#004 Does ESG Important, and Why?

Since the term "ESG" (environmental, social, and governance) was established in 2005, and until recently, its fortunes have been continuously increasing. For example, since 2019, online searches for "ESG" (environmental, social, and governance) have increased fivefold, while searches for "CSR" (corporate social responsibility), an earlier area of concentration more representative of corporate participation than changes to a fundamental business model, have decreased. Organisations have been spending greater resources towards strengthening ESG across sectors, regions, and corporate sizes. More than 90% of S&P 500 firms now publish ESG reports in some form, as do around 70% of Russell 1000 companies.?Reporting ESG aspects is either mandated or under active discussion in a number of jurisdictions. The Securities and Exchange Commission (SEC) in the United States is exploring new regulations that will require more extensive disclosure of climate-related risks and greenhouse-gas (GHG) emissions.?Additional SEC rules on various aspects of ESG have been suggested or are in the works.

Even if the rate of new investments has recently been declining, the growing profile of ESG has been clearly visible in investments. Inflows into sustainable funds, for example, increased from $5 billion in 2018 to more than $50 billion in 2020—and then to almost $70 billion in 2021; these funds received $87 billion in net new money in the first quarter of 2022, followed by $33 billion in the second.?Global sustainable assets are around $2.5 trillion as of 2022. This marks a 13.3 percent loss from the end of Q1 2022, but it is less than the 14.6 percent decline for the entire market during the same period.

The environmental component of ESG and reactions to climate change have been important drivers of ESG growth. However, other aspects of ESG, particularly the social dimension, are gaining significance. According to one study, social-related shareholder proposals increased by 37% in the 2021 proxy season compared to the previous year.

Critics believe that the relevance of ESG has peaked in the aftermath of the Ukraine war and the subsequent human tragedy, as well as the cumulative geopolitical, economic, and social implications.?They argue that attention will shift more to the more fundamental parts of a Maslow-type hierarchy of public- and private-sector needs, and that today's fixation with ESG will be recalled as a fad, similar to other acronyms that have been employed in the past.9?Others have suggested that ESG is an unusual and unstable blend of factors, and that focus should be only on environmental sustainability.10?Simultaneously, threats to the integrity of ESG investment have multiplied. While some of these arguments have been directed at policymakers, analysts, and investment funds, the analysis presented in this article is focused at the individual company level. To put it another way, does ESG really matter to companies? What is the business-backed, strategic justification?

ESG criticism is not new (Learn more). As ESG has gained popularity and acceptance, it has also faced scepticism and criticism. There are four major sorts of objections.

1. ESG is undesirable since it is a source of distraction.

Perhaps the most famous criticism leveled at ESG has been that it interferes with the essence of what businesses are supposed to do: "make as much money as possible while conforming to the basic rules of society," as Milton Friedman put it more than a half-century ago. In this light, ESG might be viewed as a sideshow—a public-relations maneuver, or perhaps a way to capitalise on the higher motives of consumers, investors, or workers. ESG is "good for the brand," but it is not fundamental to corporate strategy. It is addictive and only occurs on occasion. MSCI, a supplier of ESG ratings and scores, discovered that roughly 60% of "say on climate" votes?in 2021 were simply one-time events, with only one-fourth of these votes slated to have yearly follow-ups.?Others have labelled ESG initiatives as "greenwashing," "purpose washing,"?or "woke washing."According to one Edelman poll, nearly three out of four institutional investors do not trust corporations to meet their declared sustainability, ESG, or diversity, equality, and inclusion (DEI) promises.

2. ESG is impractical since it is inherently tough.

A second criticism of ESG is that, aside from achieving the technical criteria of each of the E, S, and G components, finding the balance necessary to execute ESG in a way that resonates with various stakeholders is simply too difficult. When calculating financial returns, the goal is clear: maximise value for the firm and its shareholders. But what if the mandate is larger and the viable answers are even more complex? Solving problems for various stakeholders may be difficult, if not impossible. Who should management pay the additional ESG dollar to? To the client, through cheaper prices? Increased perks or better compensation for employees? What about suppliers? In terms of environmental considerations, perhaps an internal carbon tax? The best option is not always obvious. Even if such a decision existed, it is unlikely that a firm would have a clear mandate from its shareholders to make it.

