Investors are flocking to so-called ESG investing. In the public-equities markets, attention to environmental, social and particularly governance issues seems to have a positive correlation with reduced risks.
The argument is so strong that some asset managers argue that not considering ESG exposes legacy conventional investors to uncompensated risks and may even constitute a breach of fiduciary duty (see, “As assets flow to ESG investing, investors on the sidelines face hidden risks”).
Impact investors looking to drive positive benefits across their portfolios, however, have to ask a tougher question: Does ESG performance actually make any difference in terms of actual social and environmental impact? As ImpactAlpha’s podcast roundtable put it earlier this year, “If ‘ESG investing’ is so great, why is the world going to hell?”
To get at the question, we caught up with George Serafeim, a professor at Harvard Business School, who has emerged as a leading thinker on corporate impact. His course, “Reimagining Capitalism: Business and Big Problems” won an Ideas Worth Teaching award from the Aspen Institute. In an essay he co-authored in Harvard Business Review last year, Serafeim tried to provide a “a road map for corporations to pursue profitable multisector strategies to transform impoverished communities into vibrant, sustainable economies.”
Serafeim will address “Impact at Scale” in his keynote at the Palladium Impact Summit in New York next month. (ImpactAlpha is a media sponsor of the June 25 event; subscribers can get 10% off with the code IMPACTALPHA10.)
Serafeim is a master of three-part frameworks. In our conversation he laid out the three deficits that hinder corporate sustainability efforts, the three stages of corporate organizational maturity around such issues and the three obstacles to corporate transformation.
“In many cases transformational change requires a short-term decline in performance and return on capital because you need to invest in future long-term growth,” Serafeim told ImpactAlpha. “That issue of managing the worse-before-better is a very difficult issue.”
Excerpts of our conversation (edited for clarity and length):
ImpactAlpha: Let’s cut straight to the chase: Are good ESG data actually going to show that the environment, social conditions and governance is actually getting better?
George Serafeim: It’s a great point. If every large consumer goods company has a great deforestation policy, why are the forests still disappearing? This is the conundrum that we are facing: at the end of the day does this accumulate to something that is moving the needle, or are we playing in the margins?
For many well-intentioned impact or sustainability strategies, the reason why they fail is three-fold: an ideation deficit, a financing deficit, and a governance deficit.
The ideation deficit is because most large corporations—in their supply chains, products and so forth—are not thinking boldly enough and in systems-level terms, because that’s not how they are trained to think. They can find point solutions but not systems-level solutions.
For example, when you’re thinking about consumer goods companies and farming practices, the traditional intervention has been “Let’s give a little more money to the farmers and hope for the best.” And this hasn’t worked, because you’re not changing fundamentally the incentives in the system. When you pull back that financing, the equilibrium becomes whatever it was before.
The financing deficit is because many of those companies have fairly high costs of capital in underserved areas. There aren’t that many opportunities to satisfy hurdle rates of 15% and 20%. They haven’t been collaborating with alternative sources of financing that might have lower cost of capital – impact investors who might say, “I could invest and rationalize this with 6% or 7% return on capital.”
We’re having a governance deficit because many of those interventions in those markets have been happening in the absence of good metrics brought together by a balanced scorecard system and a strategy map, where the whole community can agree on how value is being created and shared.
ImpactAlpha: So we have an investor movement to ESG at the same time we have corporate deficits of ideas, financing and governance?
Serafeim: You find that in consumer goods sector, efforts to lift people out of poverty have failed. In the mobility sector, why we cannot actually accelerate cleaner transportation in a faster way—and how we’re failing to recognize the complementarities between electrified mobility, shared mobility and autonomous mobility.
We are failing to make fundamental improvements in health, because in the healthcare sector, we are failing to understand the social determinants of health. We’re trying to fight the outcomes rather than the true roots and causes of the problem, like affordability of housing or workplace conditions or community relationships.
If we don’t take a step back and try to understand some of those fundamental problems, innovations and management practices to bring people together and collaborate will fail to have more positive impact from the company side and, as a result, from the investment side as well, both in the traditional impact investing space—the private markets— and in the ESG and public markets.
ImpactAlpha: Your focus is on large corporations. Many impact investors are interested in startups, or small businesses, or just smaller, younger companies. Why?
