The knives are out for ESG.
First, some politicians sought to make environmental, social, and governance factors in investing a right vs. left issue. Then the world’s largest investment firm said shareholders have gotten out of control by taking over this year’s proxy season with too many prescriptive ESG proposals. And now Elon Musk has loudly joined the fray, incensed that Tesla has been kicked out of the S&P ESG Index.
The detached observer might ask, if Tesla isn’t fit for an ESG grouping of companies, then who is? The nondetached Musk just tweeted, “ESG is a scam. It has been weaponized by phony social justice warriors.” Musk has a lot going on right now, so we can excuse his critique’s lack of nuance.
But we run an ESG company, and we’re here to tell you that Musk has a point.
Imagine, for a moment, you are asked which professional athlete is the best. Or asked to rank all athletes. The obvious questions that follow might include: which sport? By which measure? Team wins? Individual statistics? Over what time period? And are we just talking about end results, or do we include the athlete’s attitude and conduct as he or she competes?
In Tesla’s case, few dispute that its cars play an important, perhaps critical, role in pushing the auto industry toward becoming greener. However, S&P’s exclusion is not driven by Tesla’s cars, but because of concerns around issues like Tesla’s working conditions, how it handles investigations into crashes, water use, its supply chain, and the company’s lack of a formal low carbon strategy and codes of business conduct.
The problem with ESG disclosure as a tool – whether for investors or even society – is that it is way too blunt a frame. As it is currently conceived, ESG is at risk of becoming little more than a marketing slogan, destined to confuse, or be labeled “greenwashing.” The risk is that the whole ESG concept gets thrown down the drain before it gets the chance to grow up.
So, what should be done? Here are a few steps that might help ensure ESG moves from a debatable abstraction into a set of effective tools that can drive positive change.
First, those three letters need to be unbundled.
Which company in an industry group, or in a market capitalization grouping, is more responsible for CO2 emissions? This is a question we can ask and answer. Which company is doing a better job of paying employees a living wage? This is a question we can ask and answer. Which company has a better worker safety record? This is a question we can ask and answer.
We run into trouble if we try to roll these and other questions together to answer, “Which company is better?” It might make for fun trivia, but the question isn’t answerable in any way that would help markets allocate capital. Is Serena Williams a better athlete than Michael Jordan? Is Tiger Woods a better athlete than Lindsey Vonn?
Second, the metrics that are used in each of the E, S, and G categories need common definitions. It is not that all companies need to track the same metrics, because some metrics that matter for one industry are irrelevant for another. But we need the definitions of each metric to be close enough to enable useful comparisons when employed. The work of the International Sustainability Standards Board to update and globalize the SASB’s industry-based standards is incredibly important in terms of enabling comparability.
Third, we need to stop focusing on overall rankings and binary choices, such as inclusion or exclusion from a particular index. Each provider of those services will have its own methodology and nuances, developed to meet the needs of its target audience. Right now, the information that underpins those products – company nonfinancial data – is all over the place. One level up, there are weightings applied to those metrics to roll complex data into a single rating or score. Pick a company in the Fortune 500 and sample the top five ESG ratings providers – a correlation of less than 50% is normal. By comparison, the top five ratings providers for a typical corporate bond from the same Fortune 500 company would likely have a correlation greater than 80%. This kind of result undermines confidence in ESG writ large.
Benchmarks driven by actual data generated by companies themselves and held to the same standard as financial data, on the other hand, are useful. They are useful for the company itself when its managers and board seek to understand areas they need to focus on and improve. And they are useful for investors trying to understand where to allocate capital based on more than just traditional financial metrics.
But for benchmarking to work broadly, for both public and private companies, we need some basic agreement on a core set of E, S, and G metrics that should be tracked, and we need a way for companies to share the data on an anonymized basis.
In some countries, regulators are pushing more of a common framework of which ESG factors should be tracked. Europe is rolling out Sustainable Finance Disclosure Regulation to improve transparency related to investment products. And last March, the Securities and Exchange Commission issued a new draft proposal to add standardized climate reporting to required disclosures by public companies, while the U.K. passed a Climate-related Financial Disclosure law in January. Over time, there will be more convergence, analogous perhaps to how generally accepted accounting principles, the international financial reporting standards, and other accounting regimes drive to similar end points.
Importantly, as more companies choose to report ESG metrics, their boards of directors should ultimately be accountable for an appropriately rigorous method of collecting, storing, and analyzing such data. Industry groups, in turn, should collect the anonymized data and provide benchmark visibility to all participants. We’re entering an era where forward-thinking CFOs are beginning to review ESG data with the same rigor as company financials.
It took Elon Musk a lot of time and a lot of failures to get his cars and rockets on course. There were numerous false starts and modifications along the way.
Let’s give the ideals behind ESG a chance to get it right too.