ESG – Escondido Framework

My grandmother’s oranges and Frank Hester’s rants

My grandmother lived through two world wars and difficult times. She kept her politics, other than a general sense of fairness and distaste for injustice, close to herself. I remember it came as a surprise to me when she announced that she made her selection of fresh fruit (oranges if I recall) on the basis that they shouldn’t come from a nation with a pretty toxic regime and social system. Only a few years later, after discovering marketing during my Stanford MBA, I realised that it should not have been a surprise. It is an essential component of the Escondido Framework that our choices are informed by a wide range of considerations and trade-offs, albeit some may swamp others in their importance, and this affects what we buy.

I recently introduced an old friend who is researching impact investing by charity trustees to a former colleague who is chief executive of one of the largest group of family charitable trusts in the UK. The old friend is interested in the use of charity endowment to make mission-aligned investments rather than purely for financial yield. The former colleagues recounted how, as custody of the inherited wealth that the family invests in charitable giving passes from generation to generation, not only does the direction of the charitable giving shift, but also the attitude of the family members towards the non-financial impact of their investment decisions changes. This should be no surprise either, as impact investment strategies are only a short step beyond avoiding investing in industries that conflict with your charitable purposes (for example, as chair of the finance committee of Versus Arthritis, I had no hesitation in making the case that a health charity should avoid investing in industries like tobacco and alcohol whose businesses contributed to ill-health).

TPP’s Frank Hester

So what do I feel about the use by my family doctor (in common with all the GPs in west London and a large part of the NHS community services locally) using SystmOne, one of the most widely deployed electronic patient record systems in the UK? Most of my fellow patients have no idea that TPP (The Phoenix Partnership), which developed and operated SystmOne, was founded and apparently remains owned exclusively by Frank Hester. It was Frank Hester, the largest single donor to the Conservative Party, who has been alleged recently to have declared a few years ago at a company gathering that looking at Diane Abbott makes you “want to hate all black women” and that she “should be shot”. I don’t often have sympathy with Diane[1] who has very different political views to mine and has said some pretty daft and sometimes unpleasant things in the past. Comments of this type are unacceptable for many reasons and it reflects very badly on the company and its people that he felt able to make them.

I imagine that I will be holding my nose metaphorically when I next sit down in my GP’s consulting room as he or she updates my patient record with the details of my visit. If I was still chair at West London NHS Trust, where we were in the process of replacing a legacy electronic patient record system with SystmOne to provide for better interoperability with that used by our primary care partners, I doubt whether the knowledge that SystmOne was provided by a company headed up by someone with such views and that the profits were adding to his wealth would have changed my view of our IT strategy. Notwithstanding Mr Hester’s unpleasant views, the system produced by his company is the only one in town, or at least in my bit of London.

Whether things might have been different many years ago when TPP was starting out is moot. I imagine that Mr Hester was more cautious about what he said, how he said it and in whose hearing he said it, even in as recently as 1997. Certainly, I don’t recall being any less sensitive to boorish, racist and sexist language then, or my NHS colleagues being any less easily offended. But a generation on, and with the money in the bank and the software widely adopted, the customer (and ultimately their patients) has far less choice. Reflecting on this episode in Escondido Framework terms, the shape of the market interfaces have changed. How Frank Hester behaves, which has a bearing on how he does business, has almost certainly changed. Given the strength of his product with its customers and its established position against its competitors, he can (despite the widespread negative reaction his comments received) say unpleasant things without it affecting his business. For those of us who metaphorically are holding our noses, we have fewer degrees of freedom in our decision taking than we might have had many years ago if presented with a prospective supplier who acted in such a way (rather than exercising the restraint that was probably the case when Frank Hester was starting out with TPP in the late nineties).

[1] ……although I am entertained by the memory of serving with her as a fellow member of the Joint Academic Committee in the History Faculty at Cambridge University in 1974, when she (it can have been nobody else) described me in a student newspaper as “rather too obviously a Cambridge politician on the make” – wonderfully ironic given that she became the career politician whereas I made my escape from politics in the 1980s.

US Republicans who don’t understand shareholder capitalism

Freedom, but not to do business with ESG informed institutions

Ron DeSantis, governor of Florida and fancied candidate for the Republican presidential nomination in 2024 is proving to be an unexpected enemy of investors in US businesses and the “free market”. The FT reports that he announced legislative initiatives on 13^th February to ban banks and other financial groups from “discriminating against” energy companies, gun sellers and other businesses, and asset managers from considering ESG in investment decisions.

