An Interview with Alex Edmans

Q: Can we start by talking about your views on the importance of purpose for companies?

A: While I’m a strong advocate for purpose, it’s important to acknowledge that purpose is not a panacea, nor is it a 180-degree turn from traditional approaches to business. Businesses can both do good, and do well, by focusing exclusively on profits and nothing else. This might seem like sacrilege in 2023, when it’s almost a requirement to bash Milton Friedman to be accepted into polite society. But Friedman’s argument is much more nuanced than it’s often portrayed. He argued that “the social responsibility of business is to increase its profits” because the only way that a company can increase its profits, at least in the long term, is if it serves society. It has to provide customers with high-quality products, or they’ll stop buying; pay its workers fairly and treat them with dignity and respect, or they’ll leave or underperform; and be a responsible steward of the environment, otherwise customers, employees, and investors will walk away. 

Even if a car manufacturer cares only about profit, and doesn’t care at all about climate change, it will still invest in electric cars and thus have a positive impact on society. This is because the economics of electric cars are sufficiently attractive. Thus, as long as you define profit as long-term profit, there’s not too much wrong with companies focusing entirely on profit. Pursuing long-term profit ensures that a company produces what society wants and reduces the resources used in doing so. Indeed, purpose can distract companies from focusing on long-term profit, and thus serving its customers, employees, and other stakeholders. Leading investor Terry Smith famously argued that it was unnecessary for Unilever to define the purpose of mayonnaise, as it is nothing more erudite than being used in salads and sandwiches. 

Similarly, Ben & Jerry’s claim that “ice cream can change the world” is seen by many as PR spin to dupe customers into buying a high-sugar, high-fat product. So why is it that I’m still a strong advocate of purpose? The electric car example is an instrumental motivation. Focusing on long-term profit works for electric cars, because you can calculate — at least roughly — the effect of developing electric cars on your future profits. While the future is uncertain, you can do a sensitivity analysis. But there are many investments that you can’t justify with an instrumental calculation. If a company chooses to give more parental leave to its employees, it’s very difficult to estimate — even roughly — how much more productive it will make its workers, and how much this productivity will increase profits by. There’s not even a midpoint around which to build a sensitivity analysis. That’s the power of purpose. It frees a company to take actions for intrinsic reasons — to build a better world, even if they can’t be justified by a financial spreadsheet. By inspiring a company to create, discover, and explore, it leads to companies being even more innovative and pursuing even greater standards of excellence, thus leading to them becoming more profitable — even though profits weren’t the primary motivation.

Q: In your book Grow the Pie: How Great Companies Deliver Both Purpose and Profit, you argue that companies should aim to create long-term value for all stakeholders. How do you reconcile this with shareholder primacy arguments?

A: I actually don’t argue that companies should aim to create long-term value for all stakeholders. This is an important point. Many companies claim to do this, and policymakers, executives, and even some academics argue that the law should change to force companies to do so. Serving everybody sounds enticing, but it’s unrealistic and a false promise. Most decisions involve trade-offs. Transitioning to clean energy will put workers in the fossil fuel industry out of jobs. Online banking (and the ATM before it) are transformational innovations that provide customers with easy access to finance, but similarly lead to branch closures and job losses. If a company can’t take an action unless it creates value for all stakeholders, this will stifle many innovations.

Grow the Pie argues that a company should be driven by purpose — by the desire to create value for society — for the reasons given in my answer to the last question. But serving society in aggregate doesn’t mean serving every single stakeholder in society. Importantly, the book introduces three principles (the principle of multiplication, the principle of comparative advantage, and the principle of materiality) to provide practical guidance on which investments in stakeholders a company should make, and when it should show restraint.

If these principles are applied, there is no conflict with shareholder primacy arguments. It’s seductive to think that “you can always do good by doing well” — that everything you do to help society ultimately bounces back and turns into a profit, but that’s not the case. These principles ensure that any stakeholder-oriented investments do eventually benefit shareholders, i.e., they grow the pie for the benefit of shareholders and stakeholders alike, rather than giving part of the pie to stakeholders at the expense of shareholders.

That’s the power of purpose. It frees a company to take actions for intrinsic reasons.

It’s important to stress that “benefiting shareholders” doesn’t just mean increasing shareholder value. Nor does shareholder primacy mean increasing shareholder value. Both these terms involve increasing shareholder welfare — doing what’s in the best interest of shareholders. A shareholder that’s a pension fund doesn’t just care about the income it can pay to its pensioners in 30 years’ time, but the state of the planet as this will affect its pensioners’ welfare. Shareholder primacy is much more nuanced than often perceived, because it allows for shareholders to have non-financial goals. Similarly, the “principle of materiality” in Grow the Pie doesn’t consider only financial materiality, but intrinsic materiality. Shareholders might care about an issue (e.g., climate change, biodiversity, or social justice) for intrinsic reasons, not just because it affects shareholder returns.