3. ESG is not quantifiable, at least not to any significant degree.

A third issue is that ESG cannot be reliably quantified, particularly as shown in ESG scores. While individual E, S, and G characteristics may be evaluated provided the necessary, auditable data is collected, some opponents say that aggregate ESG ratings are meaningless. The problem is exacerbated by variances in weighting and methodology across ESG rating and score suppliers. For example, although S&P and Moody's credit scores are linked at 99 percent, ESG scores across six of the most significant ESG ratings and scoring providers correlate at just 54 percent on average, ranging from 38 percent to 71 percent.?Furthermore, organisations like as the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB) might evaluate the same phenomenon in various ways; for example, GRI analyses staff training in part by amounts invested in training, but SASB measures by training hours. As a result, it is to be expected that different rating and score providers—each with their own analyses and weightings—will produce varying results. Furthermore, significant investors frequently employ their own proprietary algorithms that draw on a number of inputs (including ESG rankings) that they have refined over time.

4. Even when ESG can be monitored, there is no substantial link between ESG and financial performance.

The fourth criticism leveled about ESG is that favorable correlations with outperformance when they exist, can be explained by other variables and, in any case, are not causal. It would defy logic if ESG ratings from different ratings and scores providers, measuring different industries, using different methodologies, weighting metrics differently, and examining a diverse range of companies operating in different geographies all produced a near-identical score that nearly perfectly matched company performance. Performance correlations can be explained by a variety of reasons (for example, industry headwinds or tailwinds) and are susceptible to change.?Several studies have called into doubt the existence of a causal relationship between ESG performance and financial performance.?While a recent metastudy found that the majority of ESG-focused investment funds beat the broader market, some ESG funds do not, and even those that do may have an alternate rationale for their outperformance. (For example, technology and asset-light firms are frequently among the broader market leaders in ESG ratings; they tend to warrant better ESG scores since they have a comparatively minimal carbon footprint.) The director of one recent study said unequivocally, "There is no ESG alpha."

In addition, to these four issues, recent events and volatile markets have prompted others to question the relevance of ESG ratings at this time.?It is true that the recognised, pressing need to strengthen energy security in the wake of the invasion of Ukraine may lead to more fossil-fuel extraction and usage in the immediate term, and the global collaboration required for a?more orderly net-zero transition?may be jeopardised by the war and its aftermath. It is also conceivable that patience with "performative ESG," as opposed to "true ESG," will grow thin. True ESG is in line with a prudent, well-thought-out strategy that promotes a company's mission and business model.

Nonetheless, many corporations are making important decisions today, such as ceasing operations in Russia, protecting staff in at-risk nations, and organising relief to unprecedented levels in response to public concerns. They also continue to commit to science-based objectives and develop and implement plans to meet these commitments. This suggests that ESG factors are becoming more significant in company decision-making, not less so.

The primary issue underlying each of the four ESG critiques is a failure to adequately account for social license—that is, stakeholders' perceptions that a firm or sector is functioning in a fair, reasonable, and trustworthy manner.?It has become cliché to assert that businesses exist to produce long-term value. If a company does something that destroys value (for example, misallocating resources on "virtue signalling," or attempting to measure with precision what can only be imperfectly estimated, at least to date, through external scores), we would expect ESG criticism to reverberate, especially if one is applying a long-term, value-creating lens.

However, some detractors fail to recognise that managing and addressing large, paradigm-shifting externalities is a prerequisite for preserving long-term value. Companies might appear to be reasonable in their operations, seek to provide returns quarter after quarter, and plan their strategy for five or more years. However, if they presume that the base scenario does not contain externalities or the erosion of social licence as a result of failing to account for externalities, their forecasts—and, indeed, their key strategies—might not be possible at all. In the midst of a tangle of measurements, estimations, objectives, and benchmarks, managers might lose sight of the reason for measuring in the first place: to guarantee that their organisation survives, with society support, in a sustainable, ecologically viable manner.

ESG ratings: Does variation matter?

As a result, replies to ESG critics focus on three essential points: the acute reality of externalities, the early success of certain organisations, and the long-term development of ESG metrics. Furthermore, links between ESG scores and financial success, as well as variations in ESG ratings over time, do not negate the argument for ESG. (See the sidebar "ESG ratings: Does Change Matter?" for more on ESG ratings and their link to financial success.)

