Ander McIntyre/Camera Press/Redux
Milton Friedman Versus Kofi Annan
Sorting Through the Value of ESG

andrew siwo is an adjunct assistant professor of public service at the Robert F. Wagner Graduate School of Public Service at NYU where he teaches an ESG investing course and also teaches a similar course at the Jeb E. Brooks School of Public Policy at Cornell University. Siwo has tri-sector ESG expertise (nonprofit, for profit, government). The views expressed here are his own.

Published April 3, 2023


On an unseasonably warm winter day in New York, I used a ride-hailing service to travel to a restaurant for dinner. After a noticeable delay in being matched, I was relieved when the car arrived. The driver lowered his window as he came to a stop. But instead of confirming my identity, he inquired about my destination. He sheepishly pleaded with me to cancel the ride, murmuring that transporting me to my destination was uneconomical for him after accounting for gas, insurance, tolls and other fees.

Sensing my desperation, he agreed to drive me. During the ride, he shared that refusing rides was sometimes necessary, lamenting that some rides were uneconomical. And he pointed out that, in every circumstance, he would earn less on the ride than the ride-hailing company. He also shared his exasperation at being forced to sign an employment-related document preventing him and other drivers from participating in activities that would provide a more desirable working environment as a condition for continued employment.

Of course, I felt terrible for the driver, but outside of tipping him well, I could not do much to rectify our respective circumstances. It was clear that despite the convenience of ride-hailing services, something was broken.

Imperfect Assumptions

This encounter reminded me of the broader issue of how markets work and how they ought to work. The Nobel laureate economist Milton Friedman championed a concept often referred to as “shareholder primacy.” Friedman posited that the sole responsibility of any business is to maximize profits. Corporations that do not maximize profits are thus not meeting their fiduciary responsibilities. Underlying Friedman’s case is the idea that what is good for shareholders was generally good for society — and only when their interests diverge should government intervene.

Friedman presented these ideas for a broader audience in a 1970s New York Times essay. Social responsibility, broadly defined, is outside the responsibility of corporations, he asserted. And in many cases, competition will drive corporations to do the right thing anyway. But his argument was largely based on a “perfect market,” a set of assumptions that tend to be flawed. Friedman also ignored incentives for corporate managers to favor short-term results over long-term returns. Friedman’s views about business organization seem almost naïve.

The issues are relevant to the ride-sharing sector and the travails of our aforementioned driver. It’s certainly true that the rise of ride-sharing providers has meant more innovation and consumer convenience. But it is also true that rapid change has reduced the incomes and wealth of many of the stakeholders in the urban transport business, and exacerbated traffic and imposed other environmental costs.

Where ESG Fits 

ESG (environmental, social, and governance factors) was formally introduced to the wider public early in the century. UN Secretary-General Kofi Annan argued that companies aware of ESG factors could become better corporate citizens by aligning incentives among managers, shareholders and other stakeholders. But we cannot depend on Adam Smith’s invisible hand to get them there.

The corporate community has mixed views on the relevance of ESG factors, in part because of the widespread misunderstanding of the acronym, which has become a catchall for just about anything good or bad. However, the push toward this sort of ranking is not new. The idea of socially responsible investing is credited to the Quakers, who in the 1850s eschewed investments in companies that generated revenue in what they deemed to be objectionable sectors.

And there are certainly instances where cost savings and other benefits rest within ESG factors. Setting one’s printer, for example, to double-sided printing is mostly standard across corporate America. The practice reduces the amount of ink and paper used and thus lowers expenses. And lower expenses generally lead to higher profits.

That Milton Friedman and Kofi Annan shared the same ends and philosophies highlight the inextricable link between shareholder value and ESG factors.
Focusing Capital on the Long Term

But ESG is gaining a foothold even where the narrowly defined interests of corporations don’t fully reflect values to society. The Business Roundtable, the prestigious group of large-company CEOs, includes language in its Principles of Corporate Governance affirming that “corporate purpose does not accurately describe the ways in which we and our fellow CEOs endeavor every day to create value for all our stakeholders, whose long-term interests are inseparable.”

