How do ESG and Sustainability Fit Together?
People just can’t help but adopt new acronyms, and ESG is one that we first started to hear more prominently around 8 years ago. Since then, it’s made quite an impact with detractors and evangelists alike.
In this article, I will cover the history, arguments and evolution of ESG and question its relationship to sustainability.
ESG stands for “Environmental, Social, Governance”, and it’s a non-financial reporting tool for companies to disclose their performance in line with a series of standards related to social responsibility, environmental impacts and corporate governance.
The intent of ESG is for companies to be more transparent about their impacts, and in turn, investors will then prefer investing in those that have high ESG performance, which will help move the stock market away from polluting, damaging industries onwards to virtuous companies that are doing good for the planet.
Great idea, right? Well, depending on which side of the Atlantic Ocean you are on, ESG is playing out in very different ways.
As it stands right now in mid-2023, ESG has evangelical proponents and detractors in equal intensity. Let’s dive into a quick history of where and how ESG came to prominence and overtook another acronym loved by companies, CSR.
A QUICK HISTORY OF ESG
Before there was ESG, there was Socially Responsible Investing (SRI), or impact investing, which contributed to companies wanting to report on their Corporate Social Responsibility, or CSR. Impact investing is when decisions are made to divest from polluting industries and invest in sustainable or socially-beneficial companies. Perhaps some of the most famous impact investors are Leonardo DiCaprio and Melinda Gates. So, CSR became the dominant way for companies to publicly disclose their environmental and social performance for a couple of decades. Until ESG came along.
To be fair, the categories that make up ESG have been around for decades, even centuries if you look at pre-industrial communities. But the modern incarnation of ESG really got going in 2005 when the United Nations released a report called Who Cares Wins, where it first mentioned ESG as it is used in the modern context. This report leaned in heavily, encouraging all business stakeholders to embrace ESG long-term. Managers, directors, investors, analysts, brokers — the report addressed them all. Then the UN set up the Principles for Responsible Investing (PRI), which has six principles developed by investors, for investors, and where signatories contribute to developing a more sustainable global financial system.
Source PRI
In 2006, The Global Reporting Initiative (GRI), which is one of the most widely used frameworks for sustainability reporting (and had originally promoted CSR in the 90s), introduced the idea of materiality as an assessment tool for Corporate Sustainability Reporting.
Global Reporting Initiative (GRI), ”Materiality is the principle that determines which relevant topics are sufficiently important that it is essential to report on them.”
They borrowed the term and approach from the financial sector and set up guidelines for businesses to evaluate their ESG impact and performance through what’s called a materiality assessment. Then after the infamous 2008 market crash, ESG grew rapidly and continued gaining momentum so quickly that it caused a flurry of confusion — confusion that is still very much present today.
Many major companies had been doing CSR reporting (the term was actually first coined in 1953 by Howard Bowen), but for many, despite years of CSR, there was not enough movement on addressing pressing environmental and social issues. So CSR kind of fell out of flavor, and some early proponents of it like John Elkington (who coined the “triple bottom line” concept of people, planet, profits) even issued a product recall, stating, “CSR and the citizenship agenda is now — not waning, because it continues to expand. But it’s gradually being replaced by several other agendas. The capitalism we’ve grown up with, particularly as it went into overdrive after 1989, is not working…. It must now not be about just tinkering language, or even with economics. The change will be fundamental this time.”
And so, after a couple of decades of glossy graphs and sexy statements that resulted in not a lot of significant changes, CSR started to be replaced with ESG. The rise in the circular economy also helped to push the needle away from CSR toward more economic changes.
Perhaps one of the reasons ESG got on the map so quickly was the January 2020 Letter to CEO’s from Blackrock’s CEO Larry Fink. Imagine the impact when the boss of the world’s biggest investment fund says openly that it will be divesting from companies that don’t actively address climate change! This triggered a flurry of activity, with companies wanting to be able to prove that they had indeed started to take action. Now most big financial players are in the ESG game, but the previous head of impact investing at Blackrock, Tariq Fancy, is one of the detractors from ESG. His argument is that ESG is BS and that the only way we can have true data and transparency on the ESG criteria is with better government intervention via legislation.
If you want to get into the history of this more, then the MSCI offers a great interactive review of the last 30 years of ESG, or how the precursor of responsible investment got started in the 90s.
“ESG is a hot topic. That’s not surprising given the sums of money flowing into Environmental, Social and Governance (ESG) strategies. Investments in ESG strategies grew 42% from 2018 to 2020. Today, one of every three dollars of assets under management is invested in ESG strategies.ESG funds are on track for a record year of inflows in 2021 as well, raking in more than $21 billion in the first quarter alone.” — NASDAQ
WHAT DOES ESG ACTUALLY ACCESS AND HOW?
ESG was born out of a need to shift the investing landscape toward more ethical and sustainable options, and early approaches focused on “screening out”, i.e. excluding companies from investment portfolios based on poor environmental, social or governance performance. This has now evolved into ESG being used to identify companies that are making positive changes toward ESG, called “positive screening.”
