species extinct. If that species was not something that we were using for food or for pollination there’s not a financial consequence. But does it make life far less beautiful? Absolutely. The value of the coral reefs: okay, one might say there’s value to that because you can have tourism and that tourism generates money; nut also one of the big principles of economics, going back to applying economics and not gut feel, is consumer surplus. Value to society is far more than the value that you pay in terms of having a holiday to look at the coral reef. So you can’t just look at the amount of financial value in order to look at the value of something for society. Because you have all of these other consequences, the externalities, you can’t just leave it for investors to sort out 

Chris: You mentioned Friedman little earlier on, and his famous (and slightly misquoted) theories that the only requirement of the firm is to be pursuing profits. 

Alex: So he said that the social responsibility of business is to pursue profits, it is to increase its profits. And why that important thing has changed is the social responsibility. He said actually, it’s good for society if a company goes after profits. Because if you go after profits, you’re going after signals of what society cares about. Going back to the early example, why would you make electric cars and not petrol cars? Because the demand for electric cars is higher, reflecting what society wants. 

Section eight: Is pricing in ESG impossible?

Chris: Thank you for that, it’s important. You were referencing Friedman as someone who has been misunderstood, but one of the issues with Friedman at least in my mind, is you need to be able to rationally price things and put a dollar value on externalities and the rest. But since Friedman’s time, there’s been the advent of the whole behavioural economics cycle, where the assumption of rationality isn’t as strong as it was. Can we be leaning into Friedman with his assumptions on being able to rationally price in, in a world of behavioural economics?

Alex: I think so. I think there’s a lot of omissions in Friedman’s work, and most of my book is just to explain why you can’t simply apply Friedman’s principles. But I do think Friedman still gets you quite far. It might get you to 80%, to 90%. I think the final 10% to 20% is still important – that’s why I wrote the book. But on the idea of being unable to price things, I think Friedman does still take that into account when he says the social responsibility of business is to increase its profits while obeying all laws and obeying ethical customs. So if there are things which are not priced, because there are externalities, he says the government should deal with that through taxes. 

Why it is good for the government to deal with it is that the government is democratically elected. If it’s only investors who are deciding which externalities to care about, it may be that you argue for a really rapid decarbonization and you don’t actually care about the loss of jobs for those who are working in the fossil fuel sector, who may be 50 years old and can’t retrain. Why? Because they might not own a lot of stocks. It might be the one-percenters who are represented by capitalism, whereas with the government, they’re democratically elected and everybody has the same one vote. So unpriced externalities should be dealt with by government.

Now should governments are not perfect. Are there things that you can’t fully regulate? This is why he says things like ethical custom. There are customs as to prompt payment of suppliers and so forth. And there are many companies who will do this rather than waiting until the final potential date. 

Chris: Going back to your PhD paper on the value of employees and the value of treating employees well; as you said, you found very strong alpha, very strong value. Then over 10 years later it was repeated and the same type of studies came out. You would’ve thought the market mechanism should say that it should have been priced in; that once the knowledge is there people should be following that. But obviously it hasn’t been. Why is that? And are there any lessons for the types of conversations we’re talking about on ESG and climate?

Alex: The paper I wrote was published in 2011. A more recent paper was published in 2022 I believe, which extends the data to 2020, and finds that in the 10 years since then you can still earn alpha. Which is surprising because you might think that if I found a trading strategy which works by taking companies with high employee satisfaction then that should go away because everybody should have done it and eroded the alpha. So why might this not be the case? Because a lot of the focus on ESG has not so much been on the S, because people don’t know how to measure it. If they were to measure it, they might measure things like the CEO to worker pay ratios, or percentage of diversity in the boardroom, not more intangible issues such as how employees are being treated. So the lesson for investors is that if you want to try to generate alpha – and that’s not the only motive for sustainability, but that’s one motive –let’s try to look at these intangible factors which are beyond just the metrics. 

