Why everyone hates ESG
Environmental, Social & Governance (ESG) has attracted its fair share of detractors as it’s become a more established way for investors and other stakeholders to understand and compare corporate performance. Initially, criticism came from right-leaning folks who said the shift to “woke capitalism” wasn’t representative of the company’s business interests. Now more criticism is coming from the progressive side of the spectrum, who take the opposite stance: that ESG is a marketing ploy which misrepresents itself as altruism when it’s actually all about maximizing shareholder wealth.
There are certainly a lot of misconceptions around what ESG is and what it’s not. A lot of the confusion comes down to how companies use ESG data to make decisions.
How ESG Data is Used
ESG data is just that — data on environmental, social, and governance factors. It can be applied in different ways. To oversimplify, ESG data can be used 1) to improve a company’s impact on society and the environment (referred to as the “impact orientation” in this post) or 2) to manage how environmental and social factors impact the company’s bottom line (the “risk orientation”).
Impact Orientation
One way that companies can use data on social and environmental factors is to amplify its positive and reduce its negative impact on people and planet. This is referred to as the company internalizing its externalities — addressing costs borne by the community and environment that were caused by the company’s operations. The impact orientation is what comes to mind for a lot of folks when they hear about ESG and don’t read the fine print.
When used this way, ESG strategy and reporting represents a more sophisticated and quantitative step in the evolution of corporate social responsibility. This is a welcome change for social impact professionals (like me) who struggled with the fuzzy, hard to measure nature of corporate social impact. The externality-focused use of ESG data is exemplified by companies like Pategonia, and corporate responsibility certifications like B Corp.
Even though increasing profits isn’t the primary aim, taking an impact-driven approach to ESG does accrue business value, largely through improved business relationships and brand perception. Consumers and employees increasingly expect companies to take a stand on social and environmental issues. Additionally, companies that are concerned with internalizing their externalities will presumably be out in front of their peers in terms of regulation compliance. In order for impact-driven ESG strategies to pay off though, it must be championed at the highest levels and embedded into the company’s culture and operations. Anything less will accurately be perceived as disingenuous by an increasingly discerning public.
Risk Orientation
Despite complaints from some around ESG’s “woke” connotations, most companies — especially big ones listed in ESG indexes — use ESG data to identify and manage risks and opportunities with the goal of increasing long-term shareholder returns. The risk-oriented approach is nothing new: companies have been incorporating social and environmental issues into their risk management strategies for decades. Mega trends like climate change, regulation, and shifting consumer preferences have just made these issues more relevant. For example, a big risk facing fossil fuel companies is that of stranded assets — oil & gas investments and infrastructure that will need to be written off in the future because of reduced demand. Investors will want to see how companies are managing the climate change transition risks by, for example, investing in renewable energy or carbon capture technologies.
This approach enables a clear strategy for incorporating ESG factors into financial valuation and analysis. Despite ESG’s “green” connotations, ESG rating systems and funds use this more pragmatic definition of the term.
Is any ESG a “force for good”?
Even if a company’s use of ESG data is in service of shareholder wealth, one could assume that increasing access to social and environmental information will improve corporate performance in these areas inherently, regardless of how self-serving the intent. The crux of the issue here is around the concept of materiality: how the company decides which ESG issues which are important enough to report on. For companies that take the risk-oriented approach to ESG reporting, materiality is tied to the extent to which environmental and social issues could impact the company’s bottom line. Assuming that any ESG data is better than nothing equates corporate benefit with societal and environmental benefit, two things that do not always mesh.
The tension between ESG for good and ESG for profit is exemplified in the discrepancy between ESG ratings and corporate conduct. There are many examples of the companies’ ratings going up even as their impact on the people and planet worsens. An example featured in this article by the New York Times is of McDonald’s, which was given a better ESG rating even as its greenhouse gas emissions rose, because the rating company didn’t believe increased emissions posed a financial risk to the company. One study (which to be fair gathered data on ESG funds from 2010 to 2018) found that companies included in ESG funds actually had worse compliance records on labor and environmental laws than their non-ESG peers. This inconsistency between the promise and actuality of ESG leads many to believe it’s a dangerous distraction when urgent action on issues like climate change is so desperately needed.
Ok, but what about returns?
The line from ESG proponents is that it improves both social and environmental performance and risk-adjusted returns: a win-win for the community and shareholders. As we’ve already discussed, good ESG performance does not necessarily equate with positive impact on people & planet. The data is equally fuzzy around ESG and shareholder returns. While many studies have shown that ESG performance is positively correlated with financial performance in theory, this hasn’t been always been borne out in terms of ESG fund performance, which have underperformed the market in 2022. This discrepancy leads many people to say that ESG is “the worst of both worlds”.
Path forward
At this point I should acknowledge the fact that this criticism is coming from me 👋 someone who has arguably dedicated a significant chunk of their life towards helping companies pursue ESG strategies. ESG is a burgeoning field and I think it’s possible and important to recognize its shortcomings while still believing in its potential. Many folks agree there are 3 things that need to be done to help ESG get to where it needs to be.
Common language: ESG currently involves a broad range of stakeholders — investors, business leaders & the social impact sector to name a few — each of whom have a unique perspective of and priorities around ESG. Until they share a common language and taxonomy around sustainable accounting and investment terms and strategies, productive discussion will be impossible. A future set of definitions, for example, could separate “ESG” investments from “impact” investments per this letter from Blackrock co-founder Barbara Novick.
Reporting integration: Aligned with the need for clear terminology around ESG is the need for a cohesive framework for measuring ESG performance. There are currently a plethora of ESG reporting frameworks which companies can choose from to guide their disclosures, which makes this difficult. At the U.N. COP26 climate talks in 2021, the International Sustainability Standards Board (ISSB) was established in order to merge the many ESG disclosure standards into one, and to encourage the uptake of these standards globally.
Government intervention: The problem with ESG is that what’s material for companies is not necessarily what’s best for people and planet. Clear regulation is needed to incentivize companies to protect the interests of diverse stakeholders. In March of this year, the SEC took a step in this direction by proposing new requirements for public companies to disclose greenhouse gas emissions from their operations as well as their strategies to address climate change risk.
ESG is exciting because it makes it possible for companies to report on environmental and social measures in a comparable way — something that wasn’t possible in the past. While ESG in itself is not a magic bullet for the ills of capitalism, when combined with more rigorous policies and consistent demands from consumers, employees, and community members, it has an important role to play in creating a future where companies are held accountable for how they treat the people and environment they rely on.
