Towards A New Theory of ESG Metrics:

The Contribution of the South to ESG Is Essential To Our Sustainable Future.

Dr Samah El-Shahat, Beijing, July 2020

The power of environmental, social and governance (ESG) performance for companies operations, and its potential trajectory to effect real measurable change in the world, depends on the diversity of people, nationalities, and ideas which are shaping the metrics of E, S and G.

The Overlooked Social Component Strikes Back And Forces Rethink of ESG

“E”, for environment, has been easiest to quantify and relate to. The Climate crisis has featured strongly on both the political and media agenda. The environmental movement and the threat of climate change have made it an easier box to tick than “S” & “G”. But trees don’t cry, and rivers don’t scream and, sadly, animals do no talk. These reactions have been left to society deal with. “E”, while particularly important, is also defined in terms of impact on people’s lives and their reaction to changes to it. In short, “E” is largely a derivative of “S” in the way we react to it. And when we talk about the stewardship of our environment, we are really referring to the governance of the governments that run it, the people who need it for their livelihoods and the companies which profit from it. And while great strides have been made in ESG, the exercise remains largely one of box-ticking.

The onset of COVID-19 and the ensuing social upheaval about race have shown that companies really need to home in on what matters and go beyond lip service to ESG, to actual and real measurable change. For this to happen, we need to create the right criteria to directly measure S and G. We need to be able to reward companies which can show that doing well by doing good is a reality and not just a slogan. ESG needs to enter the phase where people are finally at the centre of companies’ goals and where the link between alpha generation and scientifically measured social conduct of a company is established. To generate this “social” alpha from ESG, which we wish to call SociAl-phaTM, we need to have more sophisticated, granular and correct measures and metrics of S, and G. This is good for both shareholders, and stakeholders because only then can ESG truly become more holistic.

The potential for ESG, and stakeholder capitalism in general, to help shape a more sustainable, equitable and fairer future is huge. The reason is simple. ESG is a tool of change in the hands of the gatekeepers of real change in our economic system, those with capital and power. These are the wealthy investors, asset managers, and the titans of business of our capitalist world. It is identifying that they ultimately are the stewards of capitalism. Yet they are both at the roots of its current problem, as well as critical players in the creation of a fairer form of capitalism. The US Business Roundtable more or less accepted its role towards a fairer capitalism when it redefined the purpose of the corporation last summer by renouncing shareholder primacy.

Hence, ESG has the potential of a shakeup of the status quo by the status quo, and herein lies both its strength and its vulnerability.

One source of this vulnerability stems from the paucity of ideas, and metrics, particularly surrounding “S” and “G”. Wealthy investors, their asset managers, companies, and hedge funds can only use metrics that are within the limitations of the intellectual ideas which permeate their socio-economic milieu (class), and that of their advisors and consultants. So, it is important to revisit the source of these ideas and inject them with new much needed economic and scientific credentials and vitality as well as a promotion of methodological expansion. What we do not want to have is an echo chamber where we rehash what we already know, and which has evidently not worked so far.

It is worth remembering Einstein’s definition of insanity, namely doing the same thing over and over and expecting a different result. If we do not undertake this project of renewal, ESG will lose its potential, and inequality and despair will keep eating away at the roots of our already fragile capitalist system. We are not going to get there by having “metrics” that have been mostly designed only by the C-suite, their accounting firms and asset managers. The same people now heralding the zeitgeist of ESG, were the ones who oversaw most of the demise of the social contract in our economy, the weakening of labour vis-à-vis capital, the expanding of massive pay differentials and the resulting soaring inequality. The ones who are rallying for stakeholder capitalism were the ones who engineered and benefited from the cult of “maximising shareholder value” which became the rallying cry of corporate culture and decided on how we position ourselves in the global economy. And which took us deep into the territory of economic and social inequality.

The American enterprise in particular decided to pursue policies of creating value for shareholders to the detriment of the larger economy, productive capabilities, innovation and its workers. How else could we explain the obscene amounts of share buybacks of the last few years and how much did they cost us in productive investments, and well-paid jobs for the middle and working classes? What was good for America Inc. or Wall Street was not necessarily good for America’s Main Street, and definitely not at all beneficial to the working class and the disappearing middle class.

