EC Corporate Governance Initiative Series: 'Diagnosis Before Treatment: The Use and Misuse of Evidence in Policymaking'

I commend the European Commission for producing an extremely timely report and for being committed to ensuring that business works for wider society, not just short-term profit.

However, given the substantial risk of unintended consequences, it is essential to base any reform on the highest-quality evidence. In places, the evidence presented in the report is very one-sided and low-quality. At times, it reads as if the authors have already decided that companies and markets are short-termist, and that short-termism is a cause of most of society’s major problems, and then have searched for all evidence—regardless of quality—to support this contention, while ignoring even high-quality evidence that suggests the opposite.

This matters. While short-termism is indeed a problem, not every aspect of the economy is short-termist, and short-termism is not the cause of every problem in society. An accurate diagnosis of the problem is critical in order to guide the appropriate treatment, rather than labelling everything as short-termist and interfering with parts of the economy that are generally well-functioning.

The following thoughts are grounded in rigorous academic research, which uses large scale datasets and, in many cases, demonstrates causation rather than correlation. Certainly, evidence should not be used dogmatically—we should be guided by evidence, not blindly follow it. Moreover, it is important to be critical of the evidence. There is a huge range in quality of academic evidence, and most papers are wrong, or at best misleading. The top academic journals reject up to 95% of papers; lower-ranked journals have substantially laxer standards. It is almost always possible to find ‘evidence’ that supports what one would like to show, often ignoring the quality of the journal in which it was published, or whether it has even been published. The peer review process at the very top academic journals is critical to ensure the integrity of evidence. Many papers remain unpublished after several years because they have constantly failed peer review due to major mistakes.

It is surprising that such an influential document was produced by a consultancy with no academic co-authors. I recognise that academics were interviewed, but this is very different from an academic being a co-author. I have very deep respect for practitioners and they have much greater knowledge of individual companies that any academic. But, for a study which aims to be grounded on evidence, academic oversight is necessary.

The main issues that I have raised in my submission to the Commission’s consultation are as follows:

1. Shareholder value is an inherently long-term concept. The study frequently uses the phrase ‘short-term shareholder value’ and its variants. This makes no sense, because shareholder value is an inherently long-term concept – it includes all of the future cash flows of a company. A company that cuts value-creating investments in stakeholders is maximising short-term profit but harming shareholder value. Thus, the solution to short-termism is actually a greater focus on shareholder value, not less.
2. Shareholder value and stakeholder value are aligned in the long-term. The study implicitly assumes a ‘fixed pie’ mentality throughout, where the only way to increase stakeholder value is to reduce shareholder value; conversely, reducing shareholder value will automatically increase stakeholder value. However, the pie is not fixed. Evidence shows that a greater focus on shareholder value (not short-term profit) leads to an increase in stakeholder value. In contrast, reducing the CEO’s accountability for shareholder value can lead to her pursuing her own interests, shrinking the pie for both shareholders and stakeholders.
3. Quantitative ESG metrics are inherently incomplete. There is a significant role for quantitative ESG metrics, but they must be used with extreme caution as they omit many important qualitative dimensions. For example, quantitative measures of jobs created, wages, and working hours ignore many important qualitative dimensions such as meaningful work, skills development, and corporate culture. Thus, while companies should set targets and report on progress, they should beware of focusing excessively on meeting goals else they may ‘hit the target, miss the point’. For the same reason, such targets should generally not be included in remuneration packages.
4. Shareholder payouts have a key role in creating value for wider society. Dividends and especially share buybacks are two of the most misunderstood corporate actions. Many of the accusations are based on no evidence, and in fact strongly contradicted by the evidence. For example, while both lead to a short-term stock price increase, the long-term stock price rises even more. Moreover, both forms of payout are critical to reallocate capital away from mature firms with poor investment opportunities to growing firms with good investment opportunities. While there are cases in which shareholder payouts are misused, they are often the symptom of underlying problems (eg, short-term pay packages or a focus on quarterly earnings) rather than the problem itself. Solutions should tackle the root cause.
5. The focus on long-horizon investors, and encouraging them through loyalty schemes, is based on a fundamental misunderstanding. It mixes up the horizon of an investor (whether they hold for the long-term or short-term) with their orientation (whether they sell based on short-term or long-term information). An investor may sell a company, despite good short-term earnings, because it is insufficiently investing for the long term. Encouraging long-horizon investors may lead to investors remaining with the company regardless of its treatment of stakeholders, thus entrenching management.
6. Sustainability cannot be legislated; attempts to do so will lead to compliance rather than commitment. The study treats sustainability as a compliance exercise, suggesting that it is something that companies need to be forced to do because a focus on ‘short-term shareholder value’ would lead to companies ignoring sustainability. A far more effective approach is to emphasise the business case for sustainability—that it is in a company’s own interest to take sustainability seriously, as doing so improves long-term company performance and thus shareholder value. This will encourage companies to truly embed sustainability, rather than doing so to the minimum possible to comply with the law. The emphasis is ‘long-term’, so any regulatory changes should be to encourage a long-term focus, rather to discourage a shareholder value focus. In contrast, regulatory changes to attempt to legislate sustainability may backfire—for example, companies may focus only on the quantitative sustainability measures included in executive pay contracts, rather than the very many qualitative dimensions of sustainability.

Alex Edmans is Professor of Finance at London Business School and author of “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”.

This post is part of the new OBLB series: ‘European Commission Initiative on Directors' Duties and Sustainable Corporate Governance’.