The architects of ESG wanted accountability and transparency, and so ESG was modeled off of the same accounting mechanism of materiality used in financial disclosures. So the same approach of due diligence needed for publicly-listed companies to share their financial assets, losses, etc., is used, but it focuses on the social and environmental aspects. This way, investors have more of a framework for assessing an asset’s performance against multiple criteria, not just financial.
Companies thus assess their exposure to environmental issues, such as divesting from fossil fuels and ensuring that their products are providing solutions to the climate crisis; the social side is about making sure that there are ethics in the supply chain, no use of slave labor, etc. For governance, it covers things like corporate due diligence, corruption and whether or not companies have investments from countries that are known to be doing unscrupulous things in the global market.
But here’s the thing: ESG does not provide any impact assessments that would actually provide the formidable data needed to inform positive change.
ESG is used to assess past and current conditions, not set standards for reduction or policies for future action. Although one could argue that poorly- performing companies will adjust behaviors to increase their ESG rankings, this can also lead to greenwashing, as the techniques applied to the materiality assessments being conducted are not currently assessed by a third party (although the concept of assurances is starting to be built in).
This is all to say: ESG has some merits and some issues.
THE CRITERIA IN MORE DETAIL
The environmental criteria include the company’s energy, waste, pollution, natural resource use, and animal welfare. It may also look at the environmental risks that a company is exposed to and assess how they address these, such as issues with ownership of contaminated land, carbon emissions, disposal of hazardous waste, how toxic emissions are mitigated, or compliance with government environmental regulations.
The social criteria focus on the company’s business and stakeholder relationships, along with how it works with suppliers and treats workers. Does the company donate profits to the local community or have an employee volunteer program to give back, for example? Does the company provide a high level of worker health and safety? How is social impact measured and improved?
The governance criteria look at how the company uses transparent and appropriate accounting methods to measure and report on performance. Are stockholders given an opportunity to vote on important issues?
This criteria also explores the avoidance of conflicts of interest and assurance that ethical practices are adhered to. It is important that they don’t use political contributions to obtain favorable treatment and that no illegal practices are partaken in.
MATERIALITY ASSESSMENTS
Materiality assessments are the main tool for ESG reporting; these are not the same as an environmental or social impact assessment, which is what is commonly used to assess sustainability and gain the data needed to report on details like greenhouse gas contributions, for example.
The word materiality has been brought over from the financial field and refers to those issues which are most important to a specific enterprise. This can include assessing which topics are the greatest priorities from an internal and external stakeholder perspective.
A material assessment is done by engaging stakeholders, but there is no one set way of conducting it (which proves some issues with consistency). However, guidelines are increasingly being produced, as is the case with the ESG taxonomy and CSRD in the EU (and beyond). Stakeholders ranging from customers, employees, and board members are surveyed or interviewed for their perspective on what is material against the ESG criteria. This is then aggregated, usually in a spreadsheet, and the degree of importance along with performance is documented.
This data is then turned into a materiality matrix, which is usually a graphic that shows where the company is falling against the criteria.
Many of the new EU legislations (check out our article on this here) require companies to conduct what’s called a double materiality assessment.
In a double materiality assessment, companies need to not only pull in engagement from many stakeholders, as in a standard materiality assessment, but also report on what affects them and show investors the vulnerabilities they might have in relation to say, inaction against climate change, or other threats against the ESG criteria. By default, this should drive less investment in companies with greater exposure to climate change and therefore encourage companies to transform their behaviors and actions so that they do perform better against these criteria.
There are ranking providers who will rate a company regardless of if they have published ESG reports. MSCI, Refinitiv, S&P Global, Sustainalytics, Dun & Bradstreet and Bloomberg are all competing to provide the most relevant ESG performance rankings. But here’s a free version from Statista!
THE KEY DIFFERENTIATORS BETWEEN ESG AND SUSTAINABILITY
ESG and sustainability are not the same. They share similarities and interconnections, but they have differences that are worth mentioning. ESG is a non-financial reporting framework that covers several aspects of sustainability, whereas sustainability is about the social, economic and environmental factors that a company negatively impacts and can, in turn, create a positive impact on through changes to the way the company operates.
ESG defines investment decisions that prioritize the Environmental, Social, and Governance factors that are central to measuring the success of a portfolio or future performance of a business.
A lot of what sustainability is about is assessing the impacts associated with actions to then create decisions, policies and procedures to reduce those impacts over time. Whereas ESG is more about accounting for what has happened and the performance of the company, it’s not a tool that is used to drive innovation or change. So that’s the primary difference between ESG and sustainability. However, ESG falls under the overarching umbrella of sustainability as a tool for transforming the economy to make sure that the decisions we make from business and society are in line with social, environmental and ethical guidelines.
To recap, where sustainability tends to be the three pillars of social, economic and environmental as a concept, and uses impact assessments to collect data and take action to systematically reduce impacts, there is confusion in the market about whether ESG is the same as sustainability. ESG is more of an accountability tool for the current or past activities of the organization. That said, ESG is going through a maturity phase, one that may help it take even greater hold.
