The ESG Advocate 005 - ESG: One more system of systems
I usually plan my newsletters starting Sunday. By Tuesday, I've cobbled the theme together. Then, by Saturday morning, it's just a matter of putting things together and editing. This week though, The Economist spoiled my flow by causing ESG to be a distraction to climate change. Yes, you read that right.
Instead of focusing on the intense heat in the West, I'm going to deconstruct The Economist's latest on ESG and its conclusions.
NOTE: Just like The Economist, I'm not going to get things 100% right because ESG is hard.
Should economists stay out of ESG?
ESG should be boiled down to one simple measure: emissions | The Economist — www.economist.com
The article's subtitle, "Three letters that won't save the planet," starts us off on the wrong foot, so let's course correct immediately.
ESG represents risks and opportunities for a company and the ecosystem in which it operates.
ESG is not an investment methodology but can be used as one. This makes it difficult for investors to understand what's truly going on. Is an ESG fund considering broader risks, or is it trying to save the world? The latter is Impact Investing, which considers the components of the company's E, S, and G impacts on the planet. This conflation and greenwashing are where many funds are getting into trouble.
In other words, things are not very clear right now. Investors may think they are using their dollars to save the planet by rewarding responsible companies when their fund manager is rewarding companies who are mitigating their ESG risks and potentially driving them to long-term value.
Let's unpack this article section by section, calling out where things go right and where they go wrong.
ESG is an attempt to make capitalism work against climate change.
The article consistently falls over because it frames ESG incorrectly. If we were to take the original quote and reword it, it would go from:
It is an attempt to make capitalism work better and deal with the grave threat posed by climate change.
to:
It is an attempt to make companies understand their risks and opportunities better and can inspire action to address issues like climate change.
Here's what this looks like. Let's take the example of a coffee shop. As the climate changes, farmers are having issues growing coffee beans because of the temperature change, threatening the downstream shop. This presents a risk.
A thoughtful coffee shop owner would work with farmers to ensure a sustainable supply.
A financially-focused coffee shop owner might create a mix of suppliers they can switch around to, but this might open up other risks, like consistency in flavors.
A passionate coffee shop owner might join a consortium focused on climate change and drive impact at scale.
To some degree, a coffee shop owner might need to address the immediate risk and pivot toward the bigger issue to ensure survival in the long term. This is a rudimentary example, but I see it in practice at some of the world's largest companies.
Here's another way to put it. Many pundits have lamented Tesla's removal from ESG funds due to their S and G issues, arguing that Musk has done more for climate change attention than anyone else.
If that's true, ESG is like Musk because it brings ESG issues to the board level and surfaces those risks and opportunities, leading to broader issues.
The idea is that investors should evaluate firms based on their ESG record
To the point above, this statement is completely off the mark but again shows how Impact Investing is getting conflated with ESG Investing.
So, let's get The Economist's quote a little closer to reality.
The idea is that investors should evaluate firms based not just on their commercial performance but also on their environmental and social record and their governance, typically using numerical scores.
to:
Investors can evaluate firms based not just on its commercial performance but also on its understanding of its environmental and social and governance issues. This is commonly referred to as ESG Investing. Investors can also evaluate firms based on their ESG impact on the world, which is called Impact Investing.
Misunderstanding of this difference is where many fall into the "ESG will save the world" trap. It requires a bit of nuance to see the difference. Companies, boards, and investors aren't quite telling the story right and creating a mess for themselves.
Enter the SEC. On May 25th, the SEC announced a new ESG draft proposal targeting investment firms. The goal is to address this confusion by "establishing disclosure requirements for funds and advisers that market themselves as having an ESG focus" per SEC Chair Gary Gensler.
I created a handy graphic based on their proposal.
To learn more about this and the work the SEC is doing, I recommend reading the Harvard Law article: Name That Boon: SEC Proposes Rules on ESG Fund Names & Disclosures or listening to this episode of the PwC Accounting podcast.
To me, this misunderstanding is the core issue with ESG, but I could care less because I look at it from the point of the company. Of course, fund managers need to get their funds labeled properly with the right disclosures. As long as a company addresses an ESG risk or tries to save the planet, I'm happy!
#1 ESG is hard and illogically tying three disparate things together
ESG is hard, but there are problems in this argument. If you are an ESG practitioner, like my good friend Alexandria Fisher, you might have gotten to this first point and threw up your hands like this:
Let's start by unpacking the concluding statement here.
By suggesting that these conflicts do not exist or can be easily resolved, esg fosters delusion.
I've never encountered an ESG practitioner who suggested that E, S, and G issues are easy. These issues are horribly complex and can lead to analysis paralysis. In fact, I tell sellers who are going in to talk to customers about ESG issues that they don't know what they're in for!
It isn't ESG but business leaders who don't understand the complexity causing issues. Let's say you are the perennial favorite example, a widget manufacturing company. You've made Scope 3 commitments for 2030 to lower supplier emissions by 75%. This is a sustainability commitment, not necessarily ESG. You have an engaged Procurement team and are working with suppliers. The analysis reveals a particularly difficult yet critical supplier with significant emissions problems in an emerging market.
Making the decision on that supplier is where ESG and critical thinking come in. If they are a critical supplier, what is the risk of switching? What economic issues would arise in that community if you pull out? What is the reputational risk or opportunity if you engage more directly?
