CAN ESG REPLACE THE STATE?

The debate about whether asset managers, and corporates more generally, should explicitly take “social issues” into account in terms of their investment decision-making is not without controversy

For what it’ s worth, I am a strong believer in the need to tackle the challenges facing our society today and, like many South Africans, deeply sceptical about the ability of the state in its current guise to do much about it

However, I am also realistic about what the asset management industry and private sector can do to drive change, and why its incentive structure is not necessarily aligned to resolving many of our pressing social challenges These challenges are linked to a failed state rather than a market failure

This view risks upsetting two camps in our industry: those who maintain that the state must simply stay out of our industry, and all will be well, and those who (perhaps naively) believe that we can fundamentally shift the industry’ s incentive structure through sheer force of will

For the purposes of this discussion, I think it is useful to distinguish between market failure and state failure and the fundamental differences between the two

The classic textbook example of market failure is a factory polluting the lake that a town relies on for drinking water

Framing this through an “S” (from ESG) lens: child labour is banned because it is not in society’ s best interest to have uneducated children, though cheap and dextrous labour serves private interests

So far so good, perhaps This is the classic framing of the negative externality problem where a private company is incentivised to oversupply something with a negative externality unless prevented from doing so

Importantly, this is not because the private company is bad or hasn’t fully integrated ESG into its decision-making, but rather because unless the state regulates it, it remains in its financial interest to persist with the behaviour

Most private companies, to the extent that they frame their investment decisions through an ESG lens, have tended to see the state (or regulator) enforcing rules, and creating hoops that the private sector needs to jump through, albeit with a benign intention of mitigating some of the abovementioned negative externalities As long as companies abide by the legislation, the firms remain open for business and asset management firms can respectably invest in them, no matter what a particular interest group may think

But what happens when there is state failure as opposed to a market failure?

Let’ s go back to the child labour example Assume the child is not allowed to work and the public sector school sys- tem is broken State failure here refers to the inability of the state to provide a public good with a positive externality Will embedding “S” in the decision-making metrics of the private company make any difference to whether the company sponsors the child’ s education (and all the other children who can ’t get a decent education)? And should it?

Most “social issues” , such as a decent education, citizen safety and adequate infrastructure, are public goods where the benefit of providing it is shared more broadly than the individual who directly benefits from it or would be willing to pay for it. Here the incentive for the private sector works in the opposite direction, and the private sector structurally undersupplies the public good, no matter the legislative pressure

Much of the muddle we have with ESG, and especially with “S” , is based on arguments regarding the obligation of the private sector to provide public goods with positive externalities, and in sufficient quantity (though they have limited incentive to do so)

Sure, the private sector and the asset management industry can play some compensatory role, but this would predominantly be when the “S” issues at hand have a direct bearing on the viability of long-term sustainability in the eyes of their clients or consumers and where it needs to maintain its “social licence” to operate in the communities where they coexist

And certain asset management firms that have better integrated ESG into their purpose are arguably better placed to provide some of these goods than the traditional asset management firm These firms might well play a more enabling role in future

We shouldn’t take this argument too far, however. Just as state legislation dealing with market failure is often poorly framed, subject to unintended consequences, and beholden to vested interests, so the market response to state failure is unlikely to ever be in sufficient quantity to replace the state and could even be negative as the anti-progressive backlash in the US is perhaps demonstrating

It is only because the South African state has failed so spectacularly that we are even contemplating the importance of private companies investing in public goods with positive externalities Given that a private company will only supply a public good up to the point at which the costs outweigh the benefits, it is not realistic for the private sector to fulfil the state’ s role (even if the firm’ s marketing schtick implies it could, and/or the state would allow it)

The failure of the South African state to supply public goods is uncontroversial, at least to all but the most blinkered cadre. It should be equally obvious to all of us that the private sector cannot be expected to bail out a failed state x

Crosoer is an investment executive at PPS Investments