Imagine for a moment you start feeling unwell. You go to your doctor and try to describe your symptoms. Inevitably, you will be asked lots of questions. Some might be very specific about what the pain feels like, and others might be quite general, asking about your sleep patterns, stress level, eating habits, and overall mood.
Now imagine the medical profession comes under attack for being too inquisitive, leading some insurance companies to refuse to work with doctors that ask these comprehensive questions when they diagnose a patient.
The topic of ESG (environmental, social, and governance) and investing is in the midst of a similar dynamic. Some stakeholders argue that their institutions should no longer do business with investment firms that might consider ESG factors when analyzing companies. And some leaders have built this position into their candidacy for political office.
Wait a second, you might think, this analogy works because ESG is rooted in subjectivity whereas medicine relies on objective data. And those “lifestyle” questions a doctor asks have clear links to diagnoses that have been proven with data.
If this is your reaction, you have a point. Or at least you used to, because this debate is about to shift.
But first, some history.
The practice of capitalism has evolved over the past century. After World War II, a refreshed social contract between citizens, government, and the private sector led business to embrace its responsibilities to employees, communities, and society at large. This led to extraordinary growth in the middle class, as the bottom 90% of all Americans experienced 77% growth in real wages between 1945 and 1980. However, the concept of stakeholder capitalism gradually eroded, and by the late 1970s it became widely accepted that the only social responsibility of business was to maximize profits, as Milton Friedman famously put it. Economic history shows real wages of American workers declined between 1981 and 2019, despite a significant increase in productivity during that same period. At the same time, wages for the top 1% rose dramatically.
In 2019 the Business Roundtable released a statement, signed by more than 180 CEOs, that redefined the purpose of a corporation to promote “an economy that serves all Americans.” This announcement was, essentially, a return to the values of stakeholder capitalism. The result? ESG was pushed into the public domain, turning an academic, technical concept into a culture war pinata.
Let’s return to that doctor visit.
Imagine if, as your doctor asked you questions to try to formulate a diagnosis, she inquired, “And are you a Democrat or a Republican?” Surely you would react with outrage, questioning how that is relevant to health.
Similarly, many ESG factors are easy targets for criticism because their link to financial materiality is unclear. There are two reasons why, and both have to do with data.
First, there are disparities in the conclusions from the rating agencies that rank public companies on ESG factors. Second, most companies in the world are private, not public, and there has been very limited data collected on what these hundreds of millions of firms are doing around ESG issues. How can an investor or a business manager know what to do with the results of one company’s ESG metrics if they can’t compare it to its peers, public or private?
Medical diagnoses work because doctors benefit from accurate data collected over decades. That data enables them to compare one patient’s dynamics to those of millions. ESG has been the opposite – more like allegory in Plato’s Cave, which famously highlights the difference between the “reality” of people’s sensory understandings compared to real knowledge gleaned by seeing the truth.
This situation, however, is changing.
Today, thousands of private companies have partnered with the ESG public benefit corporation Novata to contribute (de-identified and aggregated) their data to create over 250 private-market-specific ESG benchmarks. Now, there are accurate examples of what bad, average, and good looks like across hundreds of critical, nonfinancial metrics such as worker safety, data breaches, board diversity, pay equity, emissions, etc. And this data is not derived by a third party using algorithms. Instead, it’s collected and reported by its actual owners, delineated by industry. This is like opening the door of Plato’s Cave to see what the outside world really looks like.
This means that ESG metrics can now be effectively linked to financial materiality.
As an example, suppose an investor is considering funding a private company and analyzes the percent of renewable energy that company uses compared to its peers. If the investor discovers the result is bottom-quartile, there is a predictable implication for the company’s future profits. Why? Because there is no question businesses will need to shift their energy sources to a greater proportion of renewables over the next decade, and there is a cost to decarbonize. Suddenly, an ESG question becomes material because the data has been collected and can be accurately compared to peer performance.
In 1936 GAAP accounting was introduced, creating a uniform way to report financial activity. This transparency was widely adopted, investing went from niche to mainstream, and the modern capital markets were born, supercharging the century’s economic activity.
A similar trajectory looks likely for ESG. As regulators around the world adjust to require companies of all sizes to report on wide-ranging ESG metrics, demanding transparency (like GAAP), investors and companies will have clear insights into how such factors are linked to a company’s financials.
This is how we reframe the ESG debate – not through discord, but with data.