“At the end of the 2020 proxy season, 90% of S&P 500 companies had published some kind of ESG report, up from 86% the prior year and 20% a decade ago.” — Harvard Law Forum
HOW ESG IN THE US DIFFERS FROM ESG IN EUROPE
The European Union has taken charge in establishing rigor and defining what it actually means to do sustainable investing. Over the last few years, they developed the ESG Taxonomy Regulation, which offers a set of standards that require companies to report against a defined set of criteria, and includes what is deemed appropriate as “sustainable” and what is not. There is also legislation, the Sustainable Finance Disclosure Regulation and Directive on Corporate Sustainability Due Diligence, that provides reporting criteria and frameworks, whereas in other regions like the US, there are currently no set standards for compliance guidelines.
However, in March 2022, the U.S. The Securities and Exchange Commission did propose expansive climate- related disclosure rules that would require disclosure only of climate-related information, rather than other ESG factors.
So what we see is that some jurisdictions are advancing the rigor and transparency of the ESG process, working to define criteria and set standards to ensure that the processes and data are valid and useful for driving sustainability in the financial sector.
But as Europe is making headway, the US is building an army of anti-ESGers committed to seeing that sustainability-based investments become distrusted and even banned.
Outside of the US and Europe, there are also ESG movements in places like Australia with their sustainable finance taxonomy, which is essentially a series of guidelines around how you can calculate your equivalency or the impacts associated with your activities.
BENEFITS AND CRITICISMS
“Global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total assets under management” — Bloomberg, 2021
In the US there’s been a lot of recent backlash against ESG because it’s seen as being anti-capitalistic and so-called “woke investing”. This is ironic since realistically, it’s about transparency and actually could be argued as pro-capitalistic because it’s really about the investors being able to truly see behaviors and actions to make sound investment choices. To get a glimpse of this chaos, go ahead and google “anti-ESG movement” and see for yourself. The general gist is that investors started to divest from fossil fuel companies, and in some jurisdictions, pension funds managed by states also divested from polluting industries. This angered the conservatives, so now they are putting in laws to ban the use of ESG as an investment tool in their states.
It all boils down to realizing that there’s ESG from the side of companies making the assessment and then there’s ESG on the investor side because remember, ESG predominantly started as an investment tool to make decisions about who is worth investing in based on the ESG performance or criteria because the market started to demand this.
“ESG data sorting by itself does not identify a responsible investment. What it does is provide starting points to do further research on how companies operate within their context. So when we look through the ESG lens, we’re looking beyond a company’s business context. Instead, we’re looking at its economic, regulatory, social, dynamics, and environmental contexts. Concentric circles are perhaps a little wider than the conventional view.” NASDAQ
Many investors argue that using the ESG criteria helps them avoid companies whose practices could signal a risk factor in the future, and as a result of the increase in demand, many major financial companies now review and report on ESG approaches and benefit from it. Many companies are also now linking executive pay to ESG performance.
From the business side, the benefits of reporting and complying with ESG reporting standards are that you demonstrate your willingness to address these important issues to potential investors. But some of the obvious issues are:
Deceptive reporting (see here)
Greenwashing and false claims
Significant lobbying and anti-ESG political activities in the US
Seen by some as just a branding activity
No assurances or third-party validation to ensure that data is correct (this is being rectified in the new CSRD legislation in Europe)
SO, WHAT’S NEXT FOR ESG?
It’s hard to say how the backlash in the US will play out; there is a lot of lobby money being invested in anti-ESG laws. Texas and Kansas have already passed bills, so perhaps ESG will become stronger for it, or be weakened to a point of no return in the US market. This year, Larry Fink (BlackRock’s CEO, who has been personally attacked by the anti-ESG lobby) made no mention of climate change or ESG in his CEO letter.
But in Europe, ESG and materiality assessments are becoming more solidified into standard business practices. Countries like the UK, Australia and Japan are working on their own taxonomies, and as a result, we may see an increase in legislation requiring non-financial reporting as part of a company’s standard due diligence and reporting frameworks. Certainly, there is a push for more assurances and auditing, with KPMG, EY and Deloitte investing heavily in staff to support this.
Standards have been developed by The Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-Related Financial Disclosures (TCFD) to enable businesses to identify and communicate financially material sustainability information to their investors. And as mentioned previously, the new Corporate Sustainability Reporting Directive (CSRD) in Europe requires a double materiality assessment and will apply to many non-European companies, so it will have an impact beyond the EU.
I would say that this is a case of the good and the bad, and perhaps it’s a case of waiting to see how this matures over time. Regardless of what the future of ESG is, it’s not a replacement for sustainability. If anything, it’s in addition to, but not the only thing a company should be doing.
There are many important sustainability decisions and assessments that companies need to be doing to ensure that they are responding to the international demand for responsible and ethical actions, from developing products that fit within the circular economy to setting climate action targets. All of these are covered in my Swivel Skills training platform, which is designed for easy access and rapid integration into the DNA of your organization.