Do not get me wrong, I am all for change, and for people and companies learning from their mistakes. From personal engagement with many investors and asset managers, I see the beginning on an evolution in thinking about sustainability, particularly when their wealthiest clients are demanding that their investments make a difference to the world by making it more sustainable and fair. Growth and evolution, are after all, part of the human journey of life, and I hope equally, as corporations reflect upon the constituents of corporate culture, that this change of heart would also enrich the journey of the moral evolution of the corporation. But, and I underscore this “BUT” quite firmly, we need to bring other voices and other ideas to the table, the voice of workers, of the suppliers, of the grassroots, of the wider community needs to be part of a wider consultative group on ESG. The C-suite and its advisers are predominantly coming from a certain upper class, Western, middle aged and male, particularly in the Anglo-Saxon world. This has brought with it a false sense of achievement which COVID-19 has ruthlessly exposed. There has been too much white noise preventing real change.

So where can they get ideas?

The End of An Era of Asocial Economics

Milton Friedman, in his 1962 book “Capitalism and Freedom” wrote:

“Only a crisis—actual or perceived––produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around".

He later blessed us (please excuse my sense of irony) with the concept of maximising shareholder value, an ideology of how business corporations should allocate the resources under their control. This ideology has singularly shaped a global system which has delivered inequality, insecure employment, stymied productive investment, wrecked livelihoods and lives, and anaemic productivity. It took a pandemic, that of Covid-19, to uncover the importance of the “S” - the social component of the economy. It has brought to the fore the importance of the community, of workers, and of suppliers to a company’s bottom line. It took death to make us appreciate the importance of the social contract.

Mainstream economics, namely neoclassical economics, is often relied upon to be the source of ideas. Maximising shareholder value was one such idea. Yet neoclassical economics displays nothing but contempt for all things social. In fact, current mainstream economics is asocial, ahistorical, and acultural. Some economists, such as Ben Fine for example, have called this “methodological individualism”, namely the detachment of economics from society and history. In short, a situation where social phenomena are often reduced the aggregate behaviour of one maximising individual. However, we all know that the real foundation of society derives from its ability to create a whole which is much richer than the sum of its constituent parts through our social interactions, struggles and cumulative social bonds. All of us would be horrified at the representation of our family, or any for that matter, as an aggregate of one person.

Yet, for the sake of simplicity, political convenience and mathematic rigour, neoclassical economics has sacrificed everything that makes us human.

It has also done this by avoiding another supreme characteristic of all societies, namely the presence of conflict and power relationships. This meant that it opportunistically lost the ability to anticipate dangerous imbalances with disastrous impact on inequality. For example, despite the fact we could track the gradual decline in the power of workers bargaining position, this was not deemed of importance within the purview with which neoclassical economics regards the world. When relations of power are out of balance, we were all set to lose and society was to be the net loser. But what can we possibly expect from a school of thought that reduced a worker to a price?

We should have heeded the lessons of the previous crisis, that of the Great Financial Crisis (GFC) of 2008. It showed us that most Americans were living in debt because their real incomes had been steadily declining for 30 years. The only way to bridge the gap between their income and their outgoings was to massively borrow. After all, how could they afford to live in an economy where the state had retreated from providing such essential services as decent and affordable housing, schooling and healthcare (thanks to another neoclassical idea)? The decline in their real incomes was also reflected in a decline in their bargaining position vis-vis their employers – the corporation. Yet, from 2008 leading up to the current pandemic, “never have corporate profits outgrown employee compensation so clearly and for so long”, according to The Federal Reserve Bank of St Louis, 2018 Covid-19 crisis has shown us that our sophisticated virtual economy, increasingly reliant on rampant zero-hours contract and the gig economy, seemed precarious and vulnerable. Covid-19 has taught us that the most vulnerable members of society, such as the frontline workers, were the heroes of this crisis, and the backbone of our economy that kept us going. They got us food supplies, they cleaned our trash, they cleaned hospitals, and provided lifesaving medicine and care and so much more. They held us up, but our economic system is made to hold them down. The irony of this is truly heart-breaking. How could we not have seen this before, or more aptly put why did we not care to see this before?

Going forward our economics, our metrics for measuring ESG, and the value system which underpins our economy will have to be linked to how we make members of our economy feel about their own worth.

Are they resilient and secure enough in their future to contribute the best of themselves? Ultimately, a wage, a job, is not just about money, but equally about how it makes you feel about your tomorrow and the prospects for your family. Only this way can we truly speak of a caring capitalism, and begin shaping elements of the crucial “S”, the linchpin of our life. If mainstream economists do not “do social” well, I dread to think what they will do with the even more fuzzy concept of “feelings”. But the very possible scenario of the elite calling for a more material ESG might well force the hand of the mainstream economists. They will have no option but to “do social” and this process will start with the corporation, and how they analyse and measure corporation metrics particularly in terms of E, S and G.

