The Real-World Impact of ESG Policies
Thirty-year-old Sam Bankman-Fried, popularly known as “SBF” of FTX crypto currency exchange fame, made headlines when he was arrested on December 11, 2022, in the Bahamas on fraud charges. His net worth was estimated to be more than $20 billion, and he had pledged to donate 99% of his income to charity, including toward environmental causes such as global warming. But FTX, the exchange he led, had declared bankruptcy on November 11, 2022.
This news surely rocked those who were excited about the prospects of such massive philanthropy benefiting pressing global problems. Sadly, the FTX case has become an extraordinary example of “an utter failure of corporate controls at every level of an organization.”
On the face of it, this case seems to support the strong argument made by Tariq Fancy, BlackRock’s ex-chief investment officer, that the rapid spurt in Environmental, Social and Governance (ESG) investing could be as dangerous as offering “wheatgrass to a cancer patient.” The FTX collapse and discussions about crypto currencies bear some resemblance to the debate around ESG investing—that ESG, a well-intentioned initiative to tackle the biggest flaws of free-market economic, can also be accused of providing cover for “greenwashing,” or marketing environmental improvements when little or none exist.
Greenwashing is a diversion that can delay urgent action to stem global warming.
The recent 27th UN Climate Change Conference (COP27), in Sharm el-Sheikh, Egypt, focused again on the goal of the 2015 Paris Climate Accord (COP21) of keeping the long-term global temperature rise to below 2 °C, preferably to 1.5 °C (2.7 °F). Carbon emissions should be reduced by roughly 50% by 2030 and reach “net zero” by the middle of the 21st century to substantially reduce the effects of climate change.
Carbon emissions should be reduced by roughly 50% by 2030 and reach “net zero” by the middle of the 21st century to substantially reduce the effects of climate change.
UN Secretary-General António Guterres articulated one of COP27’s major concerns: “We must have zero tolerance for net-zero greenwashing and ensure credible, accountable net-zero pledges.” His admonition relates to the central issue of the ESG debate and ESG implementation by big market players and even nations.
The idea of ESG was first elaborated in a 2005 study, “Who Cares Wins,” by lead author Ivo Knoepfel. Then-UN Secretary-General Kofi Annan had brought together CEOs of fifty global financial companies, the International Finance Corporation, and the Swiss government, and together they made a case for embedding environmental, social and governance issues into the way capital markets operate. ESG refers to environmental sustainability-related issues, such as greenhouse gas emissions and biodiversity loss; social responsibility towards gender equality and respect for human rights; and good corporate governance practices, such as having a well-balanced board and a whistleblower policy.
Before the rise of ESG-driven impact investing, terms like ethical investing, corporate social responsibility (CSR), the triple bottom line of profit, people, and planet, and so forth, tried to capture the same issues but in a more voluntary framework. Many ideas, such as corporate social responsibility, started out as a voluntary initiative of the corporate sector to support promising social causes but have been subsequently mandated and regulated by governments.
Many ideas, such as corporate social responsibility, started out as a voluntary initiative of the corporate sector to support promising social causes.
In India, for example, a CSR regulation requires companies of a certain minimum size to spend 2% of their net revenue on CSR activities. Ethical investing uses a negative filter to eliminate investment in specific sectors that have a demonstrable negative social impact, such as tobacco.
Environmental, social and governance are three dimensions in which the impact of a company, or any other organization, on our society and the environment can be measured. The same set of parameters can also be used to measure the economic sustainability of a business itself, though detractors say ESG can be bad for the bottom line. In any case, the global climate crisis driving disruptive extreme weather events has obvious implications for many businesses.
Traditionally, free market-driven economics demanded only return on investment from entrepreneurs and their ventures and paid little attention to whether the enterprise damaged the environment, abided by labor laws, respected human rights, promoted diversity at the workplace, and followed good governance practices. Those issues tended to be considered as externalities, almost like inevitable side issues in the pursuit of profit.
Interestingly, it is not concern for the impact of business and industry on the environment and society alone that drove the adoption of ESG policies. The realization that so-called non-financial ESG factors do ultimately have an impact on the bottom line of a company was also a major driver. Investors and fund managers became interested in ESG reporting and ratings for the same reason.
Standards and Regulations
In an article published in December 2021, Bloomberg Businessweek exposed what it called the “ESG Mirage.” It investigated 155 companies that were given a rating upgrade by MSCI—the leading provider of ESG-based ratings that form the basis of investment funds offered to the public. MSCI looked at the sustainability of the companies and their profits as affected by their governance practices and socially responsible behavior.