Social factors have increasingly become a focal point across the corporate and investment landscape. And while historically, labor practices have often lacked the same attention given to environmental or governance factors, that is changing. According to FCLT Global, a nonprofit researching corporate best practices, “long-term-oriented investors deliver superior performance and long-term-oriented companies outperform in terms of revenue, earnings and job creation.”

Patagonia, a privately held outdoor clothing and gear retailer known for making the “earth its only shareholder,” opted against becoming a publicly traded company. The founder transferred the firm to a nonprofit trust upon retirement. As a result, Patagonia arguably has much more latitude to address stakeholder concerns than a publicly traded firm. Private companies can shift their focus to longer-term activities void of quarterly earnings pressures that often can emphasize short-term gains for management at the expense of more lucrative long-term rewards.

Steps Boards Can Take to Strengthen Alignment

Corporate governance — the “G” in ESG — tends to be the least controversial category when assessing the strength of a company. Central to strong governance is the make-up of the board of directors, which should be a mostly independent group tasked with ensuring management carries out its duties. In short, management must be overseen by an engaged board that clearly understands company goals, and managers’ incentives must compel the necessary behaviors to achieve company objectives. Boards have several critical areas for engagement.

1. Re-examine management incentives. Fundamental corporate governance practices involve aligning incentives. The operational complexity of multinational corporations heightens so-called “principal-agent“ concerns and can muddy the waters. As such, rewards and consequences must be clear to channel behaviors and ensure accountability.

2. Scrutinize peer-group results and set iterative goals. “Good” or “bad” is hard to measure without benchmarks, and ill-defined benchmarks also tend to be less helpful for spotting areas of strength or weakness. As a result, assessing performance based on the results of a peer group is a useful gauge of performance. For example, the recent collapse of Silicon Valley Bank resulted from the bank having an unusual risk-assessment model compared to its peer banks, which proved to be disastrous when interest rates rose.

3. Balance scoring with judgment when assessing qualitative factors. One limitation of ESG is that it cannot be distilled into an informative quantitative score the way that, say, corporate credit ratings are used to price a bond. So an ESG score of 70 — as opposed to 60 or 80 — is hard to interpret actionably. ESG is thus an input that can inform judgement, but a comprehensive analysis should include a sector-specific assessment. For example, a car manufacturer cannot be usefully compared to an oil and gas company across E, S and G factors.

4. Link corporate action to revenues and expenses. Structurally, the quarterly corporate reporting cycle is not conducive to long-term decisions. Executives leading publicly traded companies rarely have the will and the way to adequately advocate for long-term decision-making in the teeth of expectations of near-term results from shareholders. Establishing appropriate long-term as well as near-term goals allows management to address priorities thoughtfully through proper rewards and consequences.

• • •

“There is another important difference between the debate during Friedman’s time and current ESG strategies,” says Shawn Cole, a professor at Harvard Business School. “In Friedman’s time it was often stakeholders who were not shareholders advocating that companies should behave differently. Now, much of the ESG pressure is coming from company shareholder’s themselves, who want to ensure the companies they own are preparing for risks associated with climate change, and operating in a way consistent with the shareholders’ values,” Cole concludes.

Corporations have often gestured toward understanding the bottom-line benefits of stakeholder awareness — for example, providing healthcare to employees is an acknowledgment that a healthy workforce is a more productive workforce. Government can be an effective intervenor, meshing shareholder and stakeholder goals, though it is not infallible. CEOs advocating for stakeholder capitalism though rewarding behaviors counter to the corporate goals they support will likely receive mixed results.

Friedman’s advocacy of shareholders is not entirely invalid. But it was controversial in the 20th century and still is in the 21st. Kofi Annan’s advocacy of broader stakeholder interests can fall short of a panacea — a company can be a model corporate citizen and still underperform. However, it is unimaginable to conclude that the best decisions can be made with consideration of less information. Some ESG factors will be material to performance and some will not. That Milton Friedman and Kofi Annan shared the same ends and philosophies highlight the inextricable link between shareholder value and ESG factors.

main topic: Finance: Capital Markets
related topics: Governance