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ESG Challenge: Todd Cort, Yale School of Management Interview — Transcript

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0:00perfect so we will start off with could
0:03you please introduce yourself and your
0:05areas of
0:07research sure my name is Todd Court uh
0:10I'm a professor at the Yale School of
0:12Management and the Yale School of
0:14environment uh I'm also the faculty
0:16director for two centers the center for
0:19business environment at Yale as well as
0:21a um an initiative the Yale initiative
0:23on sustainable finance and then I direct
0:26the Executive MBA program here at Y in
0:30sustainable
0:31Finance
0:32awesome great oh and you also asked
0:35about my research areas yeah I'll tell
0:37you about my resech areas a little bit
0:39they're a number um but the two primary
0:42ones is I'm interested in how we can use
0:46ESG data to Better Price Financial Risk
0:49uh for companies and portfolios of
0:51Investments um and I'm also interested
0:54in uh ESG and fiduciary duty uh the the
1:00um the ability of fiduciaries to use ESG
1:03data and whether that creates liability
1:05for them awesome thank you
1:09Tod all right so let's start with your
1:11research on better pricing of risk how
1:14would you characterize the current state
1:16of ESG data today and what are the
1:19biggest
1:21gaps so there's ESG data of course is
1:25incredibly broad um it can be anything
1:27from your scope one g greenhouse gas
1:30emissions to uh your your expectations
1:34on the reputational damage from a human
1:36rights violation found your supply chain
1:38like it could be there's so much under
1:41the ESG umbrella and so as you would
1:43expect there's a wide range of data
1:46quality under the ESG umbrella so I
1:51usually kind of I I try and categorize
1:54it into two big buckets so there's one
1:57set of data that is uh uh that is
2:01generally interesting to investors um
2:05whether it's because it's financially
2:06material or because they think it could
2:08become Financial material and that data
2:11is um there's a lot of pressure um and
2:16levers being pulled by Regulators by
2:19investors by other stakeholders to
2:21standardize that information uh to get
2:24companies uh to report it consistently
2:27in a consistent way with consistent uh
2:30scope and Boundary um that data is
2:34improving uh at a at a relatively brisk
2:37rate um there's still challenges with it
2:39and I'm happy to go into those but I
2:41think like scope one and scope two
2:43greenhouse gas data is is improving
2:46rapidly um the risks associated with
2:49scope one and scope two greenhouse gas
2:51data is improving rapidly um water
2:54exposure water use is is getting better
2:57health and safety information for
2:58employees uh and in the supply chain
3:01it's getting better the other big bucket
3:04of of ESG data is that information where
3:08it's unclear if it's financially
3:10material it could be under some
3:12circumstances we'll call it kind of
3:14lightly correlated information that
3:17information can be really bad um there
3:20are some bright spots but a lot of it is
3:22is is uh is really unknown the scope is
3:26really terrible uh there's very little
3:29validation it can it can be really
3:31non-timely information meaning that
3:33you're collecting it but you don't know
3:35what the information is until 12 18
3:37months after the fact um the there is
3:43value in that information because that
3:45information is essentially unpriced by
3:47the market there's no way to price it
3:49right now so if you want to outperform
3:51the market um you have to use unpriced
3:53information uh and there's a lot of
3:55unpriced ESG information uh for
3:58speculators for Hedge funds uh for
4:00private Equity firms Etc so that's kind
4:03of the other big bucket of of data and
4:05it can get really uh really ugly but you
4:08know it's it's big messy data sets um
4:12you also ask kind of where are the
4:13biggest gaps um because there's these
4:16two buckets there's there's one bucket
4:19which is pushing towards standardization
4:21and there's one bucket which is really
4:23we're happy to have big messy unpriced
4:26data sets where the gaps are is really
4:29on the standard ization side because
4:31that's where we want a full picture
4:33across our portfolio um so the gaps are
4:37things like um scope three greenhouse
4:40gas information which is somebody else's
4:42scope one and scope two is your scope
4:44three information but accounting for
4:46that saying this this ton of greenhouse
4:49gas emissions came from this Source um
4:52and not that source that kind of global
4:54accounting process has been very very
4:56challenging um there's some