But it considered environmental factors such as emissions and impact on climate change only as a side issue. Therefore, many of the companies, including McDonald's, got an ESG rating upgrade, despite reporting an increase in emissions.
The article exposed many flaws in MSCI’s rating system and how it has been used to mislead gullible investors. There are other examples of this, such as Tesla's recent exclusion from the S&P ESG 500 fund (Exxon Mobil remained in the fund) supposedly due to poor scores on social and governance metrics.
Tesla is undoubtedly one of the most important companies contributing to the environment as the largest maker of electric vehicles and renewable energy storage systems. However, allegations of racism in the workplace, accidents of its self-driving cars, and malfunctions of its batteries resulted in a poor score overall. Tesla is still included in other ESG funds, which again exposes the inconsistencies in the current ESG rating framework.
Global Reporting Initiative (GRI) Standards, Task Force on Climate-related Financial Disclosures (TCFD), and SASB Standards are three of the most widely accepted ESG standards and frameworks. The GRI—promoted by the UN Global Compact and its 5,800 associated companies—is the oldest default framework.
The TCFD framework provides standard disclosures relevant to their impact on the financials of companies and additional disclosures specific to a particular industry. SASB, on the other hand, is industry-specific and is more geared toward US corporations. SASB addresses the various ESG metrics and provide information that helps investors, regulators, and other stakeholders in decision-making.
Input from these varied reporting frameworks and the many rating companies like MSCI can be confusing and often contradictory. There is, of late, a move towards unifying the various frameworks under a common globally acceptable standard. Last year's COP26, held in Glasgow, decided to create an International Sustainability Standards Board (ISSB), subsequently implemented by the reputable International Financial Reporting Standards (IFRS) foundation.
A Question of Survival
Since the downfall of Soviet Union-style communism, a thriving free-market capitalism has been fueled by Liberalization, Privatization and Globalization (LPG). Whether it will survive in its current form may largely depend on the impact of ESG investing. Major regulatory reforms would be required to avert the most catastrophic environmental consequences of the current open-ended economic growth model.
When companies like Google, Amazon, and Microsoft declare goals to become carbon-neutral in all their operations, it has huge consequences for the world's net-zero carbon goal.
In an era of trillion-dollar companies dominating the world economy, the impact of their business practices on societies and ecosystems is far greater than at any time in history. When companies like Google, Amazon, and Microsoft declare goals to become carbon-neutral in all their operations, it has huge consequences for the world's net-zero carbon goal.
Among the top ESG-rated companies listed on the S&P 500, household names like Microsoft, technology company NVIDIA, and software company Salesforce have achieved MSCI AAA ratings consistently while delivering very good financial performance. Microsoft has been carbon neutral globally since 2012 and aims to be carbon negative by 2030. NVIDIA invests over $25 million in 5,000 non-profits annually while using 65% renewable energy in all its operations. Salesforce has already achieved carbon neutrality when the net sum of emissions and the purchase of renewable energy and carbon credits are counted.
A Success Story
Despite many associated scandals and flaws, the growth of ESG ratings-driven investment and assets under management remains unaffected ($37.5 trillion and increasing). One clear win for ESG-driven policy outcomes has been the positive change in the gender balance of company board composition in the USA. In 2017, the big three institutional investors, BlackRock, Vanguard, and State Street, took up the cause of improving corporate board composition, which had female participation at an abysmal 13.1% in 2016. It increased by 50% by 2019 to reach a still low but significantly better 19.7%. Such a significant improvement over a relatively short period of time does raise the hope that ESG-driven policies can indeed affect powerful change.
A meta-analysis of 1,000 case studies between 2016 and 2020 by the New York University Stern Center for Sustainable Business found a positive or neutral correlation between ESG focus and financial performance, depending on what ESG initiatives were being assessed. It further observed that improved financial performances were more noticeable over longer time horizons; ESG integration was a better strategy than a negative screening approach; and it improved risk management, drove innovation, and helped mitigate economic downturn and social unrest.
ESG disclosure on its own does not help improve financial performance. Still, an honest implementation of ESG-driven policy actions certainly produces long-term financial returns while benefiting society at large. Clearly, a more rigorous adoption of ESG-based policies in business management and corporate governance will help save the planet and make the business world more resilient and sustainable in the process, helping the current form of free-market capitalism evolve into a more benevolent version of itself.
*Dhanada K Mishra has a PhD in Civil Engineering from University of Michigan and is currently based in Hong Kong working for an ESG-focused proptech start-up. He has a strong interest in issues around environment, sustainability, and climate crisis.