The root of the current crisis of capitalism, is largely a crisis of the corporation. As William Lazonick (2015) has shown, the onslaught on the power of workers and the disappearing working class in the US, was due to three structural changes within the corporation which spanned three decades.

1. Rationalisation occurred in the 1980’s, with plants closing, terminating the jobs of high school educated blue collar workers most of them black.

2. Marketisation occurred in the 1990s, the end of career with one company as an employment norm, and ended secure employment for middle-aged white collar workers

3. Globalisation in early 2000s, the movement of employment offshore, which left US labour force independent of their educational backgrounds, vulnerable to displacement.

As you can see the onus is on the corporation for it to be the steward of this stakeholder capitalism. I hate to say it, but in our market economy, its starts and ends with the behaviour of the corporation. It is the domain where a heady mix of inequality, power struggles between workers and owners of capital, learning, innovation, and investment decisions are acted out daily. It is the battlefield upon which we will either win or lose the war for a fairer capitalism.

The New Metrics of a More Caring Ecomomic Model: Measuring Social Better and More Humanely

Klaus Schaub, executive chairman of the World Economic Forum, eloquently stated that stakeholder capitalism is about ensuring the long-term preservation and resilience of the company and embedding a company in society. He is correct in that the company is much more than just a wage provider to its employees. Companies give people employment which in turn gives them social standing, identity, a narrative to their lives and the lives of their families. The corporation helps in the creation of social ties that bind us to one another. When we are adequately paid, the salary, the job, and the relationships they engender provide a social and emotional roadmap on which we can build a future and a hope for a better tomorrow. Put simply, the corporation job contributes to our sense of self-respect. It is not accidental that the same communities which faced rationalisation, marketization and globalisation, are the ones where the opioid crisis is raging, suicides are on the rise (particularly for white men with a high school education or less), and the ones characterised by Angus Deaton and Anne Case as “deaths of despair” (2015, 2019).

As a child born into exile, I know what despair looks like, and feels like. I saw it more times than I care to remember, in my father’s eyes. It is a fear of tomorrow, a loss of hope and cold sense of insecurity that eats away at your very core. It left an indelible mark on me. May be this is why neoclassical economics never truly sat well with me either intellectually or emotionally. It did not take account for the trials and tribulations of injustice, inequality, and vulnerability – the feelings that a majority of us feel. It simply did not recognise such aspects as being pertinent. Sadly, we now know they are very much so. I strongly feel that we should be ashamed of any school of thought that believes that acting only in one’s best interest in the most selfish sense will lead to a better society.

For my PhD, I looked at how relationships of power impacted firm’s learning from their relationships with their suppliers. It was there that I got the bug for measuring metrics which mainstream economics felt were either outside its purview or too “intangible” to measure. I became a heterodox economist. I am a political economist. Not only does my training want me to understand the world in a social and political context, but it also makes me want to change the world. From very early on, I understood the power of metrics. My clients, companies only wanted to change when competing against other companies. It is part of the human competitive spirit.

This is why we must start radically rethinking metrics. We should regard them as the questions we seek to the values and morals we hold, and as a guide to the world of the future we want to inhabit. They are also testaments to requests we make of companies in how we would like them to operate. I passionately believe that more granular families of metrics on S and G will be of great help, in particular to vanguard active investors who want to enact change and see it materialise.

Measuring What Matters to People: Metrics For A Decent Life

Crises allow us to expand our imagination on all fronts, social, economic as well as our moral imagination. The same should go for metrics. Who would have thought that the governments of the most liberal economies such as the UK and USA would actively intervene, and in such an extreme fashion in the economy to ensure the health of their societies? And that industrial policy would no longer be deemed a dirty word. I am sure Milton Friedman is turning in his grave. The state is back.

In as much as the state is back, society is also back in a big way. How the corporation interacts with society through different touchpoints becomes important in how we measure social. We need to innovate, imagine hitherto impossible to measure indicators. The best place to start is always with the stakeholder in question, whether it is a community member impacted by the company, a customer, a supplier or a worker. In as much as companies are willing to engage the customer on their “shopping or product experience”, they should do the same with all the other impacted stakeholders. What is the worker experience? When, during our own work, we asked that question, our metrics changed extraordinary. The correlations we were able to gauge between workers’ new metrics, in terms of job satisfaction, expectations, fulfilments to stock price, were astounding.

Recent research has also underscored such as in the link between ESG and happiness (Welch and Washington, 2020). Here the authors found that the portfolio with high ESG scores and strong employee satisfaction outperformed a portfolio of companies with high Performance and low satisfaction by 5.64 percent.

