By The CGC Team
A combustible mix of regulators, politicians, and the media are fueling conflicting mindsets around ESG and its usefulness today in institutional asset management.
Across jurisdictions, regulators are introducing confusing, and sometimes contradictory, regulations. In the EU, a fund classification scheme (SFDR) aiming to better inform investors on the differences between ESG integrated products vs. those with sustainable investment “objectives” has left asset managers and their compliance staff struggling to understand the requirements and ironically threatens to increase greenwashing because of the possibility to exist in a gray area.
In the U.S., Republican politicians seized an opportunity to politicize yet another facet of American society, and attack ESG as “woke investing.”
The media, meanwhile, jumps to tell whatever story gets them the most clicks and “engagement.”
Depending on who you ask, ESG is either a new way for managers to raise capital with little proof of its efficacy or it is the single aspect of capitalism that could ultimately save the planet.
The controversy doesn’t end there either -- ESG has been around for a long time or is a relatively new approach to evaluating corporate performance. Others claim ESG either goes too far to advance the liberal social values of a “woke” agenda or is window dressing that does not produce any meaningful environmental, social, or governance impact.
These prevailing views, however, vastly oversimplify ESG, which is a much more nuanced and dynamic concept that falls somewhere between those extreme ends of the spectrum.
Where’s the data?
What ESG is at its core is data – plain and simple. It is rooted in the shortcomings of traditional quantitative measures of corporate performance i.e., fundamental financial and accounting metrics, necessitating additional non-financial data (i.e., reporting on environmental, social, and governance factors) to complete the telling of an organization’s story.
Similar to the data and subsequent analytics revolution in sports, ESG metrics track corporate factors that have always existed but that have not necessarily been measured. Companies understand that ESG factors contribute to business success and respond to investor requests to disclose more information – this is neither new nor revolutionary.
Investors want this information because they: a) are seeking information that could give them an edge, b) know that the world is changing, and/or, c) understand that these factors help to identify companies that have sustainable and resilient business models making them better long-term investments. Regulators now also understand the need for this information, and in some jurisdictions, are setting the agenda for both mandatory and voluntary corporate disclosures.
There is nothing obviously controversial up to this point. So, how did we get to the divisive and sometime bellicose state in which we now find ourselves? Things started to go awry when the fledgling ESG ecosystem, which not too long ago was working mostly in concert, began to diverge.
Yes, ESG is not perfect
To some degree this is where a data revolution has hampered efforts. Field-building organizations (i.e., primarily non-profits and industry consortiums focused on advancing the public interest and efficiency respectively) try to parse data into material vs. non-material factors (while well intentioned, this has resulted in multiple, and often unaligned or conflicting, “standards”).
Academics and researchers use ESG data to examine whether companies with an intentional strategy to improve (prove?) ESG metrics outperform those that do not (some studies show that they do, and others show that they do not).
ESG data providers roll up the underlying corporate metrics into ESG scores that vary widely from one provider to another (which isn’t inherently a problem if you take the time to understand the differences in methodologies). And ESG data is oftentimes viewed in isolation and not within its larger context, which has created issues that aren’t present when looking at financial ratios.
The strife now present within the ESG community is due to the conflation of ESG with impact investing, which is traditionally defined as investment in a way that has a measurable impact across a number of variables. Proponents of impact investing often criticize investors who integrate ESG factors into their investment processes as greenwashing and not doing enough to intentionally produce positive social or environmental impact. This has led, in our experience, to some investors with more sophisticated ESG integration approaches to take the next step of investigating whether they are, in fact, driving impact through ESG. Other investors, though, are retreating and have become more cautious with labels, investment exclusions, and plan to further integrate ESG.
Where does ESG go from here?
With this grouping of adversarial participants in the ESG arena, it is easy to see how we have reached this point of disarray – but will it continue?
Paradoxical views are also entering the discourse on the future of ESG. Some are advocating for dropping the ESG label as its concepts become part of core business strategy. Others are saying it is time to reclaim ESG by embracing it as part of the “woke agenda” given the glaringly obvious potential for better investment outcomes when compared to non-woke investments. The answer lies, as it usually does, somewhere in between.
ESG is, without a doubt, part of a larger evolution that seeks to find a balance between the foundational principles of free-market capitalism and those of stakeholder capitalism. Stakeholder capitalism, contrary to how it is presented by its critics (as well as some of its advocates) is, quite simply, a more multi-dimensional approach to how business is conducted.
For corporates, which have always considered multiple stakeholders, be it customers, suppliers, or the community, it is about gaining a better understanding of material ESG factors and embedding them into core business strategy to increase the resiliency and long-term performance of the company.
For investors, it is about widening the aperture of the lens with which to evaluate business performance and investment criteria. In practice, this means defining, assessing, measuring, and reporting on relevant ESG data.
Depending on the asset manager ESG integration could include setting targets, with aligned incentives, for ESG metrics. Ideally, this is done to manage risk and/or to create value. Achieving ESG targets may, or may not, create impact. Disclosing a fund’s ESG intention would go a long way to clearing all of this up, which is on global regulators’ agendas when it comes to providing investors with transparency.
Broadening our collective understanding to recognize that capitalism includes stakeholder interests is not part of some overt, or covert, political agenda. It is a necessary change that reflects, in some cases, existing practice, and in others, the need to acknowledge that maximizing profits at all costs has led to many of the world’s intractable problems that we are facing today.
The global Millennial and Gen Z demographics are boldly driving this change, and as they move into leadership positions (decision makers) in the corporate and financial worlds, ESG cannot be dismissed as a passing phase. This pivot to multi-stakeholderism – maximizing financial returns with ESG as core considerations – is expected to accompany economic growth.
Some companies and investors will go further than others. Others may not move to address this at all and will certainly miss out on key trends. Regardless, this evolution is happening organically and out of necessity. The system is constantly changing and the ESG discourse has contributed to a consequential shift in its trajectory.
As a consulting firm with decades of experience in ESG, it is our aim to clarify what is at stake and what actions need to be taken to address the most defining issues of our time with clarity through a multi-faceted ESG lens that leads to informed decision making and ensures we all remain on the same winning team.