Well, folks, I am back, at least for this week. I am still reviewing the manuscript of my new book, ESG Mindset, coming from Kogan Page in April 2024. I’m proud to preview the launch site for you at ESG-mindset.com, where you can pre-order the book!
ESG Mindset forges an ESG perspective through the eyes of a corporate instead of the typical perspective of financial services. The long-term value of ESG has always originated with companies, not solely in what investors decided to do with their capital.
So, imagine my surprise as I raise my head from editing the last few chapters to find an op-ed in the Financial Times proclaiming ESG is beyond redemption: may it RIP by Aswath Damodaran, a professor of finance at NYU Stern.
Color me intrigued as I took a Corporate Sustainability class and a Sustainable Finance and ESG Investing course from NYU Stern.
The death of ESG, while amusingly timed with Halloween, would undoubtedly represent a material risk for my book, which has about six months left to launch!
With that, let’s jump in and see what is happening.
ESG: Goodness or not?
This op-ed’s subtitle states, “The investing framework is now facing a mountain of troubles, almost all of them of its own making.”
The author makes three specific claims about ESG from here. The first two appear related in that ESG was ‘born of sanctimony’ and started as ‘a measure of goodness.’
Let’s clarify. A connecting thread from Kofi Annan’s UN Global Compact turned attention to sustainability and social principles towards corporations and ESG. The UN Global Compact is where ESG started, but its brilliance connected these topics to value through the relevant lens of corporate materiality, not values. In the 2004 UN Global Compact paper Who Cares Wins, the connection to materiality and the movement of capital from the markets to support these efforts was made.
Despite this connection in its origin, ESG Investing is not the same as Socially Responsible or Impact Investing. SRI and Impact Investing frameworks are where an investor chooses to invest along their values, usually excluding specific industries, like tobacco, weapons, or fossil fuels, the latter of which Texas is particularly confused about. And so, Texas, like the author, is railing against SRI and Impact strategies.
The third idiom the author uses is ‘sold with sophistry,’ which is perhaps the one truth here. ESG has been a term leveraged to capture various opportunities from those with specific agendas, including in this op-ed and even this newsletter, but we’ll come back to that third claim below.
Original documents on ESG don’t try to save the world
As the author correctly notes, the messaging and strategies around ESG have evolved over its short 20-year life. However, the op-ed does what it rails against throughout, as it defines ESG in various ways to support a specific message.
For example, the claim that ESG started with ‘goodness’ comes from a linked OECD/UN PRI document from 2007. Opening this document and reading it shows that it focuses on responsible investment and ESG:
As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these Principles may better align investors with broader objectives of society.
In other words, it is responsible to consider ESG issues as material risks and opportunities in pursuing long-term growth, not as a measure of ‘goodness.’ The closest to ‘goodness’ comes through in that last line and the ‘broader objectives of society,’ but that sentence doesn’t demand values-based change. It simply recognizes that there may be an alignment. After all, as stakeholders’ preferences change around issues like sustainable products, companies must be mindful. This example isn’t a hypothetical. Per an IRI and NYU Stern study:
77% of consumers believe sustainability is important when selecting products to buy, up from 69% in 2021.
This makes sustainability a material issue at the intersection of the stakeholder, not ‘goodness.’
Let’s go back to 2004 and a UN Environmental Programme Initiative’s report called The Materiality of Social, Environmental, and Corporate Governance to Equity Pricing. Here, we can find that from the start, ESG (even before the acronym) was a measure of performance. The findings from that report reveal:
Analysts agreed that environmental, social and corporate governance criteria impact both positively and negatively on long-term shareholder value. In some cases these effects may be profound.
As always, ESG is a way to identify how material criteria can affect the company. The callout for shareholder value is well-noted. There can be intersections of ESG with goodness, but those likely have trade-offs to consider, like short-term implementation costs or long-term program management.
Are all ESG advocates created equal?
I struggle to determine the ‘ESG advocates’ who have co-opted the term to confused oblivion, but they appear to be consultants, activists, and ESG rating agencies.
These groups have each changed ESG’s definition over time to suit their unique purposes, and often those purposes were self-serving. This has forced the term’s nebulous nature to fit particular priorities, which have not always aligned with its original intent. Within these three groups, inconsistencies exist as priorities differ, but there are also alignments with the original intention.