This appears to be only one of 49 legislative initiatives so far this year across the United States. To the extent that these are the result of the efforts of lobbyists working for pariah businesses, this is fair enough and – in terms of the Escondido Framework model of the firm – represents an understandable response by the managements of such businesses to the pressures they face as they attempt to shape the interface of their businesses with the suppliers of capital.

Whether it is a rational response or is likely to succeed (by reducing the cost of capital or relaxing the pressures faced by management from active investors) is uncertain. The FT reports further that the Indiana Bankers Association, representing 116 banks, is trying to frustrate legislators in the state who are trying introduce a measure to require the state to divest and cancel contracts with financial groups that consider “social, political or ideological” factors. The Chief Policy Officer of the IBA has said “A lot of my members have ESG statements [that] could prohibit an organisation being a custodian of the state’s finance as a result of this legislation.”

But the growth of ESG is a rational response of businesses to institutional investors’ concerns about the outlook for businesses who traditional activities and business models face a long term threat because of they harm that they are perceived to present to people and to the planet. Each mass shooting in the US contributes to a ratcheting up of the anti-gun lobby and, absent short term crises resulting in a profit windfall (and these invite a taxation response) the outlook for companies extracting and supplying fossil fuels is undermined by the need to move to net zero. And when it comes to good governance, the example of value destruction by an unshackled Elon Musk, reinforces the case for the “G” in ESG.

It is reasonable for climate-change-denying and gun-toting Republican elected officials to include financial institutions that do not subscribe to the “E” and “S” elements in the ESG principles among the organisations with whom they do business, providing that such organisations can demonstrate over the long term that they serve the fiduciary responsibilities of the offices to which they have been elected (it is hard to see how they can ignore the “G”). But it is conflicts with their duties and with the commitment claimed by most Republicans to market capitalism to cave in to the pressure from the pariah businesses and legislate against doing business with ESG informed investment decisions that offer better long term returns and less risk of fraud, provider capture or adverse outcomes from wacky decision making.

The paradox of the anti-woke investor

Fundsmith founder, Terry Smith – No Nonsense?

The Escondido Framework argues that all the market interfaces of the company (with customers for their goods or services – either B2B or B2C, labour, their own suppliers of goods and services, and providers of capital) are essentially similar.

Customers for goods and services make their decisions to purchases on the basis of a variety of characteristics of the offering: quality, product features, after-sales support, credit terms, price and more, and in relation to all of these, the competing alternatives. Employees consider not only the raw salary package, but the variety of employment terms, both hard and soft benefits, company culture and values, corporate reputation, risk, opportunities for career development, and that’s just the start of the list. Suppliers of goods and services also have complex decisions in terms of how they view their customers, whom to serve and how. It is not just a matter of price. For example: is this customer big enough to justify the effort to sell to them compared to the other potential customers out there; can we support the service levels and stock requirements to meet their demands; would our brand be damaged in the eyes of our premium customers if we sell to downmarket segments? And suppliers of funds to companies, whether equity, debt, or hybrid instruments, consider a wide range of trade-offs: risk (reflecting a wide variety of considerations: operational, financial structure, regulatory exposure), term, liquidity, income generation, value growth, portfolio diversification for starters.

So what should we make of the debate raging over ESG informed investment and rise of the vocal “anti-woke” investor?

The Escondido Framework is not a normative model, arguing over rights and wrongs of ESG investment. The model describes the world as it is, and highlights the shortcomings and incompleteness of other models of the organisation. Investors, alongside with consumers, suppliers and especially employees include ESG type considerations in the mix when deciding who to do business with and on what terms. Do I want to be complicit in the destruction of the planet, oppression of minorities, exploitation of disadvantaged populations – whether on a third world plantation or facing an early death through a predisposition to consume addictive toxins (alcohol, tobacco or opiates). ESG is a fact of life in all markets, the only question is the weight and precise form in which it plays into the consideration of all the parties (aka stakeholders) with whom companies interact.

There are conflicting accounts as to whether ESG focussed companies and investment funds deliver superior returns. Part of the problem is one of definition and the nature of the measures employed: movements in share price are a poor metric because any starting point in a share price measure has future performance expectations priced in. However, to the extent that robust taking ESG issues into considerations reflect long term strategic thinking and the combination of transparency to investors and quality in decision-making processes, it is hard to see why and how ESG would not offer great value creation over an “anti-woke” alternative.