No More Cookie Cutters. Other Countries, Other Norms: The Case for A More Dynamic Asian ESG

We are also finding that more thinking outside the box in finding innovative ways to measure what we thought were hitherto “intangibles” pays great dividends in countries with vastly different histories, cultures and governance cultures. A good example is China. “S” and G are very different in Asia, and particularly in China. In as much as Klaus Schaub said that the company is embedded in society, in China we have the converse: society, history, culture, power and politics are embedded in the company. The company is a clear reflection of society, and it negotiates its position in this dynamic setting daily – whether the company is a State Owned Company, listed, or a privately held one.

It does not require much imagination to identify that criteria for metrics for “S” and particularly “G” are going to look markedly different from Western ones. There are also major differences in the measurement of what constitutes good governance and the impact this has on the stock price, and in seeking alpha for the investor. This is very important to absorb, particularly as Asian companies will also become key players in a more reformed capitalism with ESG performance at its core.

In fact, Asia has a great deal to enrich the ESG movement. Asia’s more horizontal management structure and cultural norms pay dividends when it comes to new metrics for of S and G in particular, because Asian cultures are much people-centred by their very nature. Social norms and social bonds are still the bulwark of the social contract in Asia. In Asia, the social contract is not political, it is not about how much to the right or to the left is your politics, it is part of the culture. It is part of the DNA that makes this continent. The relationship with “social” is healthier, in that it is less privy to guilt and ideology, and hence more consistent and material to a company’s performance.

Western CEOs have a great deal to learn from their Asian counterparts on how to put flesh on the still rather fuzzy concept of maximising stakeholder value. It is easy to preach the concept, but much harder and complicated to apply because of the inherent need within it to balance the interests and welfare of many actors. It is ultimately about complicated trade-offs that must be made between the interests of different constituents. This is not much mentioned in the zeal with which ESG is being embraced. Balancing the needs of different groups, requires management skill, that our Western counterparts have been extremely poor at due to the vertical nature of their corporate leadership, business model and management structure. Chinese, Japanese, and South Korean CEOs, have to always engage, consult and bring management, lower cadres, and wider stakeholders, along with them, due to the consensus and horizontal style of leadership they espouse.

Hence the need for Asia specific metrics when it comes to ESG. Thus we have found that “G” for governance, requires additional metrics that reflect the norms and values of these cultures. In Asia, for example there is the Keiretsu model of corporate governance in Japan, the chaebol model on South Korea and China’s approach to corporate governance, and this applies to both private companies and State owned enterprises. Despite this, there is very little reflection of this differentiation in how G is measured in the continent, despite the huge relevance this has for the bottom line of the company and for investors seeking alpha.

In relation to China, I often speak with investors who raise the issue of “murky ownership structures” and “dual governance” where the Communist Party pulls the string behind the scenes. This Chinese have done a stellar job in giving us boards that look like ours, but behind closed doors act very differently from ours. This oddly enough might appear at first glance as challenging or even subverting OECD governance principles. Yet, if we were take-off our “echo chamber blinkers”, we might be better positioned to see that our “norms” and “metrics” are not the only possible norms and metrics. Worse, not only are we measuring the wrong things in companies from our own Western cultural milieu, but our metrics are even much further off when measuring the ESG performance (and impact on financial performance) of companies from other cultural backgrounds.

Some investors, though luckily not all, have a tendency of looking at Chinese companies and judging them on how they wish them to be, rather than on what they really are and how they actually function. This is quite dangerous for several reasons. China is where culture, corporate path dependence and society intermesh to an exceedingly high degree and in a very dynamic way. For those seeking to change the world, and for those seeking a more sustainable SociAl-phaTM, China demands new metrics of analysis which are not binary. By binary I mean limitations such that having the Party in the company is either good or bad. This kind of thinking becomes ideological at best, and not rigorous enough for any form of investment at worst. What we need are metrics that helps de-ideologize the Party as a factor within Chinese enterprises, and outside Chinese enterprises. Once you do that, your discussion with Chinese enterprises on S, and G, and the insights you gain are critical.

If ESG is to undergo the evolution, dare I even say a revolution, it is essential to transform it into a tool for reach change and consign its box-ticking past to a confused youth phase, than we have to start with an innovation in metrics. Let us not be shackled by conventional or mainstream thinking. Let our imagination innovate in metrics, and the world of ESG and Social alpha shall become our proverbial oyster.

As Einstein said, imagination is everything, it is a preview of life’s coming attractions I would go further and say it is a preview of world that is fairer, greener, and happier. In short, a kinder world for all of us, and especially for those who fell through the cracks of what took to be accepted wisdom.