From social responsibility to better operational resiliency: why you should care about ESG.
The brief history of ESG
ESG is certainly becoming a difficult trend to ignore. Investment continues to shift towards companies with good ESG performance, and policy makers are starting to introduce regulation mandating disclosure on ESG-related issues. According to Morningstar, investment in sustainable funds grew by 53 per cent last year, reaching $2.74tn[i]. As a result, companies are putting more focus on improving reporting on their Environmental, Social and Governance (ESG) impacts.
However, despite the fact that the pressure to disclose is greater than ever and company reports are now littered with words like “ESG risk management”, there is still relatively little understanding around what can be considered “good” ESG performance. There are as many definitions for “good” ESG performance as there are ESG standards, ratings, and frameworks – the number of which was last estimated to stand at around 600[ii]. In fact, one of the only things we all seem to agree on in the ESG industry currently is that ESG stands for environmental, social and governance considerations – trying to go more in-depth than that leads to diverging opinions. In order to make sense of the current ESG landscape and understand how we got here it helps to look back on how ESG came to be.
The origin of ESG
ESG is at its origin rooted in socially responsible investment practices. The term “ESG” was coined in 2004, in the UN’s Global Compact Report Who Cares Wins: Connecting Financial Markets to a Changing World, which aimed to develop guidance for integrating environmental, social and governance consideration into asset management. The central idea of the report was that investors could “do well by doing good” – by investing in socially responsible companies, they are benefiting the society as well as themselves since they can earn higher financial returns from lower risk investments.
However, the practice of ESG investment was considered relatively niche until the financial crisis of 2008. The crisis created a turning point as investors realised that a company’s future performance cannot be predicted only on the basis of their financial reporting, as they do not operate in isolation of wider societal factors. This idea was further reinforced by the growing understanding of the negative economic impacts of global warming, leading to the conclusion that mismanagement of ESG issues can pose a threat to the company’s long-term financial performance.
As a result, investors started demanding companies produce non-financial reports discussing their ESG risks to accompany traditional financial reporting. ESG began to be considered as “enhanced investment analysis”. However, what investors did not account for was the sheer complexity of sustainability data analysis. Drawing comparisons between companies’ financial reports is relatively straightforward as financial reporting is highly standardised, but ESG reporting is more appropriately described as the Wild West, with companies disclosing whatever information they find most pertinent, seeing as no standards or regulations were in effect at the time (the situation has improved now, but only slightly and not enough to drop the Wild West reference).
The rise of the ESG ratings and standards industry
The investors’ struggle to make sense of companies’ ESG data created space for a new industry – that of ESG ratings and standards. In an effort to simplify investors’ decision-making, ESG rating agencies and standards provide companies with a score based on their management of ESG issues, rendering comparison of ESG performance across industries considerably easier. Some of the most widely used ratings and standards are Sustainalytics, MSCI, Ecovadis, Dow Jones Sustainability Indexes, to name just a few.
In addition to the ratings and standards, various reporting frameworks have emerged to guide companies in their effort to improve ESG performance. As with ratings and standards, there is a variety of frameworks to choose from with some of the most popular ones being TCFD, CDP, UN Global Compact and GRI. The frameworks aim to create a standard methodology for reporting on ESG considerations and reduce the reporting demands on companies.
However, whether the emergence of this industry indeed provides a solution to the issue it set out to solve – how to evaluate a company’s ESG performance? – is debatable. Considering the high number of different ratings and standards that more often than not come to different conclusions, meaning a company’s score can vary significantly depending on the rating used, then it could be said that the ESG ratings industry creates as many problems as it solves.
Obstacles for the Industry
There are quite a few issues the industry needs to find solutions to, before it can achieve its full potential:
- Lack of agreement on what to measure and how to measure it – The lack of agreement on what constitutes good performance, what metrics should be used to measure it and how it should be scored has created low comparability between most ESG ratings and standards, raising questions about the validity of the results.
- Lack of transparency regarding methodology – As there is no one agreed-upon methodology for measuring ESG performance, the methodology itself has become a source of competitive advantage within the ESG market and therefore many of the ratings are “black box”, impeding any scrutiny of their approach.
- Evaluating disclosure not impact – ESG rating agencies and standards are also criticised for relying too heavily on corporate information and failing to differentiate between corporate rhetoric and tangible impact.
It is in all of our interest that solutions are found to these problems and rather urgently, as otherwise ESG could end up being considered no different from greenwashing. That would be a setback to furthering the climate agenda as there is actually enormous potential in this industry. It is estimated that achieving the Sustainable Development Goals (SDGs) would require a financial contribution of around $2-3 trillion a year, and considering the budget constraints of nation states, private investment needs to play its part for us to have a chance at reaching the SDGs by 2030[iii]. Finance can drive sustainability and ESG investment could be an effective vehicle for this. Not to mention, there are a multitude of benefits for companies who integrate ESG considerations into their business strategy, so hold off on discarding ESG just yet – more on the benefits of ESG in the following blog post.
[i] https://www.ft.com/content/8891c299-7609-4cd5-9008-7e62b07b1993
[ii] https://www.sustainability.com/globalassets/sustainability.com/thinking/pdfs/sustainability-ratetheraters2020-report.pdf
[iii] Ghosh, S. and Rajan, J., 2019. The business case for SDGs: an analysis of inclusive business models in emerging economies. International Journal of Sustainable Development & World Ecology, 26(4), pp.344-353.
