ESG: Looking Back and Looking Forward
We’ve come a long way since Milton Friedman’s famous doctrine, first elaborated in a 1971 New York Times article, that the “social responsibility of business is to increase its profits”. As long as businesses conformed to the basic rules of society, Friedman argued, then the sole responsibility of a corporation’s managers was to its shareholders. Anything else—such as corporate social philanthropy—was likely to be misguided, inefficient and a betrayal of shareholder interests.
Since then, three forces have begun to erode and ultimately crack the foundations of Friedman’s thesis, putting the spotlight firmly on the role of economic, social and governance (ESG) factors in corporate performance.
Rethinking the role of the corporation
The first part of this pincer movement was a rethinking of the economic theory of the corporation. At the turn of the millennium leading academics and commentators began to question Friedman’s assertion on both theoretical and empirical grounds. What if the rules of the game weren’t right? And couldn’t businesses help to create a better game, for both itself and society? For one thing, Friedman’s argument seemed to pay scant attention to externalities, major side effects of production and consumption such as pollution, resource depletion, and climate change. Businesses also draw from a wider commons of publicly provided infrastructure, skilled workers, and basic research provision. Porter and Kramer (2011) went further, arguing that businesses could create shared value for both its shareholders and wider society, for example through creating products and services for lower-income consumers, redesigning supply chains to reduce energy usage and costs, reducing packaging and water use, investing in local producers, and providing health and training for workers. Shareholder and stakeholder value were not separate or opposing forces, but inextricably intertwined and mutually reinforcing.
The climate emergency
On the environmental side, there was a shift too. Elkington coined the phrase “triple bottom line—people, planet and profits” to indicate the new orientation towards sustainable resource use and consumption. New thinking began to emerge around the concept of a circular economy, focused on recycling, re-use and sharing of resources to increase efficiency and mitigate environmental impacts. But perhaps the biggest game changer was Lord Stern’s 2006 report on ‘The Economics of Climate Change’, which estimated that ‘the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP, now and forever.’
The investor pivot
A third pincer movement came from the money markets, as major financial institutions began to incorporate a range of environmental, social and governance (ESG) factors into their assessment of company valuations. There is now a broad array of evidence showing a positive link between performance on ESG indicators and measures of corporate performance such as profitability, shareholder returns, return on capital and share-price volatility. Thinking has moved from the concept of socially responsible investment—eschewing investment in companies with greater environmental or social risks—to active ESG investment—that theory that strong performance on ESG factors gives companies a competitive advantage in the market. At a basic level, ESG factors can be important to firms for simple legitimacy reasons—to satisfy regulatory requirements or to access capital from investors. But more and more companies are also seeing ESG factors as financially material to their business—strong ESG performance can ward off the threat of future regulation, increase market share among socially-minded consumers, and help attract talent in the marketplace.
According to Morningstar, money is now flooding in to ESG funds at an unprecedented rate: investment flows into U.S. sustainability funds reached $21.4 bn in 2019, a four-fold increase over the previous year. There are now 303 sustainability investment funds in the US—defined as those that focus on sustainability factors as a material part of the investment process. Of these, 195 are classified by Morningstar as ESG focus: they make ESG a core part of the stock selection process and actively engage with companies on ESG performance; 67 are classified as impact or thematic—the funds may invest in projects with a specific theme such as affordable housing or alignment with UN sustainability goals; and 41 funds are sector-specific, investing in sectors such as renewable energy or water infrastructure.
Alphabet soup of standards
Despite considerable progress in mainstreaming ESG, challenges and controversies abound. For a start, not everyone even agrees what ESG is or how it should be measured. There is a dizzying array of different reporting organizations and ESG benchmarks at the international level—for example, the UN Principles for Responsible Investment (UNPRI), the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), to name but a few. By one estimate there are over one hundred different organizations producing ESG ratings. This creates confusion and administrative burden for companies, as well as a lack of transparency and comparability across different sectors and companies. In response, the GRI and SASB have started a project to move towards a single set of comprehensive standards.
New issues on the horizon
So how might the ESG landscape evolve over the coming years? One thing to note is that ESG can never be a static concept—it will constantly evolve in light of societal changes and the scientific understanding of risks. Recent years have seen a renewed focus on gender disparities, particularly at the senior levels within corporations. 2020 saw the rise of Black Lives Matter, putting the spotlight firmly on the topic of racial inequality at all levels of society. Some commentators have speculated that we are seeing a shift from the ‘E’—the traditional focus of much ESG reporting—to the ‘S’, issues such as gender and race which companies have often shied away from reporting on. Certainly, there are social issues aplenty on the horizon. Food security and health risks, particularly the obesity crisis in the western world, are coming into greater focus. And technologies such as social media and AI are giving rise to new concerns, for example the growth of fake news, cyber-crime, and erosion of privacy.
Back to the earth
However, the ‘E’ cannot be ignored either. The pandemic has shone a light on issues such as urbanization, deforestation and destruction of natural habitats. The world is witnessing an alarming decline in bio-diversity—according to the UN, ‘more than 40% of amphibian species, almost 33% of reef-forming corals and more than a third of all marine mammals are threatened’ with extinction, due to commercial exploitation, changes in land and marine use, and climate change. Urbanization is transforming the earth’s surface at an unprecedented rate. A recent study reported in Nature found that in 2020 the stock of human-made mass—concrete, metals, plastics and other materials—exceed the volume of bio-mass—all living things—for the first time in history. Above all, the threat of climate change looms large and will continue to present a major challenge to most industries from an ESG perspective. The Paris Climate Agreement of 2015 seeks to limit global temperature rise to 2oC above pre-industrial levels. According to MSCI research, only 16% of the 8,900 companies it monitors are aligned with such a goal. It estimates that, to be aligned with the Paris goals, nearly every company would need to reduce its carbon emissions by an average of 8-10% per year until 2050. To put that in perspective, this roughly equates to a lockdown-sized reduction in carbon emissions every year until 2050.
Better quantification
Apart from new ESG issues, the next few years are likely to bring renewed efforts towards greater harmonization and quantification of ESG standards and performance. With so many different ratings bodies, companies have considerable freedom to pick and choose which factors they report on. A consultation launched by the EU Commission in 2020 noted some major concerns over ESG reporting: the majority of respondents felt that ESG indicators were deficient in terms of comparability (71%), reliability (60%), and relevance (57%); 82% of respondents supported a requirement on companies to use a common standard of reporting. In 2020 the EU Council adopted the Taxonomy Regulation, which introduces an EU-wide classification system for ESG-related investments. It aims to provide a common language to identify those economic activities which are considered environmentally sustainable.
Finally, we are likely to see renewed efforts towards the holy grail of ESG assessment—accurate quantification of ESG metrics. Many ESG indicators are by definition hard to measure accurately. There is increased pressure to create more concrete measures of performance. One promising area is the use of AI algorithms to create new metrics of companies’ ESG performance, often using data from non-conventional sources such as the web and social media postings. In other cases, machine learning systems are being used to assess bias in promotion decisions or in workforce diversity. Finally, visual AI systems, sensors and drones can be increasingly used to provide real-time assessments of environmental conditions at the local level.