1. Externalities are on the rise

People who are not directly connected with the firm might suffer significant effects as a result of the organisation's conduct. In a linked world, externalities such as a company's GHG emissions, influence on labour markets, and repercussions for supplier health and safety are becoming an urgent concern. Regulators are certainly paying attention.?Even if certain governments and agencies demand reforms more swiftly and aggressively than others, multinational corporations, in particular, cannot afford to wait and see. On the contrary, their stakeholders want them to participate in shaping the regulatory landscape and the larger societal sphere presently.[Millions of businesses around the world has made net-zero pledges as part of the United Nations' "Race to Zero" campaign]. Workers are also increasingly valuing factors like belonging and inclusion when deciding whether to stay with their current employer or join a competing one.?As a result, many organisations are actively reallocating resources and operating differently; virtually all are under significant pressure to shift. Even before the Ukraine conflict sparked major corporate response, the epidemic drove corporations to evaluate and modify key business practises. Many others have taken a similar approach to climate change. This tactile and palpable pressure is a representation of social license, and it has been more acute as growing externalities have become more pressing.

2. Some organisations have fared admirably, demonstrating that ESG success is feasible.

Companies do not gain the continuous trust of consumers, workers, suppliers, regulators, and other stakeholders based just on previous acts. Earning social capital is similar to earning debt or equity capital in that people who extend it look to previous performance for insights into future performance and are primarily concerned with intermediate and long-term possibilities. However, unlike traditional sources of money, where there are sometimes innovative funding options, there are ultimately no alternatives for enterprises that do not satisfy the social criterion, and no hope of business as usual, or business by workaround, under catastrophic climate change conditions.

Because ESG initiatives are a journey, there will be hiccups along the way. There is no such thing as a flawless firm. Key trends might be missed, mistakes can be made, rogue behaviours can emerge, and actions can have unexpected repercussions. Companies, however, cannot just wait and hope that all will work out since social licence is business "oxygen" and hence impossible to operate without it. Instead, they must anticipate future concerns and occurrences by incorporating purpose into their business models and demonstrate how they serve various stakeholders as well as the general public. Every company has an inherent purpose—a one-of-a-kind raison d'être that answers the question, "What would the world lose if this company disappeared?" Companies that incorporate purpose into their business strategy not only reduce risk, but they may also generate value from their values. Patagonia, a US outdoor-equipment and apparel shop, for example, has always been purpose-driven, declaring unabashedly that it is "in business to save our home planet." Natura &Co, a Brazilian cosmetics and personal-care firm whose mission is to "promote the harmonious relationship of the individual with oneself, with others, and with nature," focuses its ESG efforts on programmes such as Amazon conservation, human rights defence, and circularity. Several additional organisations, from various countries and industries, are adopting ESG to achieve both societal impact and auxiliary financial rewards.

3. Metrics may be improved over time

While ESG metrics are still a work in progress, it is vital to highlight that there have been advances. ESG measures will continue to improve over time. They are already evolving; there is a tendency towards consolidation of ESG reporting and disclosure systems (though further consolidation is not a certain conclusion). Private rating and score providers, for example, MSCI, Refinitiv, S&P Global, and Sustainalytics, are striving to produce insightful, standardised metrics of ESG performance.

In addition, there is a tendency towards more active regulation with increasingly detailed standards. Regardless of variances in analysing ESG, the long-term push has been for more accurate and complete disclosure, rather than fewer data points or less clarity. It is also worth noting that financial accounting emerged via stakeholder pull rather than spontaneous regulatory push, and did not materialise fully formed along the concepts and structures that we see today. Rather, reporting is the result of a long evolution—and often heated discussion. It is still evolving, and there are discrepancies between generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) reporting. These distinctions, which indicate how important these issues are to stakeholders, do not undermine the need for accurate reporting; rather, they reinforce it.

There is also a trend toward more active regulation with increasingly granular requirements. Despite the differences in assessing ESG, the push longitudinally has been for more accurate and robust disclosure, not fewer data points or less specificity. It is worth bearing in mind, too, that financial accounting arose from stakeholder pull, not from spontaneous regulatory push, and did not materialize, fully formed, along the principles and formats that we see today. Rather, reporting has been the product of a long evolution—and a sometimes sharp, debate. It continues to evolve—and, in the case of generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) reporting, continues to have differences. Those differences, reflecting how important these matters are to stakeholders, do not negate the case for rigorous reporting—if anything, they strengthen it.