The Financial Times has once again (Helen Thomas on 11 January, following an article by Harriet Agnew on 12 January last year) focussed on a spat between “anti-woke” investor Terry Smith of Fundsmith and the leadership of Unilever. Smith has mocked Unilever’s leadership in his annual letter to investors for highlighting its sustainability credentials and for “virtue-signalling ‘purpose’”. He takes issue with Unilever for “purposeful” brands. For example, he comments about soap that “when I last checked it was for washing” dismissing Unilever for talking about “inspiring women to rise above everyday sexist judgements and express their beauty and femininity”. But, as Thomas points out, “the huge success of Dove – one of Unilever’s biggest brands, held up as a marketing case study – suggests a bit of female empowerment and body positivity isn’t a stupid way to sell soap. Rather like efforts to make mayonnaise appealing to health-conscious millennials [Smith laid into Unilever’s account of the “purpose” of Hellman’s last year], Smith just isn’t the target market”.

He is on stronger ground in his criticism of Unilever, which has been subject to a raid by activist Norman Peltz who now has a seat on the board. He complains that Unilever has failed to engage with his fund which had been a long-term holder of Unilever stock and twelfth largest shareholder. Marketing to investors, involving both taking strategic marketing decisions about the proposition provided to the investor (ie the profile of the investment including characteristics such as those listed provide above) as well as communicating with the shareholders, is one of the core responsibilities of the chief executive.

Reading the Fundsmith shareholder letter, I take away the impression that Smith’s criticism of “virtue-signalling” reflects a politically informed discomfort with a company that responds to trends in society and to the new consensus about threats to the environment. However, his language elsewhere and his stated strategy to invest in good companies, hold onto shares for the long term, suggest that he doesn’t recognise that his fund should invest in companies that adopt the underling strategic approach of Unilever (even if not its failure to communicate adequately with large shareholders or its apparently inept approach to large transactions). Given the stated approach (effectively to emulate Warren Buffett), Smith ought to be able to leave his personal politics and any “anti-woke” tendencies outside in the carpark when he comes to work and to recognise the value of purpose and ESG when investing on behalf of his clients.

Lessons from Emmanuel Faber’s departure from Danone

On 26^th June 2020 99% of the shareholders in Danone voted for it to become an enterprise à mission, or purpose driven company, required not only to generate profit for its shareholders, but do so in a way that it says will benefit its customers’ health and the planet.

Less than nine months later, Emmanuel Faber, Danone’s chief executive and the architect of the new strategy, was ejected by the board in the face of pressure from activist investors. The FT leader writer observed on 18^th March that “a backlash against purpose-driven capitalism was overdue” and that the debacle was “a reminder that distractions from the core goal of making a profit can be dangerous” before concluding that it did “not …. signal that leaders should rein in their ambition to go further and reassert the role of companies in society” and that to “revert now to simplistic and damaging pursuit of crude share-price maximisation would be a mistake.”

The ejection of Faber was not an illustration of the primacy of Friedmanite shareholder value, but an example of a chief executive failure to manage the investor market interface. We don’t know precisely what the activist investors were thinking, but they were clearly dissatisfied with the returns they were expecting and believed that their investment returns would be increased with a different chief executive.

Under Faber’s successor, the activist investors hope that the value of their investment (in terms of capital growth and dividend returns) will increase as a result of improved internal operational performance and a changed strategy towards the customers at its other market interfaces – including suppliers, employees, consumers, owners of real estate and local communities, regulators, and government (recalling the appetite of the French government to view large domestic consumer businesses as strategic national assets when threatened by acquisition by overseas multinationals). The choices of the different types of customer will include some consideration of ESG: consumers with an eye to environmental consideration (packaging, use of sustainable resources; employees preferring to work for companies whose conduct they can take pride in; investors wanting to see good governance. The rhetoric employed by the activist investment customers may reflect discontent with financial returns, but implicitly they are concerned with how the Danone’s mission is translated into strategy and the possibility that Faber’s rhetoric around purpose conceals a lack of grip on operational performance.

The Danone debacle generated further commentary on whether this apparent backlash represented a retreat from “purposeful capitalism”. John Plender wrote a powerful article for the FT on 4^th April reflecting both on the Danone story and on the lessons from the Covid about the impact on stakeholders (particularly suppliers) who were unable to diversify their risk (unlike investors) when a business hit rocks as the pandemic closed down parts of the economy. He shared the view, which we addressed during the debate in 2017 on corporate governance reform in the UK, that appointing employee directors (or by implication directors representing any other specific stakeholder group) does not address the governance gaps. He went on to argue for changes to the incentive models for senior managers to address short-termism and that profit or share value metrics determining them should be supplemented by ESG related metrics. In short, “stakeholder capitalism must find ways to hold management to account” and that “the prevailing commitment to short-termist shareholder value has undermined corporate resilience.”

