The who, what and why of ESG

Good morning from Brussels,

Welcome back to ECGI’s monthly newsletter. Last month’s edition discussed what responsible capitalism is or can be. In sketching out this very broad topic, I spoke about sustainability and ESG, but also morals, ethics and values. Subjects such as corporate purpose or sustainable investing come along with a flood of terminology and buzzwords. Often they are ideologically charged and interpreted in a variety of ways. This month’s edition takes a closer look at ESG and sustainability, guided by Elizabeth Pollman’s paper ‘The Making and Meaning of ESG’.

Environmental, social and governance (ESG) was coined as an acronym in the 2000s by a joint initiative of the UN and the global financial sector. The idea was to group topics such as climate change, human rights or corruption as ‘ESG factors’ and integrate them in investment decisions.

Since then ESG has made a career that other acronyms like CSR or SRI could only dream of. It is no longer restricted to the investment industry but also tied to concepts such as sustainability or corporate purpose. Companies aim to improve their ESG performance and are subject to often diverging ESG ratings. ESG-minded investors can select among an ever increasing amount of ESG funds and investment products.

Ironically, ESG was initially chosen instead of sustainability to present a value-neutral term and avoid misunderstandings deriving from different interpretations. It has since developed into a highly controversial topic with a variety of uses and interpretations.

Grouping environmental, social and governance issues together and allowing them to grow and adapt is possibly what allowed ESG to become ‘mainstream’, but it disregarded the inherent tensions between them. Environmental and social interests are not always compatible, think for example of the employees working in the fossil fuel energy sector. Even different environmental objectives can be at odds with each other. Emissions from animals in free range farming are more difficult to capture than those in factory farms, which reduce animal welfare. Good corporate governance may be an important pre-requisite for companies to tackle the E and S, but it is unlikely that ESG-conscious investors would be satisfied with a company whose only contribution to ESG is a diverse board. 

Not only do we see a tension intrinsic to the acronym itself, but also concerning its different interpretations. ESG can be seen as a tool to achieve long-term value for shareholders. Both businesses and investors can employ ESG metrics to mitigate ESG-related risks and to identify investment and growth opportunities. ESG therefore doesn’t have to be value-laden, it can simply be good business or good economics. If ESG-minded companies indeed outperform their peers, then investing in them benefits the company, its investors the environment and society.

Extremely simplified, this interpretation of ESG is based on the idea that companies will be forced to internalize externalities due to new policies, market and societal pressures. Being forced to price in those externalities, ESG-minded businesses become the more profitable ones and typically benefit from a first-mover advantage. The link between ESG and long-term shareholder value therefore also depends on the successful implementation of a tremendous amount of policies and the adaption of the markets.

Ideally, long-term shareholder value and social value would coincide, but what happens in instances where they do not? Are investors willing to forego profits for the sake of environmental or social causes? Are businesses?

Other interpretations of ESG address these concerns. They contain a stronger values component and believe that ethics should be part of corporate and individual investment decisions and that corporations should also pursue broader social benefits. This view of ESG is more closely aligned with the general understanding of CSR and sustainability.

As Pollman says, ‘ESG was crafted in the language of conventional finance as aligning with long-term risk adjusted value, envisioning that at some point values and value would converge, but without fully working out the details at the time.’

Individual and collective efforts have been made in that direction, though we still haven’t worked out the details just yet. Ideally, values and value will eventually converge. In the meantime I believe that we need businesses to take on societal responsibilities. Responsible capitalism is about good business and good economics, but it doesn’t end there. We need to include questions of ethics and values in the debate as well.

What do you think? Let us know by sharing your thoughts in the section below.

Cordially yours,
Marleen