5:00topics where we know that there is risk
5:02but we're not entirely sure what the
5:04metric is for example biodiversity and
5:06ecosystem Services we know that there is
5:09risk from the collapse of ecosystem
5:11services to businesses but exactly what
5:14the Tipping points for those uh for that
5:17risk is how it would acre to the company
5:20versus them being able to externalize
5:22that risk from the company that's all a
5:24little unclear but we're working on
5:25standardizing that information um and
5:29then there's um uh there's a the other
5:31big gap is validation so there's the
5:34accounting Gap and then there's the
5:35validation Gap um so how are we going to
5:38assure the information in such a way
5:41that we do it so it's comparable to
5:43other financial information that's
5:44another Gap again we're working on all
5:46these gaps um there's it's not like
5:48these are unknown uh it's just going to
5:51take some time yeah great thank you so
5:54much so my next question is why did you
5:57pick this particularly particular
5:59research question or
6:00area I I have a pretty significant
6:03inherent bias which is that um I think
6:07that climate change uh that
6:09socioeconomic inequality that ecosystem
6:12collapses I think that these are
6:14systemic level challenges that will
6:16undermine the entire Financial system I
6:19think we we operate uh as a as a finance
6:23uh faculty as a as a kind of financial
6:27system we operate under an existing set
6:29of rules rules and that those rules are
6:31are are collapsing underneath our feet
6:34so I have this bias that we need to
6:39understand those these pillars of the
6:42environment and society that we rely on
6:45and that we need to price them more
6:47accurately um for the financial system
6:49to continue to function over the medium
6:51to long term I also as just an
6:54individual I think that we need to move
6:56money towards more sustainable
6:58operations that we need to price in
7:00these externalities for the good of
7:02society and for the good of the
7:03environment so I have an inherent bias
7:05uh which has pushed me to these research
7:07questions
7:09um uh more fundamentally I guess it it
7:12just matches my background a little
7:14better um I'm an engineer I'm an
7:16environmental engineer uh by by training
7:19um I uh I live and uh and work with
7:22environmental and social activists in my
7:25in my day-to-day um that is my skill set
7:28is kind of understanding those
7:29externalities so it made sense to bring
7:31that to bear on on Market questions yeah
7:35great thank you can you share some key
7:38insights from this research so
7:42far so yeah there's there's a there's a
7:46couple things that are I don't know if
7:48they're key
7:50insights there's a lot of confusion
7:53right now on whether ESG or
7:55sustainability information would cost a
7:57company money or would make company
7:59money um and if you look at the
8:02literature it's fairly there's a wide
8:05range all the way from you know there's
8:06a there's a big premium to consider ESG
8:09information to you will lose money uh if
8:11you consider ESG
8:13information overall it looks like the
8:16answer is fairly close to zero right
8:19neither positive nor negative if there
8:21is a little bit it might be it's going
8:22to be very very small but more
8:24predominantly there's there's enormous
8:25amount of noise in the system so so
8:27making predictions about is ESG good for
8:30your business is is really really
8:32difficult um so in in that space I think
8:37one of the first uh findings that we're
8:41that we're getting is that
8:43um ESG is predominantly unpriced
8:48information right now um and that ESG
8:51information that is quote unquote priced
8:54is already fairly well established so
8:56think for example health and safety is a
8:58fairly well establish Lish cost for a
9:00company you don't think about that as
9:02ESG information it is ESG information um
9:05it's already priced by the system so
9:07markets are responding very well to
9:09information that's already priced the
9:11vast majority of the risk associated
9:14with the SG data is unpriced information
9:17and I think that's an important finding
9:19um the vast majority of ESG information
9:22is is going to be distributed impact
9:25which means that it won't impact on one
9:28company per se it's going to impact on
9:31the entire system and drag the entire
9:33system down um so that means that for
9:36portfolio manager you know picking and
9:39choosing a company based on their ESG
9:42criteria is probably not going to make
9:45you a whole lot of money but but
9:49designing your portfolio as a whole to
9:52understand your
9:53sensitivities um uh and and exposure to
