Can traditional financial theory survive ESG?

Old economic models may still have their place in sustainable business if we can accept their very real limitations

The modern business world is built on financial modelling. Excel, more than Word or PowerPoint, has turned out to be the killer Office app for firms, reflecting the dominance of finance and mathematics in economic education (MBAs included). But that financialised business world is now confronting climate and the nest of crises embodied in ESG, and those models are coming under attack.?

“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.” So said Alex Edmans, Professor of Finance and my latest guest on Conversations on Climate. In contrast, he believes that traditional financial theory already has room for ESG, if we can only apply it correctly.?

Professor Edmans makes a strong case, one I’ve been turning over in my mind ever since. So here is my angle on the future of financial economics, its continued strengths, its blind spots, and what role it should play in truly sustainable decision-making.

Getting subjective

One of the issues where Professor Edmans and I agree is the importance of embracing subjectivity. ESG and attempts to corral it into reliable financial data has come under attack for being vague, inconsistent, and normative. In many ways, trying to fold in ethical judgements around social welfare, ecological concerns and good behaviour is a quant’s nightmare. To win this argument, we should simply cede the point. Not everything is amenable to measurement and standardisation but that doesn’t make it a second-class concern.

For one thing, we already have plenty of useful data on climate and other ecological crises it’s just from the natural science rather than finance. In other words, we have a pretty good idea of what we need to do: stop emitting carbon; stop destroying habitats; stop polluting water and air. And we don’t need incredibly precise and accurate ESG metrics to understand how to turn those imperatives into market behaviour: just stop doing those things. We can worry about optimising the last 5% with data after we get the big things right.

It is possible to express these imperatives mathematically, but it’s not necessary. As Alex pointed out, when we lose another species to extinction, the world becomes poorer. That isn’t because of some ‘ecosystem service’ that creature offered human beings, mediated through some price or market. It is simply because other forms of life are valuable in and of themselves. They make the world richer, more beautiful, more mysterious and more magical. That doesn’t need to be understood in numbers, the poetry of nature is its own language and speaks in its own defence. Anyone who has had a deep relationship with an animal or a landscape knows that first-hand.

Theory vs reality

The other thing Professor Edmans has right is that classical financial concepts can find space for ESG concerns. Take net present value as an example. Get your assumptions right, and with an appropriate discount rate (two very big ifs!) we can demonstrate mathematically that firms would be crazy to destroy the planet on which they depend utterly for their very existence. Particularly once you factor in future taxation for externalities, the minus sign can appear pretty quickly.?

The same goes for shareholder theory and social justice. No company would logically impoverish, exploit or denigrate its staff and customers if it could properly price the consequences of these behaviours for its bottom line. Long-term value, properly understood, cares deeply about the state of the planet and wider society. Shareholders are stakeholders too.

This holds for a lot of core economic and financial concepts, from game theory to welfare economics. Take them literally, objectively and fulsomely, and you can fold a lot of the world’s problems within these familiar ideas.

And yet… and yet. We’ve had the benefit of these theories for decades; and as long as they have existed, we have been busily destroying the earth at an ever-accelerating rate. Perhaps NPV, fiduciary duty, competition theory and so on do suggest that we should stop emitting carbon but the world hasn’t been listening. How can we reconcile the logic of economic theory with the indisputable logic of our actual behaviour?

One answer is the subjectivity problem discussed above. But this also needs a further level of analysis, one which makes economists nervous, that is power.

Power in practise

Financial economists know that the world isn’t perfect; they aren’t blind. As Edmans pointed out, Friedman was clear that markets didn’t get you all the way there; past a certain point, there are problems and failures that can only be solved by culture and government. The trouble starts when that understanding turns into an easy hand-off, and government becomes a deux ex machina relied upon to resolve the tensions between theory and reality and insulate financial ideas from a necessary reckoning with their impacts.

It's all very well to wave off corporate malfeasance with, ‘and that’s where government comes in.’ But we can’t pretend that government functions ideally in the real world. Let’s face it, democracy is barely living up to its name, and democratic governments are signally failing to repair the most pressing problems we face, such as climate and inequality. In fact, they often enact policies that clearly make things worse, ironically justified using the analyses of financial economics.

What corrupts government is power, and that power is almost always tied to the wealth that financial theory helps create. The oil and gas industry is a clear example. Over 150 years of fantastic profits have been recycled into buying political influence and dictating cultural narratives: Lobbying, advertising, thinktanks, dodgy research and burying good science, coups, corruption, paramilitary tactics and strategic lawsuits…this history is more than can be contained in a concept like regulatory capture. It is raw power. In the case of climate, that power has vociferously undermined policy that would have made it safe for businesses to continue to pursue profit.

Another example which Edmans mentioned is the Juukan Gorge disaster of 2020, when Rio Tinto knowingly destroyed a 46,000-year-old sacred aboriginal site to get access to the iron ore below (and extract the value to its shareholders overseas). That Rio knew full well what the impacts were and did it anyway, is all about power. But this was not an ‘idiosyncratic risk,’ an error of judgement isolated to a single firm, as Edmans suggests. In the words of the Australian government enquiry, it speaks to a ‘systemic’ attitude in the mining industry towards profit-maximisation at the cost of indigenous rights and culture.?

This is possible because of the long cultural imbalance between large corporations and indigenous peoples in Australia, a legacy of colonialism and racism. It also reflects the ability of the industry to shape the law in its favour. The rights of the Puutu Kunti Kurrama and Pinikura people should have been protected by law and enforced by government in the first place. But the heritage system is, “outdated, unfit for purpose and in urgent need of replacement,” concluded the inquiry. Since the Aboriginal Heritage Act was passed in 1972, the Western Australian government has not blocked a single application from a mining company looking to destroy Aboriginal heritage. And yet even after Juukan, the government refused to institute an aboriginal veto; the enquiry could only suggest a voluntary stay on actions at those 1,700 aboriginal sites that Rio Tino still has permission to destroy.?

A dose of humility

Traditional financial theory can cope with many of the demands of ESG. However, this often relies on an abstract ‘government’ or ‘society’ out there, to set and enforce the necessary rules and prices that make corporate profit-seeking safe. In reality, power exists and corrupts, and the profit that financial mathematics holds as the ultimate good becomes self-destructive.

The solution is a dose of humility. Economists need to recognise that their ideas have been taken for a ride, politically, in the last half-century; the result has been to make financial decision-making less safe. NPV doesn’t get us to a stable climate in the absence of a proper carbon tax, and it is the Friedman-inspired neoliberal movement (funded by a lot of oil and gas money, let’s not forget) that has fought against this.??

Let’s hold our hands up and accept the role that quantification and financial theory have played in creating this mess. Let’s embrace subjectivity, as Edmans suggests, and in so doing, stop expecting a few financial equations to do so much heavy lifting in the world. And let’s be conscious of power too.

Treasury departments and corporate boardrooms alike could do with a bit less economics and a bit more of the wisdom offered by other forms of knowledge and other voices. For ESG, the less dominant financial theory becomes, the more beneficial it will be.

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