Q: Enthusiasm — and controversy — has exploded in recent years, around ESG metrics being used as a proxy and measurement device for assessing how a firm tends to its stakeholders’ interests. What are your views on the current state of this ESG debate?

A: ESG metrics are also seen as a panacea. The argument is compelling — if we could only measure ESG in a standardized, comparable way, then we can see which companies are truly walking the walk, not just talking the talk, and allocate capital away from the sinful companies towards the saintly ones.

But that was the logic behind No Child Left Behind (NCLB) 20 years ago. Standardized test scores aimed to bring comparability and transparency to something that was previously hard to measure — education. Similarly, these scores would allow school districts to allocate capital away from the laggard schools towards the leading ones.

NCLB was disastrous. Something as intangible and multifaceted as education, which involves teaching how to think critically, how to form an argument, and how to synthesize information across many fields, was reduced to memorizing disconnected facts to be regurgitated in a test. Teachers then taught to the test. As I explain in my article “No Stakeholder Left Behind: The Dangers of ESG Metrics,” the same pitfalls exist with ESG. ESG is intangible and multifaceted, but an overemphasis on metrics reduces it to a box-ticking exercise where companies can tick the boxes just like teachers could teach to the test. Diversity comprises not just demographic diversity, but cognitive, socioeconomic, and educational diversity; moreover, it is particularly powerful when combined with equity and inclusion. However, ESG metrics typically focus only on demographic diversity. Even if a company does not care at all about DEI, it can hire minorities to tick the box. Indeed, in a recent paper, “Diversity, Equity, and Inclusion,” my coauthors and I find that employee perceptions of DEI are unrelated to demographic diversity — companies can boost demographic diversity but this has no effect on true DEI. They hit the target, but miss the point.

Instead, we should embrace the subjectivity and recognize that ESG can’t be measured; it can only be assessed. It’s just like any other intangible asset. We recognize that the quality of a firm’s leadership team matters for firm value, but there are no simple metrics for leadership quality, nor rating agencies trying to give leadership a score. You can’t assess ESG just by picking out numbers from a database or annual report; you need to truly understand a company — the context to understand which numbers are relevant and which are not, the process that led to those numbers rather than just the outcomes, and the qualitative dimensions of performance that are missed by the numbers.

Q: You recently wrote an article called “The End of ESG.” Why are you arguing that ESG should be scrapped, if you’re an ESG advocate?

A: This article actually doesn’t argue that ESG should be scrapped; instead, it recommends the end of ESG as a niche field. The first line of the paper is “ESG is both extremely important and nothing special.” Let’s break this down. ESG is extremely important because it’s critical to long-term value, and so any academic or practitioner should take it seriously, not just those with “ESG” in their research interests or job title. Thus, ESG doesn’t need a specialized term, as that implies it’s niche — considering long-term factors isn’t ESG investing; it’s investing. Indeed, there’s not really such a thing as ESG investing, only ESG analysis.

ESG doesn’t need a specialized term, as that implies it’s niche.

ESG is nothing special since it’s no better or worse than other intangible assets that create long-term financial and social returns, such as management quality, corporate culture, and innovative capability. Currently, companies get more brownie points for improving their ESG performance than these other intangibles; investor engagement on ESG factors is put on a pedestal compared to engagement on other value drivers. But we want great companies, not just companies that are great at ESG. Creating a great company involves taking ESG issues seriously, but also taking other determinants of long-term value seriously.

I’m actually not an ESG advocate either. My most cited paper, and arguably the one I’m most associated with, shows that the 100 Best Companies to Work For in America — companies that go above and beyond in how they treat their workers — outperformed their peers over a 26-year period. But this paper doesn’t mention ESG even once. I studied employee satisfaction not because it’s an ESG factor, but because it’s a value-relevant factor; it’s an intangible asset that drives long-term value for companies. Moreover, it drives long-term returns for investors as it’s not fully priced by the market. Indeed, the paper is entitled “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices.” I’m an advocate of creating long-term value — of growing the pie — not of improving only ESG factors, and certainly not of improving only ESG factors that show up in the metrics!

