ESG and the Commons: From Tragedy to Governance?

By Christopher K. Merker, PhD, CFA Posted In: Drivers of Value, Economics, Performance Measurement & Evaluation, Portfolio Management, Standards, Ethics & Regulations (SER)

“A resource arrangement that works in practice can work in theory.” — Elinor Ostrom

Sustainable investing will become the rule and no longer the exception. But this transition comes amid a disquieting change in how we must view capital, production, and their attendant effects.

Promoting the Common Good or Promoting Destruction?

In Adam Smith’s The Wealth of Nations, the pursuit of individual goals brings about — on balance — the right outcomes on a broad community scale. Think of the baker baking bread for profit: The act itself — the supplying of bread — clearly promotes the common good, even if the common good wasn’t the original intent. This, of course, underestimates the role of “externalities” in economics, or how self-interest can lead to the eventual and total destruction of certain resources. As Garrett Hardin wrote in his seminal “The Tragedy of the Commons”:

Each man is locked into a system that compels him to increase his herd without limit — in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

The massive deforestation that has occurred over the last 30 years demonstrates the truth of Hardin’s view. Indeed, today only 13% of the wetlands that existed in 1700 remain.

Amid such challenges, there has been a call to re-orient an economy’s value definition away from the pure production of goods and services — the so-called gross domestic product (GDP) — to something else: a measure of sustainable human happiness or sustainable material well-being, for example.

The problem lies in how such a number, in addition to gauging economic progress and employment, can measure resource exploitation and greenhouse gas-producing energy consumption. As a blunt instrument, the number fails to capture, for example, the transition from a manufacturing- to a service-based economy, as well as other more sustainable forms of economic activity that become part of this new emphasis. The UN’s Sustainable Development Goals (SDGs) fit the bill, but they need to enter the common vernacular. A single metric, whatever it might be, could go a long way in accomplishing that.

And yet the unclean side of the equation still needs to be addressed. Is it possible that Amazon produces more greenhouse gases than Exxon, as some have speculated? It turns out that the prompt and convenient package delivery consumers love consumes considerable energy.

Productivity and other efficiency metrics could also be applied. Making more with less or no impact through so-called neutrality measures — carbon neutral, water neutral, etc. — may work as well.

ESG: A Social-Ecological Systems (SES) Framework?

The late Elinor Ostrom developed a counter theory to the “Tragedy of the Commons.” The only woman awarded the Nobel Prize in economics, Ostrom received the honor for her “analysis of economic governance, especially the commons.” Her work focused on how humans interact with the environment so that they can harvest their common-pool resources — forests, fisheries, pastures, etc. — in a sustainable fashion over the long term.

Ostrom saw the underlying relationship between humans and their environment as a multifaceted one for which there were no one-size-fits-all solutions. In her view, caring for the commons requires a nuanced, bottom-up approach governed by local norms. It had to develop based on mutual trust and direct engagement. The phrase “Think globally and act locally” comes to mind.

This culminated in her comprehensive “Social-Ecological Systems (SES) framework” for common-pool resources management through collective self-governance. Key elements of this framework include collective choice, effective monitoring, graduated sanctions, conflict resolution mechanisms, self-determination, and multiple layers.

So, where do investors and capital fit into this framework? The terms imply a potentially compelling role and describe an already existing infrastructure:

1. Multi-Layered: Think standards makers like PRI, SASB, and GRI. Then there are the intermediaries, money managers, and institutional investors such as CalPERs, college endowments, and other funds. Associations like the US SIF and the Interfaith Center on Corporate Responsibility (ICCR) form another layer.

2. Monitoring: Corporate disclosure came first. In 2011, only 20% of S&P 500 companies provided sustainability reports. By year-end 2018, that had climbed to 90%. The data providers — MSCI, for example — have followed. Huge leaps in big data analysis have also been made. A year ago, Harvard released a study examining corporate factor materiality. At Marquette, we are working on ESG factors with implications for the public sector.

3. Conflict Resolution and Self-Determination: This is now driving board-level agendas. Screening in and shareholder activism, or “shareholder partnership,” which connotes a more earnest and trustworthy form of engagement, have all come to the fore.

4. Sanctions: Proposals have emerged to link executive pay with ESG objectives. Divestment of and screening out companies are used as well.

The ESG movement is following the SES framework envisaged by Ostrom in a number of ways. Whether it will be enough or in time are important open questions. But the resiliency, self-organization, and spontaneous adaptive nature of such systems should, at a minimum, encourage us as holders and advisers of capital to continue to push forward.

The more we ask, the more we learn, and the more we engage, the closer we can come to avoiding “The Tragedy of the Commons” and achieving the sustainable forms of capitalism necessary for our own and future generations.

Christopher K. Merker, PhD, CFA, explores these issues in the forthcoming Trustee Governance Guide, with Sarah Peck. This month, he will interview Dr. Stephen Cohen on Opportunity Zones and environmental policy at the Barron’s Impact Summit and conduct a session on trustee governance at the Commonfund Investment Stewardship Academy.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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