David Veredas: ‘When There Is No Obligation, Companies Push The Cost Onto Others’

David Veredas: ‘When There Is No Obligation, Companies Push The Cost Onto Others’
What is the best way to encourage companies to become more sustainable? And how do we ensure that they take into account the external effects of their activities more? In addition to executives, according to David Veredas, professor of Finance and Sustainability and director of the Center for Sustainable Finance at Vlerick Business School, governments also have a role to play: ‘They should encourage market parties to behave responsibly.’

The statement made by economist Milton Friedman that a company's goal should be to maximize profits for shareholders is well-known. However, few are aware that this statement is incomplete, according to David Veredas. In his article published in the New York Times in the 1970s, Friedman added that the pursuit of profit must also comply with the limits of the law.
This additional qualification is significant as it highlights the role of the government in establishing frameworks for economic activities and encouraging responsible behavior among market participants. It emphasizes the importance of operating within these established regulatory and legal boundaries to avoid causing damage to public goods. Currently, companies often pollute with impunity, violate biodiversity, or emit greenhouse gases, resulting in public losses while their own profits remain unaffected.

It raises an intriguing point: externalities often come at the expense of public goods. Could you provide further insight into this matter?
‘Public goods, such as air quality and biodiversity, are collectively owned and cherished by society, but are not the responsibility of any single entity. Unfortunately, companies often neglect the damage they cause to these public goods or view measures to mitigate harm as unnecessary expenses. Consequently, they fail to consider the side effects of their economic activities in their decision-making processes, pushing the costs onto others.
In my view, it is the government's duty to ensure that companies account for these externalities. The government carries a fiduciary obligation to prevent companies from transferring the adverse side effects of their actions to others, but also to stimulate positive outcomes. This concept of internalizing externalities is already being pursued in Europe through laws, regulations, and market monitoring mechanisms like the European Corporate Social Reporting Directive (CSRD) and the European Emissions Trading Scheme (EU ETS). Although progress has been made, more needs to be done to address this issue comprehensively.’

Considering the macroeconomic level, what measures can be implemented to further sustainability?
‘To advance sustainability, we need to adopt alternative measurements that incorporate externalities. Traditional indicators like Gross Domestic Product (GDP) fall short in capturing the true essence of prosperity as they primarily focus on economic activity. GDP, introduced by Simon Kuznets after World War II, fails to account for the magnitude of externalities stemming from production and consumption. For instance, to name a well-known example, it disregards the work of a housewife or -husband (including the very time consuming but tremendously valuable activity of raising children) or acts such as philanthropy or volunteering. Similarly, it neglects to take into account crucial factors such as pollution, biodiversity loss, resource depletion, and climate change.
One alternative measure gaining traction is the Genuine Progress Indicator (GPI), which considers GDP along with the positive or negative value of externalities. If we analyze the GPI for the United States since the 1970s, we observe that while GDP has seen tremendous growth, the GPI has remained relatively stagnant due to various adverse social and environmental impacts.’

Which ‘megatrends’, primarily, can drive sustainability forward?
‘The three most important factors driving the climate and biodiversity crises are: population growth, technological development, and economic growth. These three factors can be represented through the Kaya identity, a simple equation. Solving the environmental crises must address all three these components.
Curbing population growth is a sensitive and politically complex issue. While investing in clean technologies is part of the solution, it is important to recognize that ‘cleantech’ alone is not a panacea. In the long run, addressing economic growth becomes the most crucial aspect. Certain sectors of the economy must experience degrowth, allowing unsustainable activities to shrink while encouraging growth in sectors like the circular economy, the digital economy, and the knowledge economy.’

Does this not imply that the overall economy will have to shrink? This argument is often made.
‘This is debatable, and it depends on the activities in the economy. Theoretically, it is possible to continue growing while embracing responsible practices. Responsible growth involves considering all external effects and ensuring that it remains within the ‘Limits to Growth’ as it was referred to already in 1972 in the study commissioned by the Club of Rome. This study has to this day remained extremely relevant, as we are approaching the limits of the ecosystem to absorb wastes and replenish raw materials to sustain the economy.
If any shrinkage of economic activities is required, it should ideally occur primarily in developed countries. Developing countries, on the other hand, should focus on responsible and sustainable growth. Europe and the United States, as significant contributors to greenhouse gas emissions since the industrial revolution, hold an historic responsibility to compensate other nations for the damage caused - that is, internalizing the historical emissions. Supporting these countries in making their economies more sustainable can be achieved through instruments like trade agreements, education, diplomacy, financial aid, and technological cooperation.’