Q: The banking sector has struggled with employee well-being and satisfaction with corporate culture demands. We saw this the swirl of media attention to a report by several junior Wall Street analysts complaining of extreme working conditions. You published an interesting paper related to this, finding that firms with higher employee satisfaction generate significantly higher long-run stock returns than do their low-satisfaction peers. How would you suggest we might best reconcile the conflict between ‘drive results at all costs’ vs. ‘employee satisfaction drives long-term returns’?

A: The report indeed received a swirl of media attention, but I believe the media attention was outsized compared to the actual relevance of the report. In general, we learn much more from large-scale evidence than individual anecdotes. This report was written by 13 first-year analysts, when there are roughly 20,000 investment banking analysts in the US alone. There was nothing new in the report. I was an investment banking analyst at Morgan Stanley, so am sympathetic to the concerns that they raised, but every analyst goes into an investment bank knowing what to expect. Even though the hours are very long, investment banks still are able to hire the cream of the crop every year, and have tons of undergrads and business school students fighting over a couple of spots, because they still view the job as attractive despite it being so demanding. And they don’t view it as attractive just because of the money; you get to work with very smart people (both colleagues and clients) and on deals that shape industries. I know a banker who worked on the AstraZeneca merger; in his 30 years in the industry, this remains one of his proudest achievements. Without the merger, AstraZeneca may not have had the scale to produce the coronavirus vaccine. This contrasts with other careers where you might work on the pricing of a particular product or a marketing campaign — these are still important, but not as company- or industry-defining as mergers or IPOs. 

You can’t reconcile the conflict between “drive results at all costs” and “employee satisfaction drives long-term returns.” The latter is empirically backed by large-scale data across 26 years, and after controlling for other determinants of long-term returns. In contrast, I know of no evidence suggesting that “driving results at all costs” works in anything other than the very short-term. And I don’t think investment banks do drive results at all costs, even though media headlines will obviously latch onto the cases of egregious behavior. The best investment banks don’t act this way with their clients. My boss was a third-year Executive Director and up for Managing Director promotion, so if there was ever a time to put himself above his client, this would be it. But he told a client not to do a deal with Morgan Stanley — forgoing a large fee and potentially jeopardizing his promotion — because it wouldn’t have been in the client’s interests. Nor do they act this way with their employees. If I told my boss that I was unable to work a particular weekend, he understood unless the task was genuinely urgent. Even as a first-year analyst I was taken to a client meeting that was so important that the Global Head of Investment Banking attended. I was asked to give part of the presentation to the client; even though I would have been far less polished than the senior bankers, Morgan Stanley knew that it could only be successful in the long-term if it developed its talent.

Investment banks are large. In such large firms, you’ll always be able to find some bankers who mistreat their staff or don’t act honestly with their clients. But, for a bank to be successful over decades, in a highly competitive industry, it needs to take very seriously the long-term interests of its clients and employees. This is not to say that banks are perfect and nothing can be improved, but if you look at the workforce as a whole, their employee satisfaction is much higher than anecdotes would suggest. Goldman Sachs is frequently in the list of the 100 Best Companies to Work For.

Q: Why do banks keep making the same mistakes in managing their culture, as some have argued, despite your evidence that employee satisfaction pays off?

A: As per my previous example, it’s not clear that banks are indeed perennially making cultural mistakes, nor that the mistakes in banking are worse than in other professions. The main criticism of banking is that it is too cut-throat (you’re always in fear of your job) and too demanding (with ridiculous hours, where you have to work whenever your boss tells you). What’s the opposite of this? It’s my current career as a tenured professor. You can never be fired, and you work whenever you want. (Of course, you have to teach your lectures at their set times, but teaching is only a small part of a professor’s job; you can do your research wherever you want). And this leads to the opposite problem of insufficient incentives. There is a severe problem of “deadwood” tenured faculty, who no longer do research and care little about teaching. Government jobs are similarly more secure and less cut-throat than banking, but this puts off ambitious, hungry people who fear they will be managed by incompetent people who you can’t get rid of. In the UK at the moment, there are strikes in the health service, teachers, rail workers, and so on, because of insufficient pay, which isn’t a concern in banking. Thus, I don’t think there’s conclusive evidence that banks are managing their workers worse than other industries.

I don’t think there’s conclusive evidence that banks are managing their workers worse that other.

Perhaps you could broaden your question to: “why do all industries make big mistakes in managing their culture?” Even though my paper shows that employee satisfaction pays off, the reality is that it’s difficult to improve employee satisfaction. There’s clear evidence that scoring more goals wins more soccer games, but teams aren’t making big mistakes by not scoring more goals; doing so is simply difficult. One of the major challenges with improving employee satisfaction is that there are trade-offs. It’s all well and good saying that banks should halve analysts’ hours, but clients often have urgent requirements. Shorter working hours would mean worse client service. Similarly, the government could end the strikes by giving into pay demands, but this would cost the taxpayer. Even considering employees alone, there are trade-offs between different employee preferences. Some want job security; others prefer to work for a company that keeps only its top performers.