Then you also asked, what are the implications for climate? I don’t think there are implications. I think this is really important, because often when people find a study on ESG, they extrapolate from it and they say, this proves that ESG works. Now my study does not prove ESG works because my study was purely an employee satisfaction. It does not have immediate implications for climate, which is something quite different. Often people treat ESG as just one big umbrella, and any study which looks at one item under the umbrella, they then extrapolate from that to everything. I’d love to say that my study applies to every single ESG concept, but it doesn’t. It applies particularly to employee satisfaction, so the implications I will draw will only be limited to employee satisfaction. 

Chris: That sort of spells out difficulties that the whole ESG sector has. One of the solutions that was put forward were various ESG rating agencies, but if you have a look at any given company the correlation between one rating another is only 0.3. That’s pretty weak. How do we how do you explain that and how do we get over that? 

Alex: So people look at the low correlation between ESG rating agencies and say this is a bad thing, right? Because if these professional rating agencies, if even they cannot agree on a company’s ESG, then there’s no hope for any investor. How can we invest in sustainable companies when we can’t agree who they are?

But I’d say this is true for anything which is intangible. So if there was a rating agency rating the quality of a company’s management team, there would be disagreement because these are things which are really difficult to look at. Some people might look at certain aspects and focus on them more than others. As we’ve discussed, ESG compliance is a myriad different things. Even if you looked at one specific issue, let’s say female friendliness, how do we measure that? Percentage of women on the board? Percentage of women in the wider workforce? Do we look at gender pay gap? Do you have a working mother, or similar? Even if we agree that we should measure something, we don’t know how to measure it. 

Second, do we even measure something to begin with? Lobbying: is that a bad ESG issue because you are influencing the government as you mentioned earlier, or is lobbying sometimes submitting to government inquiries? That’s fine. When the water regulator wants to have a new calculation for the cost of capital, is it legitimate for water companies to feed into that? Is that lobbying? Some would say it is. Some would say no, that’s fair. You’re providing input into a consultation. 

Number three is even if we agree to measure different things, how do we weight it? Different people will have different viewpoints. And so the irony, why I find it so strange that people don’t like this discrepancy, is another way to look at divergence is the word diversity, which is an ESG issue which many people think of as being positive, right? You get more information from the fact that there might be six or eight different opinions out of there, rather than if everybody had to say exactly the same thing.

Section nine: finding your potential

Chris: Last question. Going back to the second part of your personal mission statement, which was that you want to inspire others: is there any advice you could give to people who are trying to get others to reach their full potential? 

Alex: I think maybe I’d look at it more from the individual perspective, because it’s hard enough yourself coaching somebody because you are expected to know something that other people do, when you suffer from imposter syndrome. I’d suffer even more from imposter syndrome if I had to coach a bunch of students. I wish I had something which would sound profound because this would be ending our conversation, but I don’t really have something profound as much as: follow your passion and do what you truly really are passionate about.

Often people think, let’s strategize about these things. So when you are choosing a career, they think: I want to end up in career Y, so the stepping stone needs to be, I can go from W and X and so on in order to get to that point. But as Steve Jobs said in his Stanford graduation speech, you can’t connect the dots looking forward. You can only connect them looking backwards. 

Those of you who are listening or watching and who are interested in this for an academic career, I have an entire paper called, ‘The Purpose of a Finance Professor,’ about how to find passion in research and teaching and these other activities.

And even though that was something which is specifically for the academic profession, hopefully it’s something that will apply to other professions as well – to do things for intrinsic reasons rather than instrumental reasons. As we said throughout the theme of this talk, if you do something which is good for society, hopefully you will trust that the profits will follow. And I say the same thing is true for your career. If you do things because you enjoy them, and you think it’s having a positive impact, ultimately it would lead to financial success and security later on. 

Chris: Fantastic. That was extremely profound, so thank you. 

Alex: Thank you, I really enjoyed it. 


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