What ESG critics have wrong ... and what they have right.

Many recent articles and pundits questioning everything from the appropriateness to the effectiveness of ESG are missing the point: Under the umbrella term “ESG” are a range of topics, efforts and results that include long-recognized and demonstrable universal drivers of corporate success and valuation, as well as elements that are sector-specific. Criticisms of effectiveness bolster the argument that we should hold ESG to a higher level of professional standards, not do away with it.

Value creation has changed

In 1970, economist Milton Friedman issued his famous maxim, “There is one and only one social responsibility of business – to use it resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”   

At that time, a company’s value was mostly captured in traditional metrics like physical and financial assets. Less than one-fifth was embedded in intangible assets like brand reputation, customer loyalty, employee engagement and the labor environment. The way stocks are valued has since changed substantially, with tangible assets making up an ever-decreasing proportion of valuation. By 2020, only 10 percent of the value for the S&P 500 was held in the tangible assets.

Prioritizing more stakeholders contributes to growth

Friedman continued, “That responsibility is to conduct the business in accordance with their [the business] desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.” What many critics of ESG fail to consider is that all stakeholders have demonstrable and measurable impact on how companies are valued.

Critics also argue that ESG is anti-capitalism, but this could not be further from the truth. Capitalism is defined in the Oxford Learner’s Dictionaries as an economic system in which a country's businesses and industry are controlled and run for profit by private owners rather than by the government. Similar to research and development, preventive maintenance and safety programs, ESG focuses on smaller investments in the short term that result in greater economic benefit (or reduced losses) over time. ESG reporting helps ensure that those private owners have more meaningful and complete information about the profit drivers of their investment. This includes things like employee intellectual capital, natural resource stewardship and evaluation of the climate-related risks to their physical operations and supply chains. State-owned businesses are accountable for none of these things, and their environmental, safety and profitability results pale in comparison to those in capitalist economies.

Companies that consider both short- and long-term growth are better positioned during downturns. ESG funds lost less during the COVID-19 and the housing market downturns. “We're looking at (ESG) as a source of outperformance,” Amber Fairbanks, portfolio manager at sustainable investment firm Mirova US, explained in June 2022, “and that's something that I think more and more investors are starting to recognize.”

Socially responsible investing has gone mainstream

ESG investment represented 33 percent of the $51.4 trillion in total US assets under professional management in 2020. Top issues included climate change, anti-corruption, board issues, sustainable natural resources/agriculture and executive pay.

There is a strong alignment between the disclosures that the SEC, major asset management organizations and ESG evaluation firms consider important to their decision-making:

Chart (c) 2022, Grant Thornton, LLP. Used with permission.

Climate risk is emphasized by Larry Fink, CEO of BlackRock, in his 2021 CEO letter: “Most stakeholders – from shareholders to employees, to customers, to communities, and regulators – now expect companies to play a role in decarbonizing the global economy. Few things will impact capital allocation decisions – and thereby the long-term value of your company – more.”

Disclosure of this information would provide consistent, comparable, and reliable — and therefore decision-useful — information to investors to enable them to make informed judgments on current and potential investments.

ESG metrics need improvement

Critics raise valid points about issues that have limited the utility of ESG metrics. It is hard to compare between companies that use different reporting criteria. Companies have sometimes provided incomplete, inaccurate and unhelpful data. Establishing standard criteria, processes and quality controls for ESG data would benefit companies and their stakeholders.

“The disclosure of this information would provide consistent, comparable, and reliable — and therefore decision-useful — information to investors to enable them to make informed judgments about the impact of climate-related risks on current and potential investments,” the SEC stated in its proposed rules.

By focusing on the issues that are most agreed upon to impact business value and defining parameters for reporting, the SEC is responding to the need that information reported is consistent and comparable, and companies report it without deception or fraud.

Recognizing ESG as a core part of business – and moving forward

It is in the best interest of all stakeholders to hold companies accountable for measuring and reporting matters that affect value and outcomes, including ESG. ESG should also subject to the same level of scrutiny as more traditional metrics included in corporate balance sheets, financial reports and public filings. As ESG reporting becomes more standardized, it can be integrated into established reporting mechanisms - further saving cost, time and effort.