With investors seeming to insist on climate-positive strategies, the "ESG" term has drawn capital to the asset managers and corporations who invoke it.
But what does ESG mean, and how can investors and regulators work to ensure that something with the ESG label moves capital toward a livable future?
This explanatory story rounds up perspectives from experts and data from the field to clarify what the ESG label means, ought to mean, and never set out to mean in the first place.
There’s an elephant in the fund: Earlier this year, some of the most vocal and proactive ESG firms, each with multiple commitments towards a net-zero future, actively funded lobbying efforts against President Biden's infrastructure bill and Build Back Better Act. These bills contain some of the most assertive climate provisions to date—something that each of these firms has issued strong support for.
What does it mean for a firm to prioritize environmental, social and governance (ESG) metrics in its strategies? As it stands, ESG is a label that’s generously applied across investments and business strategies without any consistent standard.
Is the net impact that Microsoft (a leader in accelerating carbon capture technologies) or BlackRock (the largest asset fund challenging investors to accelerate the energy transition) generates from these strategies positive, despite their lobbying efforts? In opposing the potential increase in corporate tax rates (from 21% to 28%), these major corporations are fighting to defeat the tax hikes that would fund these bills.
That leads us to ask a few key questions:
Can a company exist as an ESG leader while also discrediting active efforts by the government to fund the zero-carbon future that the same company claims to commit to?
Does the “environment” in ESG imply a low-carbon business model, or even an ethical transition towards one? Exactly how strong is the link between ESG and decarbonization efforts?
More importantly, is ESG a distraction used primarily for greenwashing purposes and depriving critical industries from much-needed capital?
Currently, ESG is not nearly as promising as it claims to be. While significant capital has flown into ESG funds, and there is undoubtedly a lot of potential for ESG to further accelerate the energy transition (amongst other pressing issues), ESG often lacks consistency and reliability. ESG topics and products need to be better leveraged as an important vehicle to help engage the private sector. But for the label to be effective, it requires greater regulation and transparency.
With these questions and thoughts in mind, let’s take a step back to explore ESG in more detail. To help evaluate the efficacy of ESG claims and private sector funding in advancing decarbonization, I’ve gathered insights from experts and across ESG reports. Join me on this journey as I attempt to unravel what the ESG label represents.
Let’s dig a bit deeper into what exactly ESG is.
The ESG label reflects a set of topic areas that fall under the broad buckets of environmental, social and governance issues. While many third-party agencies help define what falls under each topic, the realm of ESG is subjective (particularly the S and G). Although there are emerging efforts to standardize the “what” in ESG (through consolidation of frameworks such as SASB, TCFD, and GRI), the materiality is often defined by an investor or organization.
Once a specific ESG topic is prioritized, based on the stakeholder, different mechanisms engage the cause. Investors shift how they allocate their capital: BlackRock divests away from coal assets, mutual funds create ESG indices. Companies prioritize ESG in their business strategy: PepsiCo joins the OneTen coalition committing to addressing issues of systemic inequality for millions of Black Americans. In short, the “how” in engaging ESG causes varies by stakeholder.
The discrepancy in both the “what” and “how”, given ESG’s voluntary nature, creates mistrust in and abuse of the ESG label. First, a recent report published by Arabesque highlights that less than 25% of firms are on track to achieve their Paris Agreement goals. Furthermore, there’s skepticism within organizations setting ESG targets themselves. In a recent survey by the corporate governance advocacy non-profit OCEG, only 9% of executives were highly confident in their ESG capabilities.
Desiree Fixler, former Sustainability Officer to German fund DWS Group (EUR 880B assets under management) raised concerns about the firm overselling “green, ESG” products. Dismissed less than a year into her role, Ms. Fixler has since been in legal disputes with DWS Group, a firm now under investigation by the SEC in the US and financial supervisory authorities in Germany for potentially overselling ESG products.
Ms. Fixler’s concerns aren’t unique. Billionaire hedge fund manager Christopher Hohn criticizes the prevalence of greenwashing in wealth management and challenges asset managers to be more proactive, including the fund Blackrock—one of the leading voices in ESG investing.
When it comes to corporate ESG strategies, greenwashing is equally worrisome. As a consumer, it’s probably safe to remain skeptical of corporate commitments until mandated regulation becomes formalized. Several executives acknowledge that it’s common to come across ESG commitments that aren’t linked to neutral third-party standards (e.g., science-based targets or SBTs). The Energy and Climate Intelligence Unit (ECIU) and Oxford Net Zero, in a March report, identified that while 769 firms out of the Forbes Global 2000 list have net-zero targets in place, only one-fifth of them are aligned with SBTs.
In other words, given that ESG reporting is still voluntary today, firms that disclose ESG strategies aren’t obligated to align with a third-party framework. Of the ones that are aligned, discrepancies between strategies and approaches remain because the various frameworks (e.g., SBTs, UN SDGs, TCFD) use different definitions on materiality.
Even with mandated disclosures and stricter policies, some strategies (such as Google’s 24/7 by 2030 carbon-free strategy) won’t be successfully captured in these frameworks, due to the multitude and fast-changing pace of ESG approaches. We’re unlikely to see a “one-size fits-all” framework to capture all of ESG. (Disclosure: I have worked for Google and have applied for upcoming summer jobs at the firm.)
So how exactly should a consumer parse out firms that greenwash vs. those with effective ESG approaches? Or might a company do both?
Ideally, managers and their clients can rely on a balance between consistent standards—which have already begun emerging in the US (including the new formation of the International Sustainability Standards Board led by the IFRS)—and industry leaders continuously pushing these standards to a higher bar.
