“You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.”— R. Buckminster Fuller, author, inventor, and architect
“Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed, it is the only thing that ever has.”— Margaret Mead, anthropologist
“Businesses must reconnect company success with social progress. Shared value is not social responsibility, philanthropy, or even sustainability, but a new way to achieve economic success. It is not on the margin of what companies do but at the center. We believe that it can give rise to the next major transformation of business thinking.”— Michael Porter
“Corporate social responsibility is a hard-edged business decision. Not because it is a nice thing to do or because people are forcing us to do it… because it is good for our business”— Niall FitzGerald, former CEO, Unilever
“Nobody made a greater mistake than he who did nothing because he could do only a little.”— Edmund Burke, Irish statesman and philosopher
“The world will not be destroyed by those who do evil, but by those who watch them without doing anything.”— Albert Einstein
“There are no passengers on spaceship earth. We are all crew.”— Marshall McLuhan, philosopher
“Earth provides enough to satisfy every man’s need, but not every man’s greed.”— Mahatma Gandhi
The ESG – Environmental, Social, and [Corporate] Governance – movement has exploded over the past few years. ESG ratings are now controlling substantial amounts of investing and lending to major businesses. Business leaders are being forced to address expanding ESG concerns and compliance demands, distracting management attention and resources away from the underlying business. And the potential good from ESG suffers as well. Why?
The term “ESG” was originally coined by the United Nations Environment Program Initiative in 2005, but the methodology was not fully applied to the corporate world until the past six years when ESG-based investment skyrocketed.
ESG in practice is mostly about money, you will not be surprised to hear. Investments and loans are preferentially given by banks, mutual funds and the like, and even foundations, to companies that meet the investor’s guidelines of “stakeholder” interests. Companies must show that they are actively pursuing a business environment that suitably prioritizes ESG-defined goals. ESG-based investments are thus highly targeted, growing in size (for now), and very easy to get (for now). Companies are also encouraged to publicly support the ESG movement as much as possible.
This has made ESG into a powerful control methodology for dictating how businesses behave relative to ESG goals.
ESG’s potential for good
The NASDAQ stock exchange ESG metrics list, shown below, illustrates the range of concerns that businesses are increasingly required to address. This is voluntary in principle but not in practice, where it has some grown serious teeth (as noted in the prior post).
ESG ratings are being required and are used by a rapidly growing number of investors and regulators, not to mention hordes of politicians and activists. The growth in ESG-based investor assets, shown below, is estimated to account for 50% of market share globally by 2024. This is a very big stick.
Using the NASDAQ metrics list below as an example, many of its ESG items address some areas of real, common, and substantial concerns. Quite a few of these were almost certainly effectively off the radar in big businesses until recently. No longer: few large businesses can now avoid ESG action targets in decision-making, resource allocation, and managing generally.
Even though there remain huge problems with ESG performance definitions, measurements, and priorities, the areas of focus are clearly important. Significant progress on almost any of these would be considered by most objective folks as being seriously good for nearly everyone.
Consequently, ESG clearly has some major potential for doing good.
As I read somewhere recently, many – perhaps the majority – of ESG concerns are “admirable”. Not necessarily feasible to any significant degree, but good enough to justify concerted efforts to make them visible and be credibly addressed.
And, of course, it is certainly admirable to make an attempt to do something constructive on such concerns even though the likelhood of making anything major happen might be very low. The important point is that we tried our best.
Doing nothing, as was mostly the case in past, is neither admirable nor constructive. Doing something to get things moving is often a very constructive action. Who knows where things will go once a start has been made.
Coercive action is rarely productive or successful
Even though we have a gazillion or more lists of ESG-type things that seem to demand business attention, only a few are feasible in almost any respect, and even fewer when real costs and difficulties involved are considered.
Persuasion can often lead to voluntary action where costs and resource availabilities are realistically addressed. A business may find a way to tackle one aspect of an ESG goal, while other businesses may creatively develop many useful alternatives, specific to their businesses, which might actually work better.
Coercion is most often counterproductive. It may lead to resistance that does no good at all, or to compliance appearances that are mostly smoke and mirrors. You can force some people to do what they are told, but many will try to ignore or divert such pressures for as long as possible.
Even if businesses are mostly on board – at least in principle – with ESG goals at a very high level, constructive responses require digging deeply into details. We need to know what the goal itself means in practice. High-sounding or vague words are useless, or worse.