While the term ESG has lost some of its lustre as a construct, its core notion remains critical at the level of concept. Names come and go (ESG came after CSR, corporate engagement, and other similar words), and these endeavours are challenging by nature and can grow only after several iterations. However, we believe that the significance of the underlying principles has not peaked; in fact, the need for corporations to earn their social licence looks to be increasing. Companies must tackle externalities as a fundamental strategic problem, not just to assist future-proof their organisations, but also to provide long-term significant impact.

Environmental, social, and governance (ESG) concerns have grown in importance for businesses and investors alike. ESG is founded on the premise that in order to achieve long-term success and sustainability, businesses must focus on more than simply financial performance. In this blog article, we will discuss the significance of ESG and why it is important for businesses and investors.

The Advantages and Benefits of Paying Attention to ESG

Companies that prioritise ESG not only benefit society and the environment, but they also do better financially. According to research, organisations with great ESG performance have lower cost of capital, stronger profitability, and better risk management. Furthermore, organisations that prioritise ESG concerns are more likely to recruit and keep top talent, since individuals want to work for organisations that share their values and contribute to society.

Environmental Benefits

In recent years, many organisations have focused on sustainability and environmental challenges, which has become an important component of ESG. Companies may contribute to global efforts to cut carbon emissions and prevent climate change by adopting actions to reduce their environmental effect, such as decreasing waste, employing renewable energy, and implementing sustainable practises. This may assist not just the environment, but also the company's financial line by lowering expenses and increasing efficiency.

Social Benefits

ESG also includes social problems like as labour practises, human rights, and community participation. Companies that prioritise social concerns can assist address societal difficulties while also benefiting their workers and the communities in which they operate. This may aid in the development of trust among consumers and stakeholders, as well as the enhancement of the company's reputation and brand image.

Governance Benefits

Good governance is an important component of ESG since it guarantees that organisations' activities are open and accountable. Companies that have effective governance practises are more likely to make ethical judgements, prevent fraud and corruption, and stay in line with regulations. This may aid in the development of trust among investors and other stakeholders, as well as the reduction of risks and the improvement of long-term performance.

The Risks of Ignoring ESG

Companies that neglect ESG, on the other hand, suffer a range of hazards. These dangers include reputational harm, regulatory penalties, and a loss of investor trust. Companies who are not open about their ESG performance may encounter difficulties in raising funding, since investors are increasingly considering ESG performance when making investment decisions.

Reputational Harm

Negative publicity on environmental or social issues can harm a company's reputation and brand image. This can result in reduced consumer loyalty and trust, as well as bad media coverage and public scrutiny.

Regulatory Penalties

Companies that violate environmental or social standards may suffer fines and legal consequences. This can result in not just financial losses, but also harm to the company's reputation and brand image.

Reduced Investor Confidence

As investors recognise the importance of sustainable and ethical business practises, they are increasingly integrating ESG performance into their investment decisions. Companies that do not prioritise ESG risk losing investor trust because investors perceive them as higher-risk investments.

The Investor's Role

Investors may play a significant role in influencing corporations to prioritise ESG problems. Investors may indicate to firms that excellent ESG performance is vital for long-term success by including ESG elements into investment decisions. Investors can also interact with corporations on ESG problems and advocate for greater transparency and responsibility.

Conclusion

Finally, ESG problems are becoming increasingly significant for both businesses and investors. Companies that prioritise ESG do better financially, whereas those that do not prioritise ESG suffer a range of hazards. Companies that prioritise ESG may benefit society and the environment while also attaining long-term prosperity and sustainability. Investors may help promote more openness and accountability in ESG performance, as well as encourage firms to prioritise sustainable and ethical business practices.

If you read the article until now, we want to reiterate our commitment as a group of passionate experts dedicated to sustainable development and the pursuit of Environmental, Social, and Governance (ESG) advancements. Our fervor lies in leveraging these strategies to bring about significant, tangible change to our world. But our journey doesn't end here; it's just the beginning. If you find this subject as exciting and crucial as we do, we'd love to hear from you.?Engage with us, share your thoughts and perspectives, or even suggest new ESG-related topics that you would like us to explore. Together, we can pave the way towards a more sustainable and equitable future. Your interaction is more than just participation—it's a contribution to a better world. Let's get this conversation started