9:57systemic risks could make for a medium
10:01to long-term successful strategy so
10:03that's one the other is that a lot of
10:07the the the effort by investment
10:11managers and by companies to understand
10:13whether ESG is profitable or not focuses
10:16on what I call outputs uh of of the
10:19system meaning did I emit more
10:22greenhouse gas and therefore is that
10:24profitable or not did I create more
10:26fatalities is does that make me more
10:28profitable or not
10:31those those tend to wash out um there's
10:34very very little correlation with
10:35individual data sets or even an
10:37aggregate um because of that noise
10:40however it looks like there might be
10:42stronger correlation with the systems
10:44within the company that result in that
10:46output so what I'm talking about are
10:48Management Systems management controls
10:51governance structures uh accountability
10:54audit processes uh Enterprise risk
10:56management processes that integrate ESG
10:59materiality processes that integrate ESG
11:03um those systems and processes within a
11:06company seem to have a higher level of
11:10financial benefit than if you look at
11:13the outputs of the ESG so performance is
11:16less important than the ability of the
11:18company to recognize and manage risks um
11:22that's I think what of the other key out
11:24outcomes and that's significant because
11:27we base so much like if you if you
11:29invest in ESG fund for example what
11:32you're what you're investing in is
11:35performance data and an understanding by
11:39ratings agencies as to uh whether the
11:42company has identified risks or not what
11:45we really want to focus on is the
11:48structures that the company uses to
11:50assess risk and whether that integrates
11:52ESG
11:54information great that's super
11:57helpful all right
12:00right next question is a big one how do
12:03you hope this research will contribute
12:05to addressing climate
12:08change um so my hope is that um if for
12:13example people believe
12:16me and they said that okay so what I
12:19really need to understand is a couple
12:20things I really need to have better
12:23systems to understand climate risk um
12:26and then I need to put in the control
12:29rols to mitigate said risk maybe that
12:32risk is that um uh maybe that risk is
12:35severe weather right it's an adaptation
12:37risk I need so I have the systems to
12:40identify that risk and then I need to
12:41put in structures to mitigate the risk
12:44that it will occur to me and that could
12:47be a seaw wall it could be investing in
12:49in green capital or green infrastructure
12:51rather um whatever another one another
12:54company might come to it and say well
12:55the risk here is is actually that uh is
12:58the greenhouse gas themselves I'm going
13:00to have to pay for those emissions in
13:01the future whatever the risk is if
13:05people believe me then they will invest
13:07in the the risk assessment and
13:09management processes to see those risks
13:12identify them figure out how they would
13:14internalize the company and then
13:16mitigate those
13:18risks that doesn't mean necessarily that
13:20a company would come to the conclusion
13:21of I have to reduce my greenhouse gas
13:24emissions um but it would mean that the
13:26company would recognize the greenhouse
13:28gas missions are a risk to the company
13:31um that awareness is is really I think
13:34where where I'm going to have the most
13:36impact on climate
13:38change understanding the risk
13:40understanding how much Financial uh
13:43impact it could have on the company that
13:45is if we are correct that climate change
13:48is generally going to be a drag on the
13:50economy then the overall movement should
13:53be towards reducing emissions and
13:55improving adaptation that's I think
13:57where it'll happen yeah
13:59my biggest hope is that um it's it'll be
14:04a faster reaction by companies that say
14:07I'm going to reduce emissions because
14:08I'll make money than it would be for
14:10companies that say I'm going to reduce
14:12emissions because there's a regulation
14:14coming that Financial wisdom will
14:17trigger a faster change a greater change
14:19uh over time um that's my hope yeah
14:24great okay this next question may
14:26overlap a little bit with with the last
14:28one and it's also has a few parts to it
14:31so how do you want your work to be used
14:33in the financial sector and then a
14:36question related to what are the
14:38barriers that you see to Greater uptake
14:41of this type of modeling and what
14:43opportunities do you see to in uh to
14:46accelerate
14:47uptake so yeah the way the financial uh
14:51sector could should will hopefully use
14:53this information is to price that