We discussed the importance of understanding the true value creation of businesses, identifying externalities accurately, and the significance of sustainable growth and contraction. Price incentives are one way to achieve such a scenario. You mentioned the European emissions trading system as a successful method to internalize externalities. Could a similar system be implemented on a broader scale?
‘There are voices advocating for the expansion of such systems. Initiatives are already underway. However, these efforts are still in their early stages. Implementing such a system more broadly presents sensitivities as it involves placing a monetary value on nature and establishing a market around it. This will need to be controlled studiously or it can do more harm than good.’

For board members seeking to make their businesses more sustainable, what actions can they take?
‘Engaging in knowledge exchange with other executives and learning from one another is always beneficial. Vlerick Business School, in collaboration with Chapter Zero Brussels, facilitates peer-to-peer learning through the Director Climate Journey (DCJ). This program supports and is supported by the Sustainable Governance Principles of the World Economic Forum. This hybrid four-day training program equips board members with insights into the scientific, economic, leadership, and legal aspects of climate change and sustainability-related issues. Participants learn how to integrate these considerations into their strategies, risk management, and reporting.
A year after the end of the program, the participants return to campus to report on their progress within their respective organizations. Participants who achieved a significant leap forward on sustainability are invited to present their accomplishments to fellow participants. This collective effort contributes to board members becoming ‘climate competent.’

What does it mean to be a ‘climate competent’ executive?
‘A climate-competent executive possesses sufficient knowledge regarding the impact of climate change and other sustainability topics on a company's economy, strategy, finances, and stakeholders.
Such individuals can ask informed questions and view sustainability as an opportunity rather than merely a cost or threat. This perspective aligns with research conducted among 1,500 companies in the MSCI index, which demonstrates that companies strongly focused on sustainability tend to have a lower cost of capital compared to those with lower Environmental, Social, and Governance (ESG) scores.
Additionally, my own research, conducted with the support of ABN Amro, indicates that sustainably driven small and medium-sized enterprises (SMEs) are more creditworthy and resilient, facing lower risks of financial trouble or bankruptcy.
On the other hand, companies that fail to embrace sustainability run the risk of possessing ’stranded assets’ that face unforeseen or premature depreciation, leading to adverse consequences.’

How can Board members integrate sustainability into their decision-making processes?
‘Effective collaboration and garnering support from fellow board members are vital, as sustainability must permeate the organization from the top down.
Top executives must be willing to adapt the governance of the organization to foster sustainability. This entails designing assessment and reward systems that incentivize contributions to sustainability. Furthermore, they should encourage other stakeholders in the value chain to embrace sustainable practices. This is particularly crucial as indirect scope 3 emissions, which often account for a significant portion of greenhouse gas emissions, can reach as high as 90 to 95 percent in sectors like the fossil fuel industry.
Moreover, directors should be transparent about externalities and incorporate them into reporting practices. Recognizing the importance of listening to various stakeholders, such as customers, employees, investors, and society, is essential for understanding and responding to their needs and expectations.’

This last point still faces challenges. Not everyone in society fully comprehends the necessity of sustainability. In the United States, there is even a significant anti-ESG movement, even though ESG measures bring benefits to all parties involved. Measures to combat excessive inequality or limit global warming, for example, offer advantages. What is your opinion on why sentiment towards sustainability is not as universally positive as one would expect?
‘Personally, I find it difficult to grasp. It is surprising that in a highly developed economy like the US, such attitudes are widespread, particularly in states dominated by Republicans. This is particularly astonishing considering the increasing physical effects of global warming they are facing, such as heatwaves in Texas, devastating wildfires in California, smog encroaching on New York due to Canadian wildfires, and the drying up of the Colorado River. Yet, many individuals seem resistant to acknowledging these facts, choosing to deny them rather than confront the challenges head-on.
This situation reminds me of the movie ‘Don't Look Up’, in which the public dismisses the impending threat of an asteroid. Politicians and the media, fearful of losing popularity, appease the public instead of providing proper education. Unfortunately, this approach leads to disastrous consequences.’

This interview was published in Management Scope 07 2023.

This article was last changed on 29-08-2023