Today, however, we mainly rely on industry leaders. These leaders’ application of ESG rules depends on the financial advisor or the company executive. The confluence of power and influence of the private sector creates situations ripe for greenwashing, which in turn adds fuel to the backlash we’ve seen in ESG products.
However, if market regulators can shift some influence away from the private sector, by enforcing minimum standards for ESG products, there will be greater transparency in the deployment of this private capital.
But let’s be clear, ESG was not created to solve the world’s most pressing issues. Instead, it was a set of priorities that firms and investors voluntarily adopted.
Coined almost 20 years ago by the former UN Secretary-General Kofi Annan, ESG investing was introduced to 50+ CEOs of major financial institutions as an invitation to support the UN Global Compact within capital markets and company strategies. What began as an informal initiative has now transformed into over US$30 trillion in assets under management.
But how effective have we been in achieving this initial goal? To better grapple with how ESG aligns with climate and societal challenges, Professor Todd Cort, faculty co-director for the Center for Business and Environment at Yale and co-director of the Yale Initiative on Sustainable Finance, shares a framework.
The key takeaway is that most ESG funds and strategies are financially driven, whereas a small minority can be considered impact investments (i.e., representing those willing to take a cut on potential financial returns). In this world, can we better align ESG to funnel enough capital to decarbonize the sectors that need it?
Let’s look at the three categories Professor Cort illustrates to help navigate this question. In reviewing this framework, we need to recognize that the technologies that fall within the first bucket took over a decade to reach the attractive prices and market opportunity they provide today.
However, we do not have the time to wait for natural economies of scale to drive technology prices down in the remaining categories. There needs to be a catalyst to incentivize greater capital into categories two and three.
Realistically, the ESG label sometimes rides lightly on a company’s access to capital. For the label to hold more weight, we need both the carrot and the stick to drive more private capital into these pressing societal issues. According to a Bloomberg study, after evaluating 70+ sustainability-linked credit lines, more than a quarter of the firms receive no penalty when they’ve underachieved their stated goals.
The perception that markets will be the leaders in solving the most pressing societal and environmental problems is highly contested. Some businesses, like Patagonia and Unilever, have proven that by prioritizing a longer-term horizon and by putting stakeholders first (vs. shareholders only), a business is better able to mitigate the negative externalities that are commonly associated with the private sector.
And while Patagonia and Unilever are undeniably leaders, their business structures as a private firm and major conglomerate give them a unique advantage. With greater autonomy, coupled with the assertive leadership at their helm, Patagonia and Unilever can push the envelope faster and more assertively, better embracing ESG initiatives throughout their companies. Their successes, including the positive response from consumers, have inspired other companies to follow (e.g. VF Corporation, parent company to Timberland and North Face, committed to sustainable raw materials).
While businesses can serve as a catalyst to drive the change society needs, the existing incentives in a capitalist market make it challenging and unreasonable for this to be the norm. Absent significant top-down pressure by corporate leadership, it’s difficult to imagine this solution at scale.
As such, Lisa Veliz Waweru, Manager of ESG and Decarbonization at Deloitte, stresses that ESG won’t take the place of effective policy. The purpose of ESG is to serve as a vehicle to communicate comparable, corporate information that allows investors to make better decisions.
According to a Bloomberg study, after evaluating 70+ sustainability-linked credit lines, more than a quarter of the firms receive no penalty when they’ve underachieved their stated goals.
As the role of corporations and private capital evolve, ESG products continue to grow rapidly and operate in an amorphous zone. ESG considerations have shifted the lens to a greater long-term perspective to protect value, but the lack of standardization in the space has drawn a lot of criticism and mistrust.
Revisiting two key concerns we brought up earlier:
Critique #1: ESG is a fad and used for greenwashing
While the ESG label is susceptible to greenwashing, it is not meant to be corrupt. ESG factors help a business mitigate risk; as pressure mounts from external stakeholders, the lens businesses use to evaluate their decisions will continue to evolve. With greater standardization, the ESG market will become more reliable and effective as a benchmark to help accelerate capital and action to address critical societal and environmental issues.
Critique #2: ESG deprives funds from “less-popular” carbon-intensive industries
Private capital that responds to ESG topics is a result of perceived financial opportunity and risk management. The International Sustainability Standards Board in the US (and mandated TCFD disclosure across Europe), among others, begins to standardize ESG disclosure to provide greater transparency in the data. This in turn will better allocate capital to underfunded areas. Take, for example, Tesla and how it transformed the EV industry:
Tesla took the risk into entering the space that Big Auto was unwilling to, despite early government regulation in the 1990s when California introduced its zero-emission vehicle mandate (which was later dismantled by corporate lobbyists).
Tesla became the catalyst for significant private sector engagement when it proved the market viable, and now Big Auto is following (e.g., GM’s recent commitment to sell only zero-emission vehicles by 2035) in addition to $12.5B funding allocated from Biden’s Infrastructure plan ($7.5B for EV charging stations and $5B for Electric and Hybrid school buses)
One important consideration to note is that ironically, Tesla only just made the list S&P 500 ESG index (in 2021) despite leading the EV revolution. Ranked as an “Average” by the MSCI ESG rating agency, Tesla’s score reflects divergence in how ESG is evaluated, given methodology and available data.
So is ESG a gimmick or a true solution? As of today, it’s a bit of both. Perhaps the underlying question should be whether the market model of capitalism, a system that promotes perpetual growth, is feasible for a planet with finite resources.
When it comes to ESG though, its products and standards need to continue to evolve. The private sector can drive significant positive change, but for that change to be reliable, consistent and equitable, we need more regulation, standardization and government intervention.