It does not help, consequently, that most ESG goals have many flavors, and even more understandings and misunderstandings. Businesses are forced to sort out something practical from the multitude of possibilities and often-conflicting views. Having so chosen, the business must then adapt its choice to the details of this particular business as it works toward an action plan.
First, of course, is the matter of measurement. ESG goals are mostly vague – to an extreme, making it difficult or even impossible to measure either current state or progress toward the goal. And, as is so often the case, initial efforts may generate valuable learning that can lead to changes in both the goal specifics and its action plan. This can lead to starting the effort again from the beginning. Time and resources expended on the learning exercise may be largely or completely wasted.
Three simple examples to illustrate:
- Water usage (NASDAQ E6)
With droughts now almost worldwide, water availability and usage are clearly a serious matter. Not much argument here, except over who is responsible for figuring how to fix it locally, or perhaps regionally, and who pays for the fixes.
Government agencies in past typically “handled” this sort of thing, but what happens today with ESG requirements in play? Especially in places where water availability is still adequate or better? Will businesses be willing to “do their part” in a non-emergency situation such as this?
ESG today is likely to pressure larger businesses into action that depends to some extent on ESG-based funding and ESG-sensitive investors (and even customers). The first hurdle, assuming that management decides to develop a real response, is measurement of the business’ water usage in some detail. This requires water meters in each location that offers a potential point of usage control. You can see how this can get costly and disruptive for a large business with substantial water usage. Adding water meters is not always easy and can be quite complex.
When water usage measurement is feasible, there is the next problem of deciding where and how much to seek in usage decreases. Some water may go into production processes that have no flexibility whatever in usage. Or water may go into ponds and fountains that add beauty to the business environment. Do you shut all of these off, or allow only a portion to continue, or try to decrease usage non-uniformly but enough overall to meet a current reduction goal?
- Gender diversity (NASDAQ S4)
This one should be simple in theory: just hire women preferentially until each period’s gender mix achieves the period goal. In practice of course, things get much more complicated.
One example: a business that requires a lot of heavy lifting and hard work under quite nasty conditions. I had several such jobs in my early days in the oil fields. All guys on the crews, mostly big-strong-tough guys (unlike myself); zero women. The very big business that employed us would today be trying to recruit women for jobs where big-strong-tough (and tolerance for getting very dirty and banged up) on a daily basis was unavoidable.
Most if not all women, who tend to be smaller and not as strong or physically tough, are way too smart to sign up for jobs like this. My guess is that such jobs will remain almost entirely male.
So, what to do ESG-wise? If the business consists mostly of these kinds of nasty jobs – think drilling rigs, the business would get a low ESG rating forever on gender diversity. Many investors will not know anything about the gory details so will push to deny loans and stock purchases to this otherwise sound business.
Being restricted in its ability to raise growth or technology capital, the business may fall behind more diversified competitors, and even become unprofitable. ESG can inflict just this sort of damage. The business suffers and ESG’s potential good is not realized. A lose-lose outcome.
- Board diversity and independence (NASDAQ G1 and G2)
If you are not familiar with how big business boards of directors are chosen, you may not appreciate how difficult it can be to achieve any degree of diversity or independence. Board members are typically chosen based on connections, relationships, expertise, experience, and personal factors. These can rarely be subjected to diversity requirements except in perhaps one or two cases. So, the business gets a very low rating on these two ESG governance metrics.
You may also wonder a bit about what “diversity” and “independence” actually mean in practice. There are probably many opinions on this, all possibly equally valid. The board chairman (excuse me, chairperson) may get extra votes on this choice among opinions. A common target for such “governance” ratings is gender diversity and people-of-color diversity, both “social” concerns. A board is too small to even consider such metrics, which can properly apply only to large groups of employees. Even if the two G-metrics are not applicable to boards of directors, many ESG-based funds, investors, and customers won’t know or care.
Again, the business may lose some amount of access to vitally-need growth and development capital. Here, the business suffers and ESG “good” suffers.
The ESG Leash on Business Tightens — While Good Suffers
Pretty clearly, ESG is not going away. It is in fact growing rather quickly in both scope and impact. The growth in ESG-driven investments (fund assets) is shown rather dramatically in the chart below: “Ingraining sustainability in the next era of investing”. These investments can dramatically affect business capital availability and cost, as a prior post argued:
“Deloitte’s Insights studies show that ESG assets compounded at 16% p.a. between 2014 and 2018, now account for 25% of total market assets, and they believe that ESG could account for 50% of market share globally by 2024.”