Q: Your most recent paper is called “Applying Economics – Not Gut Feel – To ESG.” What motivated you to write that paper?

A: This paper is a response to the huge enthusiasm that everyone — executives, investors, policymakers, the media, and even academics — seems to have for ESG. Since ESG is “extremely important”, this is enthusiasm is welcome. However, ESG has become so popular that people feel pressured to do something or say something about ESG to demonstrate their commitment. This can often lead to actions or statements that shoot from the hip and apply gut feel rather than being based on careful analysis.

One justification for shooting from the hip is that ESG is so new, and traditional finance research so focused on shareholder value, that there is no research to guide us. However, recall that ESG is also “nothing special” — it’s no different to any other investment that creates long-term financial and social value — and decades of finance research have studied the risk and return to investment. This paper uses the insights from mainstream economics to help us understand ten key issues in ESG — and, in doing so, reaches different conclusions from conventional wisdom.

I’ll explain just one of those issues to give an example. One common claim is that ESG risks — stranded assets, executive malfeasance, employee unrest, customer boycotts, regulatory  fines, media shaming, and so on — increase the cost of capital. It seems a no-brainer that you should incorporate risks into valuations by increasing the discount rate — after all, Finance-101 tells you that the discount rate depends on risk. Indeed, the PRI’s survey concludes: “Some investors adjust the beta or discount rate used in company valuation models to reflect ESG factors: corporate governance, operational management, general quality of management, its strategic decision making etc.” It contains numerous case studies of investors that do so. One investor explains how they lower the discount rate for companies with above-average gender diversity, arguing that “Diversity also helps to reduce company-specific risk in the long term, leading to a lower cost of capital.” Similarly, the specimen exam for the CFA UK Level 4 Certificate in ESG Investing contains the question: “What impact will a high ESG rating have on a company’s cost of capital?” The answer key gives the correct response as “A: A lower cost of capital”.

But the main effect of a risk is to change the expected cash flows in the numerator of a valuation. If a cash flow should be $1 million, and there’s a 10% chance of a major ESG catastrophe that reduces it to $200,000, a 15% risk of a moderate disaster that lowers it to $300,000, and a 20% probability of a mild calamity that decreases it to $400,000, the expected cash flow becomes $695,000.
These risks need not increase the discount rate. Finance-101 tells us that the discount rate is affected only by market risk, and not by company-specific risk, in contrast to the statement by the investor in the PRI survey.

The discount rate only increases if the risk of the disaster is correlated with market conditions — i.e., a disaster is more likely in bad times. In contrast, many ESG scandals, such as Volkswagen cheating emissions tests, Wells Fargo opening fake bank accounts, or Rio Tinto blowing up Juukan Gorge, are company-specific, not market-wide — they’re no more likely in a down market than an up market. In fact, one could argue that some ESG scandals are more likely in an up market — when times are good, companies get sloppy and don’t impose as tight controls. Thus, while ESG risks definitely reduce expected cash flows, the impact on the discount rate is far from clear.
However, changing expected cash flows seems a hassle — you need to estimate the probability of different scenarios and what will happen to the firm in each scenario. Since such estimates will only be approximate, you’ll then need to do sensitivity analyses around your base case. Because this is cumbersome, some investors instead increase the discount rate because it’s easier — you just need to change one number — but the discount rate shouldn’t change if the risk is company-specific. Now it’s true that you can “fudge” the valuation by increasing the discount rate to reflect the effect of lower cash flows. But there’s no guidance as to how much this increase should be — there’s not even a logical midpoint about which to do a sensitivity analysis. It would be like incorporating the effect of higher energy prices by hiking the discount rate rather than raising the costs in the cash flow statement.

The classic textbook Principles of Corporate Finance by Brealey, Myers, Allen, and Edmans (2022) states the correct approach clearly: “Remember that a project’s cost of capital depends only on market risk. Diversifiable events can affect project cash flows, but they do not increase the cost of capital… Don’t give in to the temptation to add fudge factors to the discount rate to offset things that could go wrong with the proposed investment… Adjust cash-flow forecasts instead. Fudge factors in discount rates are dangerous because they displace clear thinking about future cash flows.”

ESG issues are extremely important, but that’s why we need rigorous economic principles, rather than gut feel, to guide us. As we learned from the fable of the tortoise and the hare, we need more haste, but less speed.