Consultants want to advise companies on ESG strategies and see it as a massive opportunity to capitalize on the transition. Every audit firm announced hiring small armies of ESG analysts over the past few years. Make no mistake, there is money to be made here. Still, not every consultancy has the opaqueness that the author calls out. I work with many who get pretty specific on these topics.
Tip: Consultants have experience in your industry and with ESG, but you are the expert in your company. Be sure to bring expertise about your material issues and stakeholders to every consultant conversation before making hard pivots.Activists want companies to step up and save the world, which is not what ESG is. There are connections between the two, though. Like any values-based effort, there are likely trade-offs here.
Tip: If enough stakeholders wish for non-material change, it becomes material. Keep an eye on your key stakeholders.ESG rating agencies are not the boogeymen of the industry. While there is little consistency, many publish their methodologies and will engage if you reach out to them.
The main issue with scoring has moved away from score opaqueness to the concern that some of these rating agencies have consultancies, which is a potential conflict of interest (the EU is working on this).
Tip: Use the variation in scores to your advantage and learn about varying perspectives of your business. Don’t chase ESG scores, but work on ESG issues from the material context of your business. Be transparent and open on these changes; your scores will likely improve (rating methodology pending).
All three issues seem to loom large to the casual ESG observer. Still, for practitioners, these are non-issues against their mountain of work, nor are they anything more than distractions against the long-term value proposition. Practitioners are in the mix and know what they are doing. Even some non-ESG practitioners who understand these issues and the intersection with their business get it. Last year, Coca-Cola’s CEO, James Quincy, stated:
If ESG becomes toxic as a phrase, which it basically has in the U.S., it doesn’t matter to me. I’m just going to stop saying ‘ESG.’ But the idea that for my basic product, I want to be water positive, I want to have a circular economy on my packaging, and I want to grow our business with less sugar—you can call it anything you like, but no one with common sense says those are bad ideas.
Before we go further, it is worth calling out that the author believes ESG advocates’ defense of the term is like that of the historical defense of socialism in that I am trying to convince you that no one understands ESG consistently, which is why it isn’t working. First off, it is reported that many don’t understand ESG, even in financial services. This is why when you read ESG articles, the subtitles often immediately drop in the word ‘sustainability.’ Honestly, people don’t get it. Perhaps this is a side effect of globalization and different languages, the aforementioned ‘advocates’ fitting it to purpose, or another reason like capturing opportunities (see the next section).
Still, this isn’t why I’m writing this piece. I want you to know that ESG is working because it represents core business issues that are pretty common sense, as James Quincy states. If the regulations are any indication (many are leading with materiality as a baseline), companies still need to pay attention for at least compliance reasons.
Companies do themselves a disservice when they back away from the ‘tyranny of ESG.’ After all, if ESG is nothing special and everything, then as companies pull away from ESG, they are pulling away from their core business issues and will miss the perspectives the acronym affords.
Who is to blame for ESG’s current state?
If you incorrectly start from binaries like ESG is goodness or absolutes like all consultancies are opaque, you will always miss the point of the acronym entirely and have a lot of evidence as to why ESG doesn’t work. From here, you can cast blame on the ecosystem. If you start from the material intersection, performance, and long-term value…you’ll have to read my book to find out what’s possible.
Interestingly enough, one group of advocates is completely missing from this op-ed, perhaps one who often gets all the ESG attention and one with whom some of the blame does reside, but not all.
Since its beginning, ESG was a financial services mechanism with new ways to consider risk and create opportunities for products and services. Through further investor attention to extreme weather events, COVID-19, and social justice issues, financial services firms focused on lucrative products and services. Around the world, firms have primarily kept the definition amorphous in this pursuit. This is why we now have regulations like SFDR and the SEC’s ESG new fund labeling rule.
There is even more evidence that financial services firms are the ones that drove ESG to an amorphous definition with higher fees for ESG funds, an eventual rebalancing of funds, and the more recent closing of some ESG funds. Yet, who knows what those funds were doing since the definition is amorphous.
It’s unfair for me to say every firm is doing this, as that is not the case. Still, I have observed this inconsistency first-hand across the industry and feel it is worth noting the absence in this op-ed, especially as investors appear to be the ones with the short-term mindset at the moment. I mean, if only Governance was considered when brokering the Twitter deal, but I digress.