A weak ESG rating by major ratings firms, even if it is just one of these, may cause a serious decrease in capital availability and increase in capital cost. Such impacts can be major, or possibly disastrous, to a large business.
And focusing on ESG demands going into a recession with inflation (stagflation) is not going to end well for anybody.
Huge impact globally for businesses – now and growing quickly. The nature of the impact and its consequences, however, is so often anything but adequately known and understood. The potential for lose-lose outcomes is very high.
Institutional Investor points out one unexpected, hidden ESG problem in company behavior: “Where ESG Fails”:
“In many cases, companies actually conceal the economic benefit from investors, which reinforces investor ignorance about the importance of social innovation as a source of economic value. Nestle, for example, has for more than a decade reported reductions in sugar, salt, and fat across its product portfolio. Only in 2018, for the first time, did Nestle publicly report that these healthier foods had faster growth rates and higher profit margins than traditional offerings. Nor is the economic value of social impact discussed in analyst calls. If there is any focus on social impact at all, it is usually to address a recent scandal that requires an apology.”
It is naïve at best to assume that businesses impacted by ESG are not going to game the system to whatever extent possible. This response, which should be expected, effectively moves attention away from addressing ESG goals and toward gaming the ESG impact system. Good suffers yet another blow.
This is so unfortunate because the ESG movement has much potential for encouraging good actions and good outcomes.
The threat of nefarious uses of ESG has of course surfaced
Human nature being fully at play in all of this ensures that at least a few players will use ESG for, shall we say, purposes not much in keeping with whatever underlying potential good exists. An example of such uses:
From an article by Cindy Drukier and Tom Ozimek republished from TheEpochTimes.com via Natural News:
“James Lindsay, author of ‘Race Marxism’ and other books challenging woke narratives, has taken environmental, social, and governance (ESG) scores into his crosshairs, calling ESG a weapon in the hands of ‘social justice warriors’ to shake down corporations and a tool in the hands of those seeking to impose ‘one world government.’”
“Lindsay believes the ESG concept was suspect from the very beginning and it’s unclear whether higher scores translated into good long-term profitability for participating corporations.”
“Worse still, he argued that, over time, ESG scores have been hijacked and ‘weaponized’ by ‘social justice warriors.’”
“’They have the leverage to be able to use this like a … financial gun to the head of any corporation that doesn’t do what it wants them to do,’ he said, calling it a ‘blatant weaponization.’”
Perhaps a bit harsh but it does raise some legitimate concerns about how ESG is being used today. Good business responses and outcomes are not highly likely in many such cases.
An institutional investor publication’s take on ESG in practice
The Institutional Investor publication offers this additional information about ESG in reality and with more balance:
“Even more recently, the movement to embrace a corporate purpose has drawn further welcome attention to social impact, but has also added to the confusion about its significance for competition. BlackRock CEO Larry Fink wrote in his most recent annual letter to corporate CEOs that investors should increasingly expect companies to have a social purpose. Yet purpose statements have usually been public relations exercises, disconnected from a business and its economic performance. A generic corporate ‘purpose’ creates neither social nor shareholder value. When a company devises and articulates a purpose integral to its business, however, the result is often to create unique stakeholder value. A social purpose that is truly strategic must build on and reinforce the company’s unique value proposition and competitive positioning. Companies whose employees recognize such clarity of purpose have been shown to deliver superior shareholder returns in research by Claudine Gartenberg of University of Pennsylvania, Andrea Prat of Columbia University, and Serafeim, whereas feel-good purpose statements have little impact.”
“Creating social impact through an innovative and profitable business model reshapes the nature of competition and makes social impact a part of capitalism itself. This requires going way beyond a checklist of material factors.”
“… Each of these companies reinvented an aspect of its operations in a distinctive way that created shared value, although most of these innovations would not necessarily improve the firms’ ESG rankings based on existing methodologies.”
“As these examples suggest, creating shared value is fundamentally distinct from making incremental improvements in a long checklist of ESG factors that tend to converge over time in any given industry. Shared-value companies make a different set of choices than their competitors, building a distinctive social impact into their business models. As a result, they deliver different returns to their shareholders. Shared-value strategies such as these go far beyond traditional, siloed ESG thinking by tying social impact directly to competitive advantage and economic performance. This is by far the most powerful way for companies to help address the world’s grave social challenges.”
