‘ESG’ was first used by the UN in 2004, when it called for ‘better inclusion of environmental, social and corporate governance (ESG) factors in investment decisions’. Initially a fringe concept, the popularity of ESG has rocketed in recent years. Assets in ‘ESG funds’ are now approaching USD 3 trillion. But what does that mean in practice?
No one knows.
ESG labelling is currently unregulated and the term is used to describe a vast spectrum of investment products. While the convergence of three distinct concerns (ie E, S and G) has helped raise awareness, it’s bizarre when used as a scoring system - as it is now in ESG ratings. And while environmental issues can often be presented as hard data, eg carbon emissions, deforestation and water use, issues around social responsibility and good governance are much trickier to define, let alone score. Unsurprisingly, the majority of ESG finance professionals in a recent survey were in favour of abolishing a combined ESG score.*
Let’s also not forget that ESG ratings are a financial risk metric: they score the extent to which ESG issues might affect a company's financial value. They don't relate at all to a company's actual environmental performance. A company could be highly polluting today but receive a decent ESG score if the ratings agency doesn't think it will hit future financial performance. Their assessment could be based on management’s 'commitment' to reduce the company’s impact, rather than anything more concrete.
All of this creates the opportunity for greenwashing on a grand scale. Countless asset managers label products as ‘ESG’ off the back of vague promises or positive social and governance reports, while hiding a multitude of environmental sins. It takes a lot of work for an investor to uncover what lurks beneath. But the underlying environmental data is there all along.
While governments and regulators around the world tighten the rules on ESG labelling, a quick win is to ditch the concept of ESG entirely. Give investors the information they need to make informed decisions. That means access to environmental data, presented in a clear and meaningful way. It’s directly comparable across companies and industries and could be supplemented with detail on how individual companies are working to reduce their climate impact (or not). Fortunately, such data is already available to UK investors via Sugi for free, with access here.
Meanwhile, let’s pay proper attention to the issues currently grouped into ’S’ and ‘G’. These represent standards which all businesses should meet - or at least aspire to. But they are complex and can’t be reduced to a score out of 10. As with environmental concerns, many investors want to know how companies perform on the issues themselves, not just whether they might affect