By Bengu Canliel
ESG is a highly-contested acronym and one that has taken over the investment world over the last few years. Most of us, if not all, have heard of it, but what does it mean? Here’s an introduction to ESG and why, in its current state, it may not be our solution for sustainable finance.
What is ESG?
ESG stands for environmental, social and corporate governance – the 3 pillars of ESG. Whilst there is no standard ESG framework, these 3 pillars make up a broad consensus on the issues that are covered by it. Designed to encourage responsible corporate behaviour, ESG is a set of considerations established vis-à-vis aspects of a company that are not typically accounted for such as their environmental and societal externalities. Seen by many as an essential component of increasing company value and achieving sustainable development, today, ESG has become a controversial topic that is criticised by many.
Origins of the term and its meteoric rise
ESG gained prominence in its contemporary corporate-governance context when it was first introduced and explored in the UN’s Who Cares Wins report of 2004. Crafted by 18 financial institutions, the report advocates for all corporations and their stakeholders to embrace ESG in the long run. It asserts that the effective management of ESG is integral to increasing company value, simultaneously leading to greater investment and the realisation of sustainable societies.
Although ESG has existed for over two decades, it has gained momentum in the last couple of years. Our world is facing several global challenges, non-exhaustive of climate change, increasing inequality, poverty, and balancing societal needs with economic ones. Given the severity of these issues, social, governmental and consumer attention on the negative impact of corporations on our societies and our environment has heightened significantly. Consumers, employees, and investors globally are becoming increasingly aware of the social and environmental impact of their purchases, firms’ actions, and investments. Today, more and more people are searching for products that align with their financial goals and personal values, thus leading to the acceleration of global sustainable investment.
On April 21, 2021, the EU Commission adopted the sustainable finance package, increasing the scope of reporting required from firms. This they hoped would help accelerate the global transition to a carbon-neutral economy. The EU’s adoption of the package generated greater active integration of ESG in most firms. Today, many companies are designating entire departments towards ESG practices. This meteoric rise in ESG-oriented investing has brought global sustainable investment to over $30 trillion, tenfold its value in 2004.
With sustainability at the forefront of most discussions, there has naturally been an increase in discussions about ESG and its potential role in the pursuit of sustainable finance.
ESG ratings – A need for new intelligence?
ESG was implemented to help investors identify risks that could be overlooked by conventional financial analysis; ones which could impact financial performance due to operational or litigation costs. To achieve this, ESG data must first be converted into intelligence. To therefore simplify ESG data and convert it into intelligence, financial companies have set up ESG rating companies. In theory, with a universal rating system in place, ESG ratings could be of value to investors by helping them identify the leading and lagging companies within an industry, allowing them to make informed decisions based on flagging opportunities or risks that would otherwise be overlooked.
However, today, there is no single method or universal rating system, meaning that comparisons of ESG between companies worldwide cannot be made. Instead, there are several ESG rating agencies including MSGI, Bloomberg, S&P and Moody’s. This is problematic as each agency uses a different grading scale, and curates their own ESG ratings for a company based on which risks they believe are more material for one industry vs another, so some companies that rank at the top of some rating systems find themselves at the bottom of other rating systems. Thus, ESG rating systems have often been criticised for being incomplete, unaudited and outdated, stirring distrust amongst actors in sustainable finance. It therefore comes as no shock that over 70% of executives surveyed across different industries and regions reported that they lack confidence in the non-financial reports of companies.
Given the way that ESG ratings are determined based on different criteria, in some cases, energy giants and companies that emit vast amounts of emissions don’t have bad ESG ratings. A shocking example is McDonald’s – the world’s largest beef purchaser. The corporation was responsible for 54 million tons of emissions in 2019, surpassing that emitted by Portugal. Despite continuing to generate copious volumes of greenhouse gas emissions, McDonald’s was able to attain a higher MSCI environmental rating. But how is this possible? After all, the corporation has done little to address its supply chain emissions. They installed recycling bins across France and the UK which MSCI viewed as a sufficient commitment to ESG, pushing their rating up. Whilst recycling bins are a great initiative, McDonald’s has not made an effort to reform its supply chain, which generates emissions in the first place. This initiative was also carried out in France and the UK, countries where the company could face sanctions if it doesn’t comply with recycling regulations. This makes us question whether the commitment to ESG is genuine, and if the corporation specifically targets the governance pillar of ESG to get a better rating. Cases like this reveal the intentions of firms that adopt ESG practices and ESG ratings. Unfortunately, as Bloomberg put it, ESG ratings are more interested in the “impact of the world on the company and its shareholders” as opposed to the company’s impact on the earth and society.
Greenwashing – Investor Fraud
Apart from being inconsistent, ESG funds often fall short of the promises they make as part of their marketing. Whilst ESG funds may claim their intentions to be purely in the interest of the environment and achieving a sustainable future, fine prints reveal that their primary goal is far from this – to assure shareholder profits.
Companies are exploiting the high demand for sustainable financial products by branding themselves as “sustainable” and “ESG compliant”, marketing their products as ecological or sustainable, even if these labels aren’t appropriate. Thus, they can obtain loans and investments from ESG funds by appearing more attractive to consumers and investors. This misleading of the public is known as greenwashing and can be a form of fraud. Greenwashing promotes false solutions to the climate crisis, delaying credible and concrete action.
Is there potential in ESG?
I believe that ESG, as put forward in theory, could lead to sustainable finance, however, for this to happen, many reforms must be made at once. Starting with what ESG is – a universal definition is necessary. Complementary to this, rating agencies must decide on a set of criteria they all abide by – a universal rating system would be beneficial as it would be more consistent, better audited and has the potential to implement effective regulation followed by all. Additionally, with companies and governments targeting the governance pillar to increase their ratings, perhaps rating systems should adjust the weights of the 3 pillars to elevate the social and environmental pillars. Whilst the ESG movement has accomplished bringing environmental, social and ethical corporate governance issues to the forefront of investment discussions, further actions are necessary to prevent companies from exploiting ESG for their own gain, ensuring that the true objectives of ESG are achieved.
The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.
Image courtesy of Thomas Richter via Unsplash