Serafeim: Why should we even care what large companies are doing? There are millions of companies out there. Should we try to concentrate on small companies? We should. We should definitely promote, create and finance entrepreneurship and concentrate on private markets.
If you look at the largest 1,000 companies in the world, they would represent much more than 50% of the GDP. That gives you the scale of the challenge in terms of shifting what we have now, which is an economy that optimizes for risk and return, to an impact economy that optimizes for risk, return and impact.
If we don’t shift many of those large companies, we will have a hard time shifting the whole system. You can make arguments like we won’t be able to achieve the Sustainable Development Goals.
In the last 15 years or so, inside large companies, the level of authority driving many sustainability efforts has increased. One of the things that we’ve found is that as you’re moving organizations through levels of maturity, the authority of these people is increasing.
We have classified organizations at three levels of maturity: A compliance stage, which is basically “Let me make sure my company doesn’t do anything completely bad.” Efficiency is concentrating mostly on increasing productivity. And then innovation and growth, where they’re thinking about contribution from a product perspective, and how to create new markets and products that satisfy demands and that have positive impact.
If you asked me 10 years ago, I would say 80% of the companies were in the compliance stage, 19% of the companies were in the efficiency stage and 1%—and I’m being generous—in the innovation stage. That balance has shifted more to 50% in the compliance stage, 40% in efficiency stage and 10% in the innovation and growth stage.
It’s still pretty rare to find companies reimagining their products and services and talking about product impact. Product impact is something that, even the impact investing space, we’re still lagging in terms of thinking about how we can measure and evaluate it and drive it forward.
ImpactAlpha: What are the cultural issues that organizations need to deal with?
Serafeim: As organizations are maturing, they are still lagging in terms of creating the right organizational design to be able to execute that [impact]. You need to follow a non-linear process. To go from compliance to more efficiency, you need to start centralizing those types of activities and create more authority to drive the change management process forward.
But then in order to move to the innovation and growth stage, you need to do exactly the opposite. You need to start decentralizing those activities and empowering the functions within companies to make those decisions, take control and hold them accountable for it.
ImpactAlpha: Which is hard for companies, just like any innovation. How do they actually drive those investments?
Serafeim: Transformational change is difficult in organizations for one of three reasons, or all three reasons: Change is not happening. Even if it is happening, we won’t make any money. And even if it’s happening and we will make money, we just cannot get it done.
The first one is that there is a resistance internally in organizations about the direction of travel. You see that in many organizations, for example in the healthcare space, about what actually drives positive outcomes in terms of patience. In the energy space, with climate change, it’s about whether we should decarbonize the economy.
Then you have the second challenge. In many cases transformational change requires a short-term decline in performance and return on capital because you need to invest in future long-term growth. That issue of managing the worse-before-better is a very difficult issue.
Third is that in many cases organizations are great at building capabilities around their core business, but they’re not great at building capabilities that are far away from their base.
Managing short-term and long-term performance connects to the second one. The idea that somehow markets are so short-term oriented, and that businesses want to be long-term oriented but they’re not, is a myth. It’s not supported by the data. In many cases, it is being used as an excuse. These short-term pressures are self-imposed by organizations themselves in how they have structured their own incentive schemes and in how they’re managing their own career concerns. Executive compensation plans, for example, tend to be short-term oriented. In many companies, it’s less than two years.
A lot of short term pressures are coming from boards, and the board of directors itself is looking for short-term success. That then puts the senior management and executive teams into a hamster wheel around delivering those short-term performance indicators.
ImpactAlpha: What do ‘profitable multisector strategies to transform impoverished communities into vibrant, sustainable economies’ look like?
Serafeim: It always puzzles me when I hear the argument that we will have a hard time driving growth forward [while] you still have a lot of people whose GDP per capita is $1,000 or $3,000. How can this be?
The problem is, institutionally, we haven’t been able to create the right conditions for these people to enter the supply chain, either as employees or suppliers, before they become consumers. We keep seeing disadvantaged populations as potential consumers, and we try to direct products towards them. We forget that if those people don’t enter as suppliers or employees they will never have the financial capacity to become consumers.
This is where we see a tremendous opportunity in creating an ecosystem that works with the business sector, the public sector, NGOs on the ground that can bring some of those capabilities. That’s where we see the value of shrinking those ideation, financing and governance deficits.