14:56unpriced ESG risk um
15:00so if we model out if we scenario out
15:03different you know climate scenarios and
15:05say under these different scenarios
15:06here's how much we would have to pay for
15:08example for energy in the future or
15:10here's what our adaptation costs are
15:12going to be in the future there's a
15:14processed model out this is what we
15:16think the uh the costs and benefits from
15:18climate change um or any other ESG risks
15:21are um so that modeling that Financial
15:25modeling of ESG risks is is the way that
15:28the financial sector should should be
15:29integrating this kind of
15:31information the barriers which we
15:33touched on at the very beginning uh
15:35first barrier is the quality of the data
15:37um the and that hits on the inputs to
15:41the scenario in the financial model
15:43right if I have a a piece of data and
15:45its plus or minus two or three standard
15:47deviations that's that's going to have a
15:50vast array of outcomes uh compared to a
15:53really nice tight bit of data um so the
15:56data quality has is one of the barriers
15:58the sensitivity of the models to very
16:01specific events um is is another
16:05challenge so just as an example um you
16:09know the sensitivity of of financial
16:12pricing of climate change impact is so
16:15sensitive to the price of oil and gas um
16:19that any kind of shock to oil and gas
16:21prices uh over a three month to six
16:24month period can throw your your pricing
16:27models for climate risk out the window
16:30um so and there's there's a number of
16:32kind of you know external external
16:35events uh that can really throw the
16:38models off and that's another big
16:39barrier to the modeling um so how do we
16:43accelerate it um first is we need better
16:46data for this unpriced information uh
16:48which sounds like a bit of an oxymoron
16:50but we're we're moving that direction um
16:53and then the the second is to U you know
16:56use these historic shocks to the system
16:59that have really driven the model
17:01outputs and try and control for those in
17:03the future that's a really complicated
17:05question um because there are so many of
17:08these different shocks that we've seen
17:10that have had an impact on the model and
17:12it's always a bit of a dodgy question to
17:14say I will try to control for future
17:17shocks when I don't know the nature of
17:19those shocks um but that's another
17:21another one that we're we're going we're
17:22going to have to try and figure out yeah
17:26great all right so now we're gon to move
17:29to chatting about your work on fiduciary
17:31duty and liability how would you
17:34characterize current conventional wisdom
17:36on fiduciary duty and why do you think
17:38that that should
17:39change so there's um there's a I don't
17:43know if I'd call this conventional
17:44wisdom there was uh there kind of a
17:46Doctrine the fredman doctrine which
17:49isn't a real thing but nevertheless
17:51um there there's kind of this underlying
17:55thought process that the responsibility
17:59of a fiduciary is to maximize Financial
18:01return risk risk weighted Financial
18:03return um and you it that summarized in
18:07this phrase of the business of business
18:09is business
18:11um if under that kind of Doctrine if I
18:16can pollute and no one forces me to pay
18:18for that pollution that is the best
18:21business decision because I can take
18:23that cost of the pollution or treating
18:25the effluent before I before I get rid
18:27of it and I can put that cost onto
18:29somebody else in that case society and
18:31that is the responsible fiduciary
18:34decision uh as long as it doesn't crew
18:36back to me um the and that that's kind
18:41of the you know if that's the prevailing
18:44wisdom um then that creates an inherent
18:47challenge to any kind of responsible
18:49business in reality there's very few
18:51people that would say that's you know
18:54that we would we would externalize all
18:56costs um but in practice in the kind of
18:58small decisions that a business make
19:00you'll see that over and over and over
19:02again um you know there's a there's a
19:05great paper not too long ago that came
19:08out of actually our faculty here at s so
19:10at Yale that showed that um in a
19:13short-term earnings shortfall meaning
19:16company is not going to make its earning
19:17its quarterly earnings um they would
19:21they would turn down the the pollution
19:24controls a little bit to save some
19:26energy so their pollution would go up
19:28shortly before a shortterm earnings
19:30shortfall um because they need to save
19:33some money in order to make that that
19:35earnings forecast really kind of those
19:38kind of really cynical um you know
