Assets tied to environmental, social and governance (ESG) benchmarks are projected to grow to more than US$53trn by 2025, or one-third of global assets under management. This is a welcome development. By harnessing society’s resources, markets can be a powerful driver of progress and innovation.
However, markets alone cannot address some of the most important challenges we confront today. Governments must also play their part.
The economist Paul Samuelson argued that modern markets are ‘micro efficient’ but ‘macro inefficient’. What he meant was that it is easier to spot price anomalies in an individual security and eliminate them than to do so for the market as a whole. But Samuelson's dictum is perhaps true on more levels.
There is no single issue that better illustrates the macro inefficiency of markets than the climate crisis the world faces. Since the world started to industrialise, the global mean temperature has risen by at least one degree Celsius compared with pre-industrial times. Already, this has resulted in more frequent extreme weather events and a rise in sea levels, which have caused property destruction, population displacement and deaths. Unless we reduce greenhouse emissions, it is estimated that we will see between another 1.5 and 3 degrees Celsius of warming by the middle of this century.
The climate change problem exhibits three classic characteristics that tend to lead to a breakdown in market efficiency: it is a long-term issue; its financial impact is uncertain, and many associated costs cannot be measured in monetary terms; and those most responsible are not the ones who bear the highest cost.
Financial markets are notoriously short-term in their outlook. Investors often focus excessively on quarterly earnings and pay insufficient attention to strategy, fundamentals, and long-term value creation.
Ironically, at the macro level, this can drag down long-term economic growth by creating pressures to reduce expenditures on research and development, or to forego projects with strong potential but a long payback period. Reducing carbon emissions would involve substantial costs today to replace existing infrastructure, such as coal-fired power plants and petrol engine vehicles, whereas the near-term benefits are far less tangible.
Part of the obstacle lies in the fact that markets only value things in monetary terms. A decision-making framework that relies solely on quantifiable financial metrics is ill-suited to tackling environmental and social issues, the costs of which are often difficult to quantify. This is why carbon pricing and charging mechanisms, if widely adopted, could help meaningfully reduce emissions.
Governments’ reliance on markets for the provision of public services has, in many cases, led to a decline in public accountability for outcomes, particularly on matters of social equity. Indeed, the Covid-19 pandemic has highlighted the extent to which the effectiveness of public services in many developed countries has been eroded.
Left to themselves, markets are generally unsuited to arbitrate in instances where the costs of an activity or policy are borne by one group while the benefits derived from it accrue to another. Underlying many ESG issues are a range of regional, socioeconomic, and intergenerational conflicts. Governments are stewards of society for their entire populations and, crucially, also for future generations.
Climate change is but one of the serious challenges we must address. In recent decades, many countries have experienced a growing wealth divide and greater inequality of opportunity, which have driven rising social tensions. Public finances, already stretched in many cases, have been further strained by the Covid-19 pandemic. These are not challenges that can be adequately addressed by markets.
ESG investment itself is still grappling with numerous limitations, such as disclosure gaps, difficulties in impact measurement, and reliance on voluntary guidelines. It is estimated that 70 percent of ESG metrics are focused on whether companies have a relevant policy in place. However, the mere existence of a policy gives no indication of the level of commitment or adherence to it. And investors are ultimately concerned about optimising financial returns, which may put them in conflict with course of action best suited to addressing the challenges.
Markets are a powerful tool. However, markets operate within institutional frameworks and the incentive structures that they create. It is therefore incumbent on governments to enact laws and regulations designed to achieve desired outcomes. Furthermore, unless policymakers begin to look beyond short-term incentives, our children and grandchildren will inherit not only worsening climate-related problems, but also unsustainable social welfare burdens tied to aging populations, and a mountain of public debt.
*James Fok is an experienced financial professional, corporate and government adviser, and the author of the upcoming book Financial Cold War, published by Wiley.