ESG is everything and nothing
ESG has challenges, but does it need to end?
ESG is not easy. It has multiple facets, forcing us to think in multiple dimensions, but it is far from being executed well by corporates and investors. There are a lot of interpretations out there, but ultimately ESG is focused on the long-term value and materiality of issues on a company or the world’s impact on the company.
Liz Simmie, Co-founder of Honeytree Investment Management, simplified it for me once…and she reminds me regularly, like in this Tweet:
The first time she told me that, something clicked in my head. After that, I began to see ESG in every business challenge and news story. For example, last week, I posted a link to What companies still get wrong about layoffs, which includes the intangible costs of layoffs. Quickly after, we saw significant layoffs in big tech. If you’ve been on LinkedIn or Twitter, you’ve probably seen the fallout for those laid off and employees left behind. Layoffs are an example of an ESG issue as it impacts one of a company’s most important stakeholders, its employees. It can also damage a company’s reputation and talent pipeline.
With ESG front and center everywhere I look, imagine my surprise when I saw Alex Edmans, author of Grow the Pie and Professor of Finance at London Business School, launch a paper called The End of ESG. But, wait, hold the phone, stop the presses, time out! If ESG is everything, how can it be over already?
As it turns out, he makes a pretty good case, one that business leaders, academics, and politicians should consider. We’ll start with the paper's main idea and then move into two related issues - disclosure and externalities. Finally, we’ll take a quick look at one big reason ESG should stick around.
NOTE: At this point, it is worth calling out that I have great admiration and respect for Edmans. He is far above and beyond my capabilities and forms opinions based on research, which he covers throughout Grow the Pie. So, as with all my newsletters, this is how I’ve processed the paper and meant to get you thinking!
The End of ESG: You should already be focused on long-term value
As I looked around LinkedIn, I saw Edmans paper posted in several places. As usual, the provocative headline won the attention, but the content is where it counted. Edmans thoughtfully crafted the title from a previous paper with good reason. Richard H. Thaler’s paper, The End of Behavioral Finance, predicted the mainstream integration of behavioral economics into finance.
So, I opened the paper and found relief in the opening line.
ESG is both extremely important and nothing special. It’s extremely important because it’s critical to long-term value, and so any academic or practitioner should take it seriously, not just those with “ESG” in their research interests or job title.
That opening statement reminded me of Liz’s eternal truth, so I was briefly locked in a manic mental puzzle akin to Schrödinger's cat. ESG resides in both states as everything and nothing special. Edmans states that ESG isn’t niche, but I think it is, at least at this unique moment. Like the famous physics puzzle, further observation was required.
Edmans describes how ESG is nothing special next to other intangibles that drive long-term value—centering on this perspective reframes the entire discussion, potentially solving many current problems and confusion around ESG, like those driving political controversies.
ESG isn’t unique or different because it represents things you should already be doing.
Ironically, you can’t address long-term value and resilience without the last letter of ESG, quality governance. Boards must have controls and pay attention beyond the next quarter’s results. Having spent most of my career in IT and now sitting in sales, I can tell you that those holding the purse strings look quarter to quarter all too often when there should be an investment in protecting long-term value (see the Cybersecurity examples from a few weeks ago).
If a board does have quality governance, Edmans is correct. In this world, boards function well and understand how investors uncover long-term value, and it makes sense to scrap the acronym to help clear the air. But I’m not convinced that is the business world we live in.
Disclosures and Metrics
The misdirection to ESG issues instead of long-term value isn’t the only problem. This week, a stark headline grabbed attention: Why Some Executives Wish E.S.G. ‘Just Goes Away.’ Executives at Davos have frustration with what ESG has become. Long-term value isn’t mentioned in the article, and I suspect it’s because these executives don’t understand ESG. Instead, the term has been conflated with non-material issues that help investors drive apples-to-apples comparisons across companies that sometimes make no sense.
This concern aligns with one Edmans points out, the overemphasis on disclosures and metrics. Stakeholder pressure to report metrics can lead to greenwashing risks or a refocus away from more material matters. To me, this is a huge sticking point because often, these metrics, while essential for operational reductions, are not material and do not drive long-term value.
Edmans writes:
Companies and investors are falling over themselves to demonstrate their commitment to ESG, with company performance on ESG metrics given a special halo, and investors praised even more for engaging on ESG issues than productivity, capital allocation, and strategy.
This is an important point. A commitment to ESG doesn’t manifest in non-material ESG metrics but in the focus on long-term value. Metrics do have value, however. In today’s confusing state of investing, ESG metrics would influence corporate values and purpose and, therefore, Impact or Socially Responsible Investing because they focus on the company's impact on the world. This is where the conflation of ESG and terms like ‘sustainability’ come into play.
In related news, one CEO came out swinging this week, and despite the article stating ESG, they meant non-material sustainability. Brian Moynihan of Bank of America said this:
Here’s a line that is acceptable, and you’re either above it or below it. If you’re below it, we shouldn’t do business with you, and if you’re above it, tell us how you’re making progress along these important things.
