In recent years and in 2022 especially, we have seen an unprecedented global momentum behind environmental, social and governance (ESG) investing, policy, and corporate disclosure. Despite the uptick in the ESG conversation, confusion remains on what ESG is – and is not. Here we dispel ten common misconceptions of ESG.
- ESG alone can save the world
This has never been, nor will be, the mission of ESG, despite arguments otherwise. The foundation of ESG rests on the premise that business performance is dependent on how firms manage environmental, social and governance topics that are most relevant to their enterprise. In its purest sense, ESG is a framework for risk management to support long-term value creation. To truly mitigate and ideally solve some of the world’s most challenging problems such as poverty, hunger, education, and climate change, will require concerted, collaborative, and coordinated efforts from a broad swath of institutions across government, NGOs, academe, and business. ESG is an important input into this but cannot alone support scaled solutions without a broad host of additional actors. - ESG and impact investing are the same thing
Impact investing is fundamentally about using the power of the capital markets to direct funding to companies that can demonstrate with evidence that their products or services change people’s lives (e.g., affordable housing) or the planet’s health (e.g., carbon transition funds) in a meaningful way that an otherwise business as usual approach would not have produced. An ESG approach directs investment strategy and capital allocation based on how firms manage the risk and opportunity of the most relevant environmental, social and governance topics for their business. Adopting an ESG approach does not guarantee a measurable return of net societal impact. For instance, regulators like UK’s FCA and the SEC have signaled their intention to require more rigorous disclosure on what comprises ESG versus impact investing across financial services products. While there will be increased interest in impact investing led by the generational transfer of wealth, it is an importantly different model. - ESG implies no tradeoffs
As a creation of the capital markets, ESG is inherently a game of tradeoffs. Management teams and boards get paid to make the hard decisions that may include downsides. For instance, how does a firm weigh investing in a new human capital process to diversify its talent pipeline over returning capital to its investors? Sure, it might be easy to simply say the human capital investment will pay back in the short run and a financial projection could support such an approach. But regardless of the management’s decision, there may be winners and losers. ESG is a practice that relies heavily on discipline, prioritization, and the need to make difficult decisions using imperfect data. Win-wins are possible yet may only be achieved through an incremental and integrated approach to scaling unique ESG practices across a business model. - ESG implies lower returns
There is increased evidence from a variety of sources that an ESG approach can potentially beat the market. Accounting professors Mozaffar Khan, George Serafeim and Aaron Yoon found that companies with the highest ESG ratings were also the ones that performed especially well on the financially material ESG topics for their industry per the Sustainability Accounting Standards Board (SASB). Companies that focused on topics most material to them beat the market by over 4% versus those that focus on all topics and not just material ones. Homogenous ESG box checking, as it turns out, is not consistent with long term value. - ESG has little substance beyond promotion
ESG is in its late 1.0 period of growing pains, so it is an easy target. And yes, there have been some cases of firms overstating ESG performance, leading the SEC and other regulators to start taking a more surgical look at greenwashing. As a business discipline that has taken hold precipitously - 10 years ago 20% of the S&P 500 issued an ESG report to over 90% today - it has much to improve upon and will continue evolving as a management practice. But per the above point, early evidence points to its efficacy in driving returns when operationalized intentionally and effectively. As the practice grows, a substantive conversation should be had about how ESG could evolve from single to double materiality and that should be focused on how ESG demonstrates long-term value backed by evidence. - ESG is only about reporting and is not connected to a company’s core business strategy
The genesis of today’s ESG has its roots in voluntary reporting frameworks and standards, such as the Global Reporting Initiative (GRI) and the International Sustainability Standards Board’s Sustainability Accounting Standards Board (SASB). Reporting has been the tail that wags the dog but the next phase of ESG will evolve to focus on how firms can move from transparency to long-term performance. Bottom line: reporting is critical and foundational but integrating ESG across the business is the next and more difficult step. To smooth this journey, firms might consider bringing additional functional areas closer to the table to help support ESG value creation, including tighter collaboration across the CFO, COO, GC, and Head of IR spheres of responsibilities. While ESG reporting will only continue to intensify, more time could be spent on tying the contents of the report with overall business strategy and KPIs. - ESG is best left to the Board alone
The recent emergence of ESG topics – especially climate change – in proxy battles has been well documented and covered by the media as activists increasingly join the agenda. Some boards have been caught flat footed in their response to legitimate concerns over ESG management and many in these activist battles need to be better prepared. Boards will be increasingly expected to have ESG and sustainability subject matter expertise and appropriate governance structures to best guide their companies forward. Proxy battles, which sometimes can be fueled by incomplete information from ESG ratings and ranking organizations, will continue to persist. Boards should be briefed regularly on specific ESG risks and opportunities in a fluid landscape where industry, competitor, peer, and regulator ESG movements will constantly shift the playing field. While the role of boards in understanding and managing ESG should become a standing agenda item in the boardroom, ESG as an operational imperative rest primarily at the C-suite level and below. - ESG is only about the E
The roots of today’s ESG were germinated by perceived gaps in corporate environmental regulatory disclosures. In a field so dedicated to data, especially quantitative data, environmental factors (e.g., toxic shocks like petrochemical spills or carbon emissions) tend to be dominant because they are the easiest to measure relative to S or G. But ESG is a holistic framework where the relative importance of the E, S & G factors all depend on the industry, business model, financial model, and stakeholders at each company. For many firms, such as those in technology or professional services, social and governance topics may be more relatively material than environmental ones. - ESG is only concerned with the investor audience
While investors are an important part of the mix, ESG is not solely about the investor voice. Indeed, investors are somewhat late to the party, whereas employees, NGOs and even governments, have been vocal proponents of an ESG approach to business management for decades. It is hard to imagine the energy we see today around ESG being solely shaped by investor interests. Firms would be wise to regularly engage with their investors on ESG topics and to also shape their ESG strategy and operations by engaging with a broader group of stakeholders through comprehensive ESG materiality assessments. - ESG is only procyclical and will evaporate as a recession takes hold
Do not bet on it. With the US SEC now expanding its ESG-related agenda on climate, human capital, cyber, and greenwashing, these regulatory expectations will translate into must-have operating budgets, with investor relations (IR) function playing a larger role in supporting ESG. It is increasingly understood that ESG adoption is the price of doing business and while ESG application and integration varies widely by firm, industry and geography, a retreat is unlikely, even during lean times. Few firms will wish to cut risk management and limit opportunity, AKA ESG.
So, what’s next for ESG in 2023 and beyond?
The misconceptions around ESG are in fact linked to the promotional tone of many corporate announcements as well as the political desire to create cultural issues that can drive voter turnout. The reality of what we see from our clients is much more prosaic: E, S, and G factors can and often do have a material impact on business performance and ultimately, company valuation. In the fullness of time, and perhaps as soon as the electoral calendar fades from view, ESG factors will reclaim their place as crucial data in the corporate / investor dialogue about drivers of risk and reward. ESG is not only alive and well but will continue to evolve into 2023 and beyond.
Lane Jost, Head of ESG Advisory, US, Edelman Smithfield.