If these questions sound like ones a business leader might already be asking, that's exactly the point. ESG issues are core business issues that represent complexity and nuance. In reality, ESG can't be boiled down to "Tesla did a great thing for climate, so they should be included in an ESG fund."
ESG issues have connections if you look past the metrics and numbers.
#2 Shareholder primacy above all
I can't believe this statement exists in any serious publication about ESG, especially one arguing to only focus on emissions (but we'll get to that).
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.
Putting that aside, the question here is about the link between virtue and financial returns. This comes up in Tariq Fancy's arguments again and again. He was interviewed this week by The Economist in this podcast and covers his experiences at BlackRock on pulling these things together. I don't agree with his assessment that there isn't evidence available for the value of ESG.
One of the most overly cited papers on this topic is from Mozaffar Khan, George Serafeim, and Aaron Yoon called "Corporate Sustainability: First Evidence on Materiality," which reached this conclusion:
We find that firms with superior performance on material sustainability issues outperform firms with inferior performance on material sustainability issues in the future.
NYU Stern has also published a meta-study on this topic that is worth a look.
But look, I get it. There are studies on both sides, for and against. Still, with quarterly reporting metrics and our short financial reporting window, it is near impossible to see the long-term impact across the short-term time horizons that the markets live in.
ESG is about material risks and opportunities. Logically, if a company has control of its core material issues and is focused on its stakeholders, it would have better returns in the long run. Is every investor claiming to run ESG investment strategies looking at it that way? Maybe not, but refer to the regulatory work above and be sure not to miss Lisa Woll's position in the same Economist podcast (around 25:00).
Shareholder primacy will only get you so far. It certainly hasn't gotten us to address emissions, even remotely. ESG has played a role in that.
...and despite Fancy's claims that it is a self-correcting market mechanism in disguise, investors are actually voting against Corporate Directors on this issue!
#3 ESG scoring systems have gaping inconsistencies and are easily gamed
I'll admit that this one isn't too far off, but it also has problems.
There are multiple ESG scores and rating agencies, all with IP built on their unique research and insights. It is certainly inconsistent, which is why most of the investment firms I've talked to don't make decisions based on the scores but get right to the data.
Companies can't necessarily game the market because investors aren't solely using the scores or even ESG data alone to make decisions (unless they are doing certain types of investing - see above graphic). Instead, ESG scores can help inform boards, business leaders, and investors about material issues and what their current data and disclosures are telling a researcher.
Regardless of your opinion of ESG scores, the aforementioned SEC draft proposal is attempting to address this by requiring the disclosure of what roles these scores play in the investment decision-making process.
We understand that some ESG-Focused Funds evaluate, select, or exclude investments using internal methodologies, and/or base their investment decisions, at least in part, on the data or analysis of a third-party data provider, such as scoring or ratings provider, that evaluates or scores portfolio companies based on the provider’s ESG criteria. This disclosure, if applicable, would help an investor understand how these methodologies and/or providers guide the fund’s investment decisions.
Even in the draft proposal, this note is a big wake-up call to fund managers who might be using the scores. They need to consider how the are constructing and managing funds.
Regarding the shell game that companies can play with the scores, as suggested here:
Firms can improve their ESG score by selling assets to a different owner who keeps running them just as before.
If you have business leaders dropping entire business units due to their emissions or some other value-signaling motion, that company has a serious G problem. Act accordingly in your analysis.
#4 Let's just focus on emissions because we're killing ourselves
The week started out with UN Secretary-General António Guterres stating that we are heading for collective suicide. As the week progressed, we saw the effects of extreme heat in the West with infrastructure buckling. For me, the heat was a topic of discussion on almost every call.
There can be no denying that climate change is ravaging our planet, even without hitting the 1.5C target in the Paris Climate Accords. Here we land on the final conclusion of the piece, which is a rallying cry for climate activists.
Put simply, the E should stand not for environmental factors, but for emissions alone.
Emissions are absolutely critical to measure and reduce. Every company should focus on operational reductions internally and across its supply chain. The SEC has a different draft proposal to get public companies to disclose. Charles Elson disagrees with this approach in the aforementioned Economist podcast.
However, if companies don't or can't convince their suppliers, we can't reach the scale to effect systemic change. Many suppliers are not publicly traded companies and need the influence of their downstream customers. Emissions are one place to focus, but they can't be the only place.
Another good friend, CEO, and co-founder of Earth Knowledge Julia D'agnese helped me make the connection this week. At a Microsoft event, she succinctly explained how the earth is a system of systems. A company can't only focus on emissions because that's not how the planet works. Emissions are just one externality, but there are so many others. Should a beverage company only focus on emissions if water use is more material and immediate?
If a company takes its eye off ESG interdependencies, it might introduce more risks. The result could be that your company isn't there to have an impact in the long term.
TLDR: The Takeaway for Business Leaders
We're in a transition period with ESG and climate change. Both have value. As a business leader, you can focus on both. That's what it means to lead.
Tweet of the Week
Alright, enough of The Economist!
On the heels of the intense heat this week, movies met reality with the media's portrayal in "Don't Look Up" in a hysterically scary, face-palm way.
