It’s bruising to work in ESG/sustainable finance right now.
One week, a narky tweet by Elon Musk calling ESG a scam, followed by a pile on by the American right.
The next, a damning special report in The Economist with a cover picture of a pair of scissors snipping off the E, accompanied by the withering strapline: “Three letters that won’t save the planet.”
ESG, the magazine says, should be boiled down to one simple measure: emissions.
Some of us can remember – not so long ago – when The Economist argued that emissions were of no concern to business and finance at all.
But let’s not be bitter, he says, uncomfortably digesting The Economist’s pejorative-strewn overview that pooh-poohs “woke capitalism” and sustainability “flimflam”, calling it the “unholy mess that needs to be ruthlessly streamlined” (shades of the French revolution…) before flourishing the name-calling coup de grace: ESG as “Exaggerated, Superficial Guff”.
At least the latter made me laugh.
We must now rise to the challenge. If The Economist does a critical ESG “special” and Musk launches a Twitter missile, we’re making headway!
Before taking on The Economist’s principal discussion points, it’s clear that even truncating ESG to “emissions” entails a huge amount of S and G in terms of the labour/societal implications of the clean energy transition and governance/strategy shifts required by policy makers and business/finance heads.
Indeed, The Economist makes the point itself, while claiming the contradiction for ESG partisans.
It says: “Closing down a coal mining firm is good for the climate but awful for its suppliers and workers. Is it really possible to build vast numbers of wind farms quickly without damaging local ecology? By suggesting that these conflicts do not exist or can be easily resolved, ESG fosters delusion.”
That’s exactly what ESG research doesn’t do, and no one I know has ever suggested that these complex interactions are easily resolved. Except now for The Economist, which is suggesting they should be abandoned entirely to focus on “emissions”.
It’s an example, I think, of the muddled thinking and pigeonholing – often wilfully – that permeates much of the critique of ESG.
Is ESG the finished article: hell no! It’s not even past the first paragraph as it extends into regulation and policy.
Are there major issues to be resolved? Yes… and then some.
But is that a reason to smack down when the issues ESG is grappling with – increasingly dangerous climate change, biodiversity loss, pollution, gross human rights violations, stark inequality and health problems, labour abuses, creaking democratic political systems – are often inter-related, becoming societally more problematic, massively expensive (those classic, pesky externalities) and financially relevant to investors and those whose money they steward?
Many of these issues have also been codified into international standards, even if far too often they have escaped tougher regulation.
Finance has power and responsibility in a market economy, especially when politics is increasingly captured by lobbying and short-term thinking. How it responds is paramount. It is not just about the impact on investment returns, but the materiality to society.
Definition and differentiation
There are some interesting articles in The Economist’s special report, and it merits close reading and consideration.
But one classic “framing” it deploys is to define ESG by asset manager product responses – and then to suggest that they are all the same.
ESG is not this. It can’t be easily homogenised. But that’s OK. Few people in finance think “hedge fund” means one thing.
Neither are all asset managers the same in their approach to ESG.
There is greenwashing (where isn’t there?). It needs rooting out, especially for retail clients. Institutional clients can look after themselves.
The recent strong action of US and German regulators over such claims should restrain such showboating.
We must also accept responsibility though for some of the incomprehension around ESG.
Claims are made about the size of sustainability “assets” – for example, the $35 trillion in ESG that is often bandied around – but this is a veneer of actual “sustainable” investments, as much of it is investment integration or engagement strategies with unclear outcomes.
And ESG has too readily imitated the language and behaviour of finance in order to be taken seriously, when it is seeking to redefine/reshape it.
Misnomers such as the ESG industry or ESG investing have developed.
These were never the intention in pushing for investors to take sustainability externalities seriously, while simultaneously arguing that policymakers should regulate and price the same.
I’ve already argued in Responsible Investor that I think the claim by Tariq Fancy and others that ESG has become a distraction from political/regulatory change is simplistic and unfair, so I won’t re-tread that.
But let’s take on the three main critical thrusts of The Economist.
The first is that ESG “lumps together a dizzying array of objectives, provides no coherent guide for investors, risks setting conflicting goals for firms, fleecing savers and distracting from the vital task of tackling climate change”.
On the first two points, I think the only response is yes, this is complex. Regulation at the EU-level and beyond is clarifying/prioritising this, albeit imperfectly. We are dealing with difficult ethical, societal and financial issues. Some will be relevant to investment choices. Some may be less so, but still important to clients or a broader licence to operate. The “fleecing savers” critique (I’d be less dramatic in the language) is being looked at both for ESG, and investment/finance more broadly. Caveat emptor applies, but much clearer information is necessary.
We certainly need more attention on climate, but it shouldn’t be at the expense of other important, related sustainability issues.
The bottom line
The industry’s second problem, The Economist says, is that it is “not being straight” about incentives. “It claims that good behaviour is more lucrative for firms and investors. In fact, if you can stand the stigma, it is often very profitable for a business to externalise costs, such as pollution, onto society rather than bear them directly.”
I take issue here with the lumpen “ESG industry” moniker and the aspersion that it is hoodwinking the business world.
There has been a simplistic double/triple bottom line formulation (people, planet, profit). One of the pet hate phrases among RI journalists has been “doing well by doing good”. It is, of course, much more complex than that.
On empiricism: there are studies that show that ESG activities can improve business/investment outcomes, and some that show negative correlation. There are no simple answers. It depends on what you’re doing. Investment “materiality” changes over time, sometimes slowly, sometimes rapidly.
On the externalities question, the counterfactual must be true – that society should and will seek to appoint costs back to the polluter, so to speak. This is, in part, what ESG is.
The Economist’s third main point is that ESG has a “measurement problem”. “The various scoring systems have gaping inconsistencies and are easily gamed. Credit ratings have a 99 percent correlation across rating agencies. By contrast, ESG ratings tally little more than half the time. Firms can improve their ESG score by selling assets to a different owner who keeps running them just as before.”
The direct comparison to credit ratings agencies is erroneous. ESG ratings are often not based on mandatory information, whereas credit ratings rely largely on statutory financial reporting. ESG “ratings” are akin to financial research, dressed in ratings clothing. Financial research comes in many hues, as investment banking buy/sell research shows.
Credit ratings is a multibillion-dollar industry and its decisions move markets. If only ESG ratings had that power. That many ESG raters are now owned by credit ratings firms indicates how this will likely evolve. The gaming of ESG data and asset buck-passing will be mitigated by stronger international regulation and financial reporting requirements. Both are underway, the latter via the International Sustainability Standards Board, whose recent consultation is already the subject of huge debate around the double materiality question between how information is required that represents so-called “enterprise” value or societal externalities.
Road to enlightenment
Is any of this easy? No. But the reality is that there is now important work being done by policymakers, regulators, companies and investors. A huge amount more is needed, and it must be more practical.
We need a lot more good finance and a lot less bad finance to resolve our most pressing challenges.
There is much to be done in blended finance, working with industries to transition, incubating new business models (circular economy, impact and development capital, etc), and more muscular shareholder engagement and voting to reduce externalities.
There is also much debate and clarification required about how “sustainability” is measured, contextualised and targeted if it is to be meaningful for policy.
I’m going to drop down into these important discussions in forthcoming pieces. I’d be interested in hearing your thoughts.
We are, I think, somewhere between the “plateau of inflated expectations” and “the trough of disillusionment” described in an article on RI last year.
Now comes the hard climb to the ESG “slope of enlightenment” and “plateau of productivity” that must follow.
Hugh Wheelan is a journalist and board member at ShareAction: email@example.com