What will it take to put a real ‘S’ in ESG?

This article was originally published in the Stanford Social Innovation Review (SSIR) on February 23, 2022.

Photo by Remy Gieling on Unsplash

Environment, Social, and Governance (ESG) investing — an approach to investing designed to consider a wider set of factors that influence financial returns — is everywhere. ESG is so hot, it will be a $1 trillion market by 2030. Finally, it seems, finance is thinking seriously about social factors in investment.

But whilst “ESG goes mainstream” is an attractive and seemingly good-news headline, the reality so far is mixed at best, underwhelming at worst. Specifically, the way the ESG market has developed limits the potential benefits these trillions of dollars of capital could have on society and the planet.

If we continue down this path, ESG investing is almost certain to remain a smokescreen

These limitations exist for two primary reasons. First, because only factors that affect financial returns are considered “material” for ESG investors. And second, because the S in ESG remains woefully underdeveloped.

The definition of S is still up for grabs and, without a serious reflection on ESG to date, we run the risk of compounding the original sin of ESG: ignoring the issues that matter to people and planet but don’t directly affect the bottom line. If we continue down this path, ESG investing is almost certain to remain a smokescreen, one that creates the appearance of a more socially impactful approach to capitalism while ignoring some of the most significant negative effects business can have on people and communities

The Limited Goals of ESG

Although ESG investing is often lumped in as part of the broader impact investing ecosystem, it’s important to be clear about their differences at the outset.

In its most simplified form, ESG investing is “negative screening” — not investing in companies with harmful practices or actively engaging company leadership to change those practices — whereas impact investing refers to investments made with the intention to create measurable positive impact alongside financial return. ESG investing is widely perceived as the “do good” alternative to traditional investing, but this approach as it is currently practiced does not generate or measure positive impact, other than by reducing harm relative to the status quo.

Reducing harm is a worthy aim, but the specific harms that ESG has focused on thus far are limited to those “material factors” that impact the finances of a company. Because of this “financial materiality screen,” the harms deemed relevant to ESG vary greatly by sector: they could include waste management for one company, carbon emissions for a second company, and worker health and safety for a third.

What ESG does not consider, by definition, are harms that a company may have on society or on the environment that have no relation to financial bottom line. “Materiality” is industry jargon for anything that has direct consequences or creates risk for investors.

Most ESG ratings don’t have anything to do with actual corporate responsibility as it relates to societal factors

Who Is ESG Working For?

Whenever we see the word “materiality,” we must remember to ask: what risk, and for whom? ESG frameworks were developed by standards bodies for investors, so it’s hardly surprising that their focus has been on identifying and addressing key operational and reputational risks to the financial bottom line. And while it is true these bodies deserve credit for widening the scope of what the investment community should consider in their investment decisions, the fundamental flaw with this approach remains: there are loads of things companies do that contribute to the problems of the world without it affecting company profitability.

This problem is particularly acute when it comes to social factors in ESG. As NYU professor Hans Taparia stated in a recent SSIR article, “Most ESG ratings don’t have anything to do with actual corporate responsibility as it relates to societal factors.”

The Illusion of S

What should the S in ESG refer to? It is logical to assume that it refers to social outcomes associated with our individual welfare or with thriving communities, and measures things like mental or physical health, education, and learning, or elements of subjective well-being like personal dignity or community cohesion. However, as currently conceived, the S in ESG regularly has very little to do with this intuitive and well-recognized understanding of social impact.

Instead, for the reasons highlighted above, ESG frameworks like those developed by the Sustainability Accounting Standards Board (SASB), which is used by hundreds of major corporations around the world to make sustainability claims to investors, are limited to very specific financially material and compliance-focused dimensions such as labor rights, data security, and consumer privacy.

Because of this limited definition, there are many companies that are mistreating workers and worsening health outcomes — doing obvious harm to society by improving their bottom line — while still garnering top ESG ratings. How else could one explain the fact that British American Tobacco has been part of the Dow Jones Sustainability Index for the past 20 years, garnering top scores along the way.

In the absence of any attempt to understand our collective or individual social well-being, S ratings resort to the existence of policies or committees. For example, a company with a well-written diversity policy or a workplace safety council will earn a favorable ESG rating, but, in most cases, these same companies often have limited or no data from employees themselves to capture the impact of these policies on people or places.