Hakan Jankensgard, Associate Professor of Corporate Finance at Lund University responded to Plender in a letter published by the FT on 7^th April with an assertion that the firms should adopt the Hippocratic oath since this “would ensure that firms act as good corporate citizens”, with focus on long term profitability and “not become do-gooders picking sides in social debates”. It is probably a reflection of the challenge of drafting a letter of appropriate length for publication, but some steps in his logic seems to missing. However, other parts of his letter are compelling, echo arguments within the Escondido Framework view on how firms work and pitfalls in contemporary corporate governance, and are worth producing in full:

“As far as everyone is concerned, shareholders are the root cause of all the troubles afflicting our societies.

“Well, think again. The real problem today is managerial capitalism – that managers run firms primarily to increase their own wealth and prestige. A few decades back, managers were busy building wasteful empires, and the shareholder model arrived as a particular remedy for this gross inefficiency.

“Another innovation that arrive about the same time prove more fateful. It was the idea that managers, if given the right financial incentives, would rediscover their entrepreneurial spirt. It caught on, to say the least. What it really did, however, was to shift managers’ focus from building empires to extracting wealth through compensation packages.

“As manager took n their new role, they found willing accomplices in a cabal of short-term oriented investors looking for a quick return. This unfortunate marriage is the problem at the heart of today’s economy as it creates short-termism that adds to long-term risk.”

Rio Tinto’s dynamiting of the Juukan Gorge: Jean-Sebastien Jacques’s solution-space implodes

Juukan Gorge caves after Rio Tinto dynamiting

What better illustration could there be of the Escondido Framework approach to understanding ESG investing described in last week’s blog than the defenestration of Rio Tinto’s chief executive, Jean-Sebastien Jacques, by the company’s shareholders?[1]

In relation to the distinction made in last week’s article between the impact of regulation on the solution space available to executive teams, one of the interesting aspects of the dynamiting of Juukan Gorge and the two rock shelters is that the company had previously negotiated native title agreements with the Puutu Kunti Kurrama and Pinikura people, giving it rights to mine the area and had also secured regulatory approval. In Escondido Framework terms, as illustrated in last week’s blog post, the company thought that it was operating within the solution space defined by the market transaction with the owners of the land and that the regulatory market interface had not reduced the solution space available to the company.

However, the executives had failed to appreciate the sensitivities of the company’s investors to such an egregious violation of the heritage of not only the indigenous population but humankind as a whole.

Perhaps the board and executive team at Rio Tinto paid too much attention to the likelihood that investors in mining stocks are already a self-selected group that is less sensitive to ESG considerations than the investment market overall.

It matters little whether the response of the investors whose pressure on the board finally persuaded chairman Simon Thompson (who previously had insisted that Rio Tinto would not fire Mr Jacques) was a reflection of the potential for the scandal to increase future regulatory pressure on the industry, or a concern for the response of the upstream investors in their funds, or the consciences of fund management executives themselves being pricked by comparisons between the dynamiting of the caves with the actions of the Taliban blowing up the Bamyam Buddhas in 2001.

Either way, the shape of the investment market interface was sufficiently different to that perceived by Mr Jacques and his colleagues for them to have placed themselves, not temporarily but at a personal level permanently, outside the solution space available to them.

[1] For anyone who missed the story, Rio Tinto blew up two 46,000-year-old Aboriginal rock shelters in Western Australia, offending not only the Australia aboriginal community for whom the sites were sacred but also a wider public sensitive to an ancient archeological heritage. Initially the board decided to withhold bonuses for the executives involved, but has now decided that Mr Jacques should go (albeit not until early next year and without any further financial penalties)

Understanding ESG investment

The Financial Times has published a flurry of articles and the occasional letter about ESG (Environmental, Social and Governance) investing recently.

For example, Geeta Aiyer, president of Boston Common Asset Management, was the subject of a profile on 29^th August. This followed the success of Boston Common and other investors to secure the change of name of the Washington Red Skins American Football team by applying pressure on FedEx, the logistics company which sponsors the team’s stadium.

On 1^st September the paper published an article about write-downs at BP and Shell in response to “scores of asset managers who have doggedly pressed the oil companies to set targets to reduce carbon emissions and recognise the financial impact climate change could have on their operations” . The article cites a number of leading fund managers who comment on the “explosion” in ESG investing. It also notes the role of regulation in changing perspectives, citing the requirement now placed on pension fund managers in the UK take sustainability issues into account in their investment decisions and the impact of the EU’s sustainable finance package which will, from March 2021, push asset managers to incorporate ESG risks in their decision making.