19:40outcomes are are are the result of that
19:43Doctrine um so even if even if a company
19:47would never do that kind of
19:49systematically or on purpose um there's
19:51still in these small decisions you you
19:53can see that kind of reflection of
19:55fiduciary duty which is I have to meet
19:58these these earnings forecast I have to
20:00maximize my return um I have to you know
20:03maximize my risk adjusted return um so
20:07that is the let's call that the where we
20:10are right now um there's all kinds of
20:13reasons that this is incorrect um but
20:17the basics is that this assumption that
20:20I have to maximize return has very very
20:25little basis in reality um there some
20:29fiduciaries that that are handcuffed
20:32they're really constrained uh in terms
20:34of what other factors they can consider
20:37what other time Horizons they can
20:39consider as part of their their effort
20:42to uh to uh create returns for their
20:45shareholders um but most fiduciaries
20:48actually have a lot of latitude uh in
20:51and how they can consider those risks so
20:53I'll I'll give you a quick case study or
20:57example let's say a company is thinking
20:59about you know in the in the medium or
21:01long term I'm worried about carbon price
21:04right and um you know if carbon price
21:06comes in three years and I start having
21:08to pay say $50 per ton of carbon that's
21:11a material risk on the horizon and I
21:13know that it's going to take me at least
21:15three years to start to reduce my
21:17greenhouse gas emissions because it's
21:18there's a lot of operational Investments
21:20that I have to make there's some
21:21behavioral changes I've got to make it's
21:23going to take time so in that three-year
21:26Horizon it makes sense for me to start
21:29ratcheting down my greenhouse gas
21:30emissions now to avoid that cost three
21:33years from from today that is a Time
21:36Horizon that that fiduciary is able to
21:38undertake um rather than I'm going to
21:41maximize returns right now going to
21:44maximize my capital inflow uh and then
21:46I'll just use that Capital to pay for
21:48that those $50 you know dollars per ton
21:50later and we'll figure out the the
21:52carbon price later I can just divest the
21:53worst assets uh if if they're if they're
21:56really costing me money that would be
21:58the other that would be the kind of the
22:00business of business is business of bir
22:02most fin You Know Chief Financial
22:04officers they have the ability to do
22:06that strategic thinking that longer term
22:08thinking they have the ability to take
22:10that carbon price and say yeah that I
22:12think that is material risk I can model
22:13that out um do they do it is kind of the
22:18other question but they do actually have
22:20the ability to do it and shareholders
22:21have very little recourse um to to tell
22:25that Chief Financial Officer you cannot
22:26consider that risk they have the ability
22:29to do it the the counterargument is is
22:32like a pension fund um where there are
22:36rules set down by the regulator uh that
22:40essentially say you have hundreds of
22:42thousands of shareholders you know all
22:43these people who are putting their
22:44pension money into your fund you cannot
22:47assume anything about those those
22:49shareholders other than they want
22:51maximized returns and they they put that
22:54into the regulation that assumption like
22:56you can't assume that they want to save
22:58world you can't assume that they want
23:00their children to live a good life you
23:02cannot assume any of that you have to
23:04assume maximization of returns is the
23:05only common value of those of those
23:08shareholders so that's codified in
23:10regulation it's codified in liability
23:13and and the way the courts have treated
23:15it so some fiduciaries are really really
23:18constrained in how much they can how
23:20much externalities or risk that they can
23:24assume uh for future performance for
23:27those fiduciaries they've got a put in a
23:29policy that says we will consider these
23:31risks that their shareholders can then
23:33vote on or approve or disapprove if they
23:37go against or without a policy then they
23:39can get into trouble so different
23:41fiduciaries have a lot of different
23:43flexibility it turns out um to consider
23:45this risk uh and it's a mistake to say
23:49like that we have to be really
23:51monolithic in our fiduciary duty to say
23:54I'm I'm never going to consider any risk
23:57that is not demon monly and shortterm
24:02maximization yeah great thank
24:05you um why do you think that this is an
24:08important area of focus now this shift
24:12in understanding of fiduciary duty and