ESG can build sustainable value
The theory of ESG is quite simple from the corporate lens, even though its implementation is complex and fraught with nuance beyond a binary narrative. Through ESG issue identification, a company will mitigate risks and create new opportunities, driving long-term value.
NOTE: I did not write outperformance or alpha.
ESG was built for this initially, and I’m still convinced it delivers because there are so many examples to point to. Let’s examine the Environmental, Social, and Governance arguments found in the op-ed.
Environmental - The author leads to low Environmental value by routing through the ESG scores. This makes sense since many companies chase scores and disclosures instead of actions. As mentioned above, this blame can be laid at the feet of the financial services firms, who seek comparable data to drive capital.
However, the subsequent examination covers the failure of a global transition away from fossil fuels, which is a miss but doesn’t intersect with ESG as described. In a world of climate change, a responsible transition leveraging energy efficiencies and more reliable and stable energy pricing is required. Fossil fuel companies that don’t transition are at risk over time. The Russian invasion of Ukraine shows that we haven’t transitioned fast enough to clean energy since Europe still relies on Russia’s fossil fuels. This is why the EU is working to mitigate that risk over the next decade.
Social - The author has a concise point here about the outrage of ESG advocates against the politicization of the term (which is mostly only here in the US and maybe with Nigel Farage). ESG isn’t necessarily about ‘social good,’ but there are material intersections of social justice that companies need to think about regarding topics like product development and talent acquisition.
However, the unnecessary politicization of ESG and DEI introduces new risks as companies turn away from managing the risks and capturing the opportunities around them.
All of this puts aside the idea of why anyone would be against a company pursuing social good - what a position to take! While morality is complex, apparent injustices perpetuate that could be corrected (for example, black founders raised only 1% of VC investments in 2023).
Governance - Despite Enron, Worldcom, and more recently, Silicon Valley Bank and Twitter (and maybe now Tesla), Governance’s appearance in the acronym is apparently baffling. There is an indictment of stakeholder capitalism here, which counters the author’s point in the Social since stakeholders are divided. If the management team isn’t paying attention to their stakeholders (for example, if Bud Light engaged a transgender spokesperson without realizing the over-sensitivity of conservative drinkers), they will create more risk out of what they had thought was a Social opportunity.
Further, Governance isn’t always a given for companies; as I’ve written before, it can be the one part of the acronym that takes a company down. If you assume ESG is everything and nothing, you are assuming that quality Governance is in place. Yet, quality Governance isn’t always a focus, nor are ESG issues.
This leads to perhaps the unwritten question of this op-ed—If ESG isn’t working as the author believes, what does that say about the state of Governance at these companies?
Binaries don’t work for the complexities of modern business
Two binaries in this op-ed strike me as odd. First, the author states that ESG scores measure everything and, therefore, measure nothing. Towards the end, the author writes that managers are accountable to all stakeholders, hence none.
I have no patience for reductionist and binary statements like these.
Now, we live in a reductionist social media-fueled world, where issues are often reduced to black and white. We don’t live in that world; it’s just the one that gets your attention as you scroll on your phone.
Nothing about ESG is binary, and there are no clear answers, which drew me to it in the first place. So, here’s a different take on these two statements:
Many ESG scores measure material risks and opportunities and how well the company understands and manages them concerning their peers. A company should use ESG scores to understand issues it may otherwise overlook. After all, the scores represent an analyst’s opinion of your company based on your reporting and other available information. Indeed, understanding this better and making adjustments would deliver value to shareholders and stakeholders. To the point above, the variability only serves a diverse analysis.
The management team is accountable to multiple stakeholders. Would a management team ever not state that they are customer-obsessed or that their employees are their greatest assets?
If managers are unaware of stakeholders, their needs, or how they might change, the company will be misaligned to stakeholder desires. It is essential to recognize that your company will not always be able to please every stakeholder but does need to adapt. Materiality is a good guidepost for dealing with stakeholders.
Since you are a subscriber, you likely already understand ESG well enough to see that the op-ed skims the surface only. Ironically, this surface attention is one of the biggest challenges ESG issues face. ESG issues are not simple, have trade-offs, and deal with uncertainty, but are wildly satisfying for some of us to deal with.
The term doesn’t need redemption because, like you, dear reader, many practitioners and businesses are doing it well and chasing the long-term. Please don’t lose sight of op-eds like this, but relegate them to noise, build a defense, and never take your eye off those outcomes!