The ESG – Environmental, Social, and [Corporate] Governance – movement has definitely exploded over the past few years. Despite still-limited mandatory compliance, ESG ratings are now affecting substantial amounts of investing and lending to major businesses. Business leaders are effectively being forced by investor and other groups to address expanding ESG concerns and demands for compliance, distracting management attention and resources away from the underlying business. An unfortunate consequence is that the potential good from ESG suffers as well in so many cases.
- A possible origin of the ESG terminology is described briefly by ESG Analytics in “Where did the term ESG come from anyway?”:
“So where does the term ESG come from?
The first group to coin the phrase ESG was the United Nations Environment Programme Initiative in the Freshfields Report in October 2005. According to Paul Clements-Hunt who was leading this work at the time, the initial view was that it should be called GES since they believed Governance was most the important area, followed by Environmental and Social. But it was decided that GES was ‘not so catchy, not so sexy’. Instead, they thought the E was ‘sexy’ upfront, and that the S should go in the middle as it was most likely to be ‘flicked off the end by Milton Friedmanesque lobbyists’. And that’s how they decided upon ESG as the winning acronym. It was subsequently ‘concertised’ into sustainable finance and responsible investment in the ECOSOC Chamber at UNHQ. Paul Clement-Hunts concludes: ‘We never could have imagined where it would end up.’”
- If you are not entirely clear on the difference between ESG and “sustainability”, here is what social platform provider Brightest has to say: “Defining ESG vs. Sustainability – What’s the Difference?”:
“The Difference Between ESG and Sustainability”
1. ESG is about company stakeholders, identity, and decision-making — the board, CEO, employees, shareholders, and other stakeholders — whereas sustainability is about the relationship between a company and the environment.
2. ESG is an investment framework that helps external investors assess company performance and risk, whereas sustainability is a framework to make internal capital investments (i.e., installing LED light bulbs or other energy efficiency measures, electrifying a transportation fleet, purchasing sustainability measurement software).
3. ESG is based on standards set by lawmakers, investors, and ESG reporting organizations (e.g., GRI, TCFD, MSCI), whereas sustainability standards — while also set by standards groups like GHG Protocol — are more science-based and standardized. There are dozens of different frameworks for measuring ESG, whereas carbon (CO2) is carbon and we don’t need to get too creative with nature and physics.
4. ESG includes sustainability as one of its three pillars, but also incorporates broader social and corporate governance considerations.
5. ESG is typically more relevant for large companies who are listed on public investment exchanges or who need financing from institutional investors. However, as more banks and financial services firms themselves adopt ESG principles around their business, ESG is also increasingly becoming more material to startups and smaller organizations.”
“This overall risk and materiality profile of ESG is a key place where it differs (and goes beyond) sustainability. For example, a company could have a completely carbon-neutral, zero-waste, renewable-powered manufacturing facility, but if that facility is wildly dangerous to work in from a workplace health and safety standpoint (i.e., employees are getting injured on the job all the time), the company still isn’t meeting its ESG obligations despite, again, achieving environmental sustainability on paper.”
“The opposite can also be true as well. A company might have strong governance and very detailed, thorough ESG reporting, but its core business model can still be bad for the environment.”
- And, last but not least, it seems important to describe sustainable investing. Here is what Investopedia has to offer on “Environmental, Social, and Governance (ESG) Principles and Criteria”:
“Sustainable Investing: Socially Responsible Investing: Environmental, Social, and Governance (ESG) Criteria”
“ESG investing is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI). To assess a company based on ESG criteria, investors look at a broad range of behaviors and policies.”
“Types of Environmental, Social, and Governance (ESG) Criteria
ESG investors seek to ensure the companies they fund are responsible stewards of the environment, good corporate citizens and are led by accountable managers.”
“Environmental. Environmental criteria may include corporate climate policies, energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can also help evaluate any environmental risks a company might face and how the company is managing those risks. Considerations may include direct and indirect greenhouse gas emissions, management of toxic waste, and compliance with environmental regulations.”
“Social. Social criteria look at the company’s relationships with stakeholders.
Does it hold suppliers to its own ESG standards? Does the company donate a percentage of its profits to the local community or encourage employees to perform volunteer work there? Do workplace conditions reflect high regard for employees’ health and safety? Or does the company take unethical advantage of its customers?”
“Governance. ESG governance standards ensure a company uses accurate and transparent accounting methods, pursues integrity and diversity in selecting its leadership, and is accountable to shareholders. ESG investors may require assurances that companies avoid conflicts of interest in their choice of board members and senior executives, don’t use political contributions to obtain preferential treatment, or engage in illegal conduct.”