Over the last two years, sustainable or ESG (environmental, social, and governance) investment funds have increased tenfold. During that time, the Business Roundtable strongly endorsed “stakeholder” capitalism, rejecting the traditional notion that maximizing shareholder value should be a firm’s exclusive focus. Today, managements and boards are pressured to do whatever it takes to score higher on ESG metrics. Proponents (including the rapidly growing ESG investment funds) say that giving ever more attention to ESG initiatives rings true to the firm’s purpose in society.
In the old days, management relied on a finance principle as a guidepost to fulfilling the firm’s purpose. Fund those investments that are expected to at least earn the cost of capital and create value while avoiding investments that will likely be value dissipating. The logic is sound. However, is there an element of truth that, in the past, this way of looking at the world (heavily tied to accounting numbers) shortchanged non-shareholder stakeholders? Yes.
But a firm is a highly complex system and a major change, such as the acceleration in ESG metrics as management guideposts, warrants careful deliberation.
The Purpose of the Firm
A useful beginning point is to view the firm as a holistic system and, as system thinkers recommend, first gain absolute clarity about the purpose of the system (the firm). A strong case can be made that the firm has a four-part purpose.
First, communicate a vision that inspires and motivates employees to work for a firm that is committed to behaving ethically and making the world a better place. Second, survive and prosper through continual gains in efficiency and sustained innovation. Nothing works long term if the firm fails to earn at least the cost of capital. Third, work continuously to sustain win-win relationships with all of the firm’s stakeholders. Fourth, take care of future generations. Management needs a genuine commitment to the sustainability of the environment, especially designing products and manufacturing processes that minimize waste and pollution.
Stakeholders differ as to the importance they attach to each of the above goals. However, the four-part purpose harmonizes stakeholder interests in an economically sensible way. Maximizing shareholder value is positioned not as the purpose of the firm, but as the result of a firm successfully achieving its purpose.
The long-term histories of firms document management’s degree of success in achieving the four-part purpose. Take Deere & Company, for example, a large firm with a well-recognized brand that by the year 2000, however, had significant problems with culture, innovation, and productivity, and was earning average to below-average profitability.
In an interview after becoming CEO in 2000, Robert Lane remarked: “Over the past 40 years there have only been spurts where we’ve actually even earned our cost of capital.” To assume such poor financial performance could sustain Deere to the mutual benefit of all stakeholders in the future represents pure fiction. Lane’s overhaul of Deere’s culture and manufacturing processes significantly improved profitability and set the firm on a value-creation course continued by Sam Allen who became CEO in 2010. Both CEOs, by deeply understanding the firm’s four-part purpose, successfully transitioned Deere from an Old Economy manufacturer of farm equipment to a New Economy firm, while significantly rewarding its shareholders, and other stakeholders, over the last two decades.
Today, Deere has achieved well-earned success as the innovative leader (vision) in precision agriculture. Deere’s data-intensive products earn solid profits (prospering) by enabling its farmer customers to reduce inputs and increase yields (win-win relationships), while reducing harmful environmental impacts and enabling people to purchase nutritious and affordable food (taking care of future generations).
Deere’s history (along with other successful firms) suggests that instead of analyzing a firm’s ESG performance tied to stand-alone ESG metrics, it is far better to view ESG performance as an integral part of a value-creation process rooted in the firm’s four-part purpose.