The increasing number of companies committing to Environmental, Social and Governance (ESG) efforts seems very promising to our future - yet there are still two main obstacles to overcome. This article tackles the main problems related to ESG and explores a possible solution.
What is ESG?
ESG investing is a commonly used term to describe the incorporation of Environmental, Social and Governance (ESG) aspects into investment analysis and decision-making. As the usage of this term has become increasingly popular in financial reports worldwide, this article delves deeper into ESC and the assessment criteria. The importance of the latter has been highlighted by the Stanford Social Innovation review, as they empathise with the need for an accurate rating system when it comes to ESG investing. An interesting article was published in the Stanford Social Innovation review about the importance of a good rating system when it comes to ESG investing.
There is a growing interest in ESG investing, as investors seek to align their portfolios with their personal values. In short, ESG covers environmental aspects by assessing the companies’ environmental performance and social factors are included by evaluating the relationships between the employees, suppliers, the customers and other involved actors. Further, by looking at the standards of running the company the governance is assessed. With the attention to social responsibility within corporations and social sustainability concepts, investments in ESG have grown worldwide. Last year, ESG investments were up to almost $650 billion compared to $542 billion and $285 billion in 2020 and 2019 respectively.
Assessment of ESG performance
These numbers show the ambition to invest in ‘good’ company practices. However, the definition of ‘good’ has proven to be a relatively vague term. For assessing the ESG performance of companies, investors tend to look at ESG indices. One might, logically, assume that those ESG indices assess corporate responsibility and evaluate upon those. However, most of those rating systems focus on the financial viability and status of a company and assess whether those ESG factors could cause any risk for the economic value of the company. So, reflections regarding the company's corporate responsibility or environmental impact are not necessarily included in those ESG indices. As a consequence, companies might receive a good ESG score even though they are highly polluting, because the ESG assessment shows that those emissions do not directly harm the economic value of the company.
An interesting example is given in the Stanford Social Innovation Review. This article refers to Philip Morris Tobacco, a Swiss-American cigarette and tobacco multinational, who joined the Dow Jones Sustainability Index (DJSI) of North America, which is one of the market indices that tracks firms that rate well on ESG performances. This raises the question how a tobacco company that produces a product that is both addictive and causes cancer could ever be considered sustainable and is allowed to join the DJSI? The main reason for this is the DJSI lacks a strong rating system that takes all ESG factors into account. Only a few criteria of the ESG factors are assessed, which thus mainly include whether a company is able to manage their emissions well in order to prevent harm to their economic value. This illustrates an important problem with the assessment of ESG.
Another problem with the ESG-indices that comes into light are the individual weights that are assigned to each ESG-factor. Take for example, Coca Cola, a company who has received high ESG-scores. Coca Cola ranks high on corporate governance and their greenhouse gas emissions. However, their core product is addictive and could cause diseases like diabetes and obesity, diseases which cost the United States alone over $300 billion a year. So how could Coca Cola get high ESG scores from those leading indices? The main reason is the subjective nature of the weights that are assigned to each ESG-factor. The final ESG-performance score is an aggregated value of all individual factors, which have individual weights assigned to them. Based on this approach, negative scores could easily be ‘outweighed’ by positive ESG-factor scores, resulting in an overall good ESG-performance.
In conclusion, the idea of an ESG rating system sounds promising in theory, as it involves important aspects into decision making and investment analyses. However, when looking at the current implementation and assessment of this ESG rating system worldwide, several problems have come into light. Therefore, the need for an universal rating system and assessment tool is high.
Companies committing to ESG is a step in the right direction, yet there are still many obstacles to overcome. The commitments made thus far have yielded scarce results and no concrete actions related to ESG are realised yet.The question how we hold companies accountable remains. In an article published by the Harvard business review, three main accountability mechanisms are discussed in order to make sure that these ESG efforts become more genuine.
1) Companies should be required to publicly report on their social and environmental impact with clear, standardised, and easy-to-understand metrics; like recently proposed by the SEC in the United States. This will lead to more reliable results and more valid comparisons between companies can be made.
2) Consumers, employees, and investors all have a role to play in holding companies accountable. Those stakeholders each have their own desires and demands which need to be taken into account for providing a complete overview.
3) Companies that would improve on their sustainability, social responsibility and inclusivity, becoming certified as benefit corporations would be worth considering. In order to become certified as such a benefit corporation, the company needs to explicitly include public benefits into their balancing profits.
The accountability of firms will increase considerably if the SEC decides to go through with the proposal to require companies to report their environmental impact. The agency has given the public 60 days to comment on this proposal. If the proposal is approved, it will completely alter the course of business. To learn more details about this proposal, the expected public consensus and consequences, read more here.
In conclusion, the vast majority of companies likes to claim that they are aiming to achieve environmental and social goals yet in reality they make little to no progress. This gap with reality must be made public or otherwise companies can go on by making false claims and unfulfilled promises. Creating more transparency through a far more comprehensive and logical assessment system can be a first step into revealing how well a company is really performing in terms of ESG efforts. The combination of accountability through mandatory reporting and more specific assessment systems, will likely allow the ESG trend to become far more successful and impactful.