A day later, on 2^nd September, the FT published an article by Chuku Umuna, former Labour business spokesman and now lead for ESG with Edelman, the public relations consultancy, arguing that “a company’s ability to manage ESG factors is widely viewed as a proxy for prudent risk management, and with good reason”, citing work by Société Générale on the impact of ESG-related controversies that found that “in two-thirds of cases a company’s stock experienced sustained underperformance, trailing peers over the course of the following two years.”

A few months earlier, on 9^th July, Gillian Tett wrote an article that opened by observing that the major ESG indices in the US and in Asia had outperformed the equivalent all share indices in terms of the financial returns to shareholders and cited a report from BlackRock making the same case, not only in the past year but also in 2015/16 and in 2018. BlackRock put this down to two primary reasons: the momentum created by ESG investors pushing up prices as they seek to acquire these stock for their clients and beneficiaries; and the value to companies seeking to improve their ESG ratings the scrutiny to which they subject their supply chains and employee practices and the consequent benefits that arise to their businesses.

Does the Escondido Framework approach to understanding organisations help us understand what is going on?

The Escondido Framework approach to looking at the firm is described in detail elsewhere. In essence, it explains that firms exist as a virtual space defined by their market interface with the suppliers of capital, labour, suppliers of goods and services, and customers, plus others whose needs may need to be satisfied, such as government or the wider community who implicitly or explicitly provide the firm with a license to do business. Their survival depends on creating value through the efficiency of their internal operations for there to be such a space. Where the firm places itself within the space will determine the distribution of economic rent to the stakeholders, how much may retained by the executive management, and how is available for reinvestment either in assets or long term relationships with one of more sets of stakeholders. As the market interfaces changes – through changes in supply and demand, competition, or the trade-offs made by the other parties to the markets place exchange – the virtual space (which can also be considered as the solution space available to the management team) may expand or contract (increasing or reducing the range of options, strategies and potential profitability available).

If a new external party intervenes, for example a government agency imposes regulation, the virtual space will be reduced correspondingly. Indeed, even the threat of regulation will have the effect of reducing the space as the firm is likely to take the view that it cannot afford to provoke the regulator.

Impact of new regulation to reduce solution space

So what is going on with ESG investment? ESG considerations have an impact on investment decisions in multiple ways.

Some investors will choose only to invest in businesses whose practices meet certain standards in terms of environmental and/or social responsibility and impact. When I was trustee of a large medical charity, we initially had a relatively limited list of sectors that we guided our fund managers to avoid, but progressively widened the list to avoid those whose products were implicated in contributing to the ill-health we working to address. Other charities have much wider exclusion lists, and many private individuals also choose to invest in ethical funds. Such investors are making an explicit trade-off between such potential increased returns as may be available from investing in companies (eg defence, tobacco) that don’t satisfy their ethical criteria.

Other investors decide to invest in ESG funds and businesses that meet ESG criteria because they believe that companies that with sound governance, ethical approaches to the communities in which they operate and setting high standards in their supply chains, and responsible approaches to the environment will ultimately deliver higher long term returns and be sustainable. Such investors may also take the view that these approaches also represent good business. Working in retail management as a merchandise director in the 1980s, I certainly took the view that being as environmentally responsible as possible was good business. I led a team that decided to adopt policies towards sourcing products from sustainable raw materials, reducing packaging, and developing “green” product ranges making extensive use of recycled materials on the basis that it was good for the business. It was good for our brand as it improved our standing with increasingly environmentally conscious customers. It was good for our sales, since people appeared keen to buy less environmentally harmful alternatives. It was also good for recruitment and retention of good staff, who seemed motivated (as I was) by working for a company that was trying to be environmentally responsible.

High standards of governance should also be appealing to investors, and the evidence is strong notwithstanding the mercurial successes of a few mavericks. As chair of a committee investing £200 million for the charity on which I was a trustee, I was attracted to Edinburgh based fund managers, Baillie Gifford, precisely because of the demands that it placed on the governance of their investee companies and its willingness to vote the shares it held for client like us to improve governance of the investee companies – and we were rewarded for our confidence in the approach by returns that consistently exceed the benchmarks for the fund.

If, as the flurry of FT articles suggests, there is an increasing appetite for ESG investing for whatever reason, the impact on companies is that (at least for the visually minded) the shape and precise orientation of their interface with the investment market will change reflecting either the trade-offs (in the case of the first type of investor described above) or the beliefs about the sustainability and long term returns (in the case of the second type of investor). The consequence of the appetite for ESG investing on companies is that those with business practices that align with the demands and expectations of ESG investors will face a slightly lower cost of capital and consequently increase the size of the solution space for the management teams when looking at their strategies.