‘How you’re making progress’ is effectively metrics aligned to values. It doesn’t appear to be about managing ESG risks and opportunities but around operational environmental management and the proof shown in metrics. Even if this isn’t what Moynihan meant, it is what investors and other stakeholders ask for when saying things like this.
Make no mistake. We are facing a planetary crisis that requires every company to operationally reduce emissions, manage water and waste, and consider their biodiversity impact. This aligns well with a company's purpose and values, which is essential for culture and stakeholder engagement. Disclosures can drive accountability here, but these non-material issues can be concessionary to report and deal with, refocusing the company from its core operations. Still, disclosures and attention to these issues are becoming a license to operate, which is what Moynihan is pointing out.
As a self-proclaimed ESG advocate, my problem with disclosures and metrics is that they don’t necessarily intersect with materiality or help a company drive long-term value. So, for example, a plastics manufacturer measuring waste is absolutely material vs. a financial services firm measuring waste in their offices.
Edmans makes a similar argument here:
Disclosing ESG metrics doesn’t stop a company from reporting bespoke factors.
While he writes ‘bespoke,’ I would substitute with ‘material.’ Despite impending draft and passed regulations, nothing stops a company from reporting its most material factors, which may not fall into a disclosure’s definition.
In the paper's conclusion, Edmans states this, and I agree.
Like other intangibles, ESG mustn’t be reduced to a set of numbers, and companies needn’t be forced to report on matters that aren’t value-relevant.
What’s fascinating about Moynihan’s stance is that he is effectively closing the gap between disclosures and ESG. By taking a stand on sustainability in the eco-system in which they operate, he is putting pressure on companies to disclose and act, turning inaction into an ESG risk.
The concern I have takes what the executives at Davos worry about a step further and ties into Edman’s point about 'matters that aren’t value-relevant.’ Can companies solve non-material ESG issues effectively and drive impact if these issues exist outside of their core business operations and perhaps expertise?
Externalities and Metrics
Disclosures focus on the company's impact on the world but also extend to the impact outside the company’s control. For example, Scope 3 GHG emissions occur upstream and downstream of the company. Companies also may report on forced labor in their supply chain. These issues are externalities that stakeholders, from employees to procurement teams, care about.
Edmans calls externalities “the elephant in the room.”
Externalities, which can be positive or negative, are impacts beyond the company’s primary production or control. So the question is, could externalities ever come back to impact the company’s profits? Well, logically, they are outside the company’s control, so no. Per Edmans:
By definition, externalities don’t affect a company’s profits, even in the long run.
However, if we dig deep, externalities could have some company impact. Let’s look at an example.
In her book Atlas of AI, author Kate Crawford (also from Microsoft) writes about how technology requires rare metal extraction that damages the environment horribly. This is an externality as the impact is outside of the control of a cloud company or the company developing the algorithms. Crawford poetically describes the issue like this:
From the perspective of deep time, we are extracting Earth’s geological history to serve a split second of contemporary technological time…
Let’s say a data scientist read Crawford’s book and was inspired to make a change by applying their sustainability values to it. They might figure out a way to use computational power more effectively to lower the resources needed to train the model. This has a material impact on a cloud company as fewer resources mean less revenue.
In a swift act of irony, the data scientist will likely turn to metrics to prove the value. This would manifest in something like a measurable reduction in carbon emissions but miss the externality that Crawford points out. Why? Because it’s too hard.
Today, it is nearly impossible to correlate an AI algorithm to the server component that leveraged a manufactured part from a mine. In theory, with technologies like blockchain, a controlled supply chain and manufacturing processes, and quality cloud management practices, yes. In reality or practice, not so much. This is a massive data challenge without enough quality data or linkage in the supply chain globally yet to determine the actuals for externalities.
So, how can we deal with this? Per Edmans:
All externalities are a market failure, and thus are best dealt with through government intervention to correct this failure.
Edmans goes into the real-life challenges with governments and considers investors' influence as a lever but reminds us that metrics aren’t necessarily the way to get this done. Even with government intervention, however, the Executives at Davos might balk at such a concessionary proposition.
But that one thing
This brings us back to Liz and Edmans. To steal and adapt a line from The Incredibles, “When everything is ESG, nothing is.” Maybe both are right as ESG manifests itself in the long-term value companies already focus on.
In thinking about ESG, there are more examples of risk than opportunities, making me wonder. We’ll always hear about the fallout when risks manifest, and a self-inflicted crisis emerges, but how often will we hear about a strategy implemented in years past that mitigated a risk or created an opportunity? Perhaps these things simply become part of the company and get lost in our short-term world of quarterly reporting.
And so, we land at the one reason ESG should be kept around. For those working in companies at any level, this one is for you.
Setting the E, S, and G together helps you think about your company’s ESG issues and where they connect. So let’s revisit Crawford. In the first chapter of her book, she covers the environmental impact of mining (E) and its impact on disadvantaged communities (S). This broader perspective is valuable because we can uncover new data points that lead to a more informed decision. The result could include lowering risk, finding new opportunities, and mitigating the complex web of risks that can emerge when making a change. Certainly, this is one reason to keep it around, at least a bit longer.