A more meaningful assessment of social impact by companies would consider the variety of stakeholders impacted by a business — from suppliers and employees to customers and communities — and try to understand and account for all the positive and negative impacts that the business may be having on those stakeholders. This approach would be more closely aligned to the steps being taken for climate disclosures: more and more companies are now expected to understand their carbon emissions throughout their supply chains, taking stock of both their direct and indirect activities.

Changing Course

Without a fundamental shift from the profit-first, society-second mentality that currently dominates ESG, the whole approach will likely exacerbate one of the biggest social issues of our time: growing inequality. As a result, ESG could be structurally designed to have a negative impact on S. After all, the system as currently designed reinforces the paradigm of shareholders’ returns trumping stakeholders’ demands. Without a fundamental reconsideration, ESG could be even worse than a “wheatgrass cure to tackle cancer,” the depiction given to it by Tariq Fancy, BlackRock’s first Global Chief Investment Officer for Sustainable Investing. Could it be that over the long term ESG could come to be seen as a diet of cigarettes and alcohol to shrink a tumor?

This is not to say that there isn’t space to course correct. Indeed, such opportunities present themselves all the time. One such chance, which recently passed us by, was the creation of the International Sustainability Standards Board (ISSB), which aims to harmonize existing ESG standards. Unfortunately, the current framing of the ISSB retains the structure of looking at issues that pose a risk to profit, rather than those that are of greatest consequence to people and planet. Our hope is that, in time, the standards bodies revise this definition of “materiality,” and recognize what we all know in our hearts: that it is not only material to understand the impact that social issues have on a company, but also to understand the impact that a company has on people, communities, and society. Otherwise, much of ESG, and especially the S, will remain a charade.

Paths Forward

To change this, those who are focused on the power of investing as a force for positive change need to be more vocal on the risks posed by current ESG frameworks. Collectively we should be championing the strongest interpretations of “double materiality,” a now widely-accepted principle in financial disclosure which states that information on a company is considered material if “a reasonable person would consider it [the information] important.”

Adoption of this broader definition of materiality would require companies and ratings agencies to consider corporate impacts on society and the environment even where there is no immediate financial value to shareholders in doing so. Such a step would avoid confusing signals like the ratings upgrade of McDonald’s by MSCI in 2019, citing their environmental practices, despite McDonald’s continued increase in carbon emissions to 54 million tons that year. Surely that additional harm to the environment should have been included in any credible assessment of the company’s impact. The fact that carbon emissions were not even part of the sustainability ratings calculation explains why researchers Cam Simpson, Akshat Rathi, and Jaijel Kishan believe that most MSCI investment ratings are an “ESG Mirage.”

This concept of double materiality is integrated into the EU’s Sustainable Finance Disclosure Regulation (SFDR) — perhaps the most far-reaching piece of formal legislation in this space. In its guidance to corporations, the EU has explicitly expanded the definition of materiality to require a company “to disclose information on environmental, social and employee matters, respect for human rights, and bribery and corruption, to the extent that such information is necessary for an understanding of the company’s development, performance, position and impact of its activities.” This is regulation in the right direction, creating requirements to disclose not only the risks to the business from ESG factors but the risks to people and planet from business activities.

Next, the S in ESG needs a down-to-the-studs, build back better renovation. Material social factors required by disclosure standards should be reconstructed to align more closely to established international well-being frameworks. This would encourage inclusion of subjective measures of social value such as dignity or personal autonomy that we know from extensive stakeholder consultation are amongst the most important aspects of social value. Being required to account for these stakeholder impacts would have the added bonus of creating a much stronger impetus for companies and investors to systematically listen and respond to the needs of customers, workers, and suppliers.

Lastly, we should return to having separate categories and frameworks for E, S, and G. Currently, companies focused on E or G but neutral or even negative on S can get a high aggregate ESG rating. This incorrectly implies that they perform well on all three.

Separate rankings on environmental, social, and governance factors should be clearly distinguished so that both companies and investment funds could be selected and evaluated based on their performance on individual dimensions.

ESG investing will continue to grow, and the consideration of ESG factors may become even more widely adopted. But if material factors continue to be limited to those of financial consequence to the firm and the S continues to be comparatively overlooked, then serious negative social consequences will continue. We must demand higher standards and reformulate our collective understanding of materiality, centering on our collective well-being rather than the profitability of a few.

This article was originally published by the Stanford Social Innovation Review

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