24:15liability to me it's it's critical and
24:17it's related to their previous
24:19conversation about ESG risk a lot of ESG
24:21risk is unpriced Right a lot of the the
24:25and and it and it can have risks to the
24:27very system that we're working with him
24:30so if I took a strict fiduciary
24:33definition of maximization of return um
24:38then it would be really difficult for me
24:40to consider any of these unpriced risks
24:43um because I'd be afraid of getting sued
24:45or you know thrown out of my my position
24:47as a as a manager um so anyone that kind
24:52of comes to this conversation and says I
24:54have fiduciary duty to not consider
24:57those risks given the nature of those
24:59risks that is a hindrance um to to
25:03considering these these these ESG
25:05factors um and if you're really strict
25:07about that that definition um that kind
25:11of Freedman Doctrine then ESG most of
25:15ESG just will will never be considered
25:17it's very very difficult to consider it
25:19so it's incredibly important for you
25:22know for for consideration of ESG RIT
25:26large uh that we have a a better
25:29understanding of fiduciary duty and the
25:31flexibility of f fiduciary duty great
25:34thank you all right final question here
25:38so backlash against sustainable
25:40investing strategies has seemed to have
25:42a chilling effect at least in how loudly
25:44investors are talking about ESG for
25:47asset managers hesitant to engage in
25:49sustainable investing what would you
25:52want them to take away from your
25:55research so I mean my main message to to
25:59an investor that's thinking oh I
26:00shouldn't do sustainable investing is um
26:04I don't care what you call it yeah um
26:07You can call it ESG investing you can
26:09call it you know ostrich Farms I don't
26:11care what you call it um the the core of
26:15the issue is are you are you addressing
26:20the financial risks that are most
26:21material to your investment um and if
26:26that's you know it's one one investment
26:29manager could come to that question and
26:32say I am I'm only going to consider the
26:35absolute you know shortest term best
26:39defined uh financial data that's how I'm
26:42going to run my fund um I'm not going to
26:44consider anything that is extra
26:46Financial um or even more specifically
26:49I'm not going to consider anything that
26:51is that could be a risk um because
26:54that's not my job um that I think is is
26:58a a I think I think that is a a terrible
27:00approach to investing because you don't
27:02see any risk on the horizon you don't
27:04see any opportunity on the horizon but
27:06some fiduciaries are are constrained to
27:09that for the rest of us
27:13um you should be considering the most
27:16material risks and opportunities to your
27:18Investments over whatever time period
27:20you're thinking of holding those
27:22Investments and I would put money on a
27:25great deal of money that environmental
27:27and social risks are some of the
27:29predominant risks and opportunities that
27:31you should be considering and if you're
27:33not considering risks like climate
27:35change or socioeconomic inequality or uh
27:39water scarcity or um you large scale
27:43migration around the world human
27:45migration around the world or the
27:47collapse of ecosystems um then you are
27:52missing orders of magnitude of of of
27:56returns that that you should be aware of
27:59I'm not saying that you should invest
28:00you know for ESG I'm not saying you
28:02should label for ESG saying that you
28:04need to understand risks and most of the
28:06risks that you're going to consider are
28:08going to be ESG related in the future so
28:12so yeah that labeling doesn't matter to
28:13me in fact to the chilling effect you
28:16mentioned there's a chilling effect the
28:18chilling effect is on the labeled funds
28:21of ESG I don't actually think there's
28:24been any chilling of the consideration
28:26of risks by assets managers I think they
28:29just said stopped calling DG and they
28:31sort of said there are some financially
28:33and material risks that happen to be
28:35environmental or social of nature we
28:37will cons we will continue to consider
28:38those right great well thank you so much
28:43I really appreciate it that is the end
28:45end of our set questions but this has
28:47been super helpful I've learned a ton so
28:50I really appreciate you taking time to
28:52chat with me it's my pleasure hope it's
28:55hope it useful hope it didn't yeah yeah
28:57that's great that's great well yeah
28:59thank you so much Todd I really
29:01appreciate it yeah of course anytime
29:03yeah all right have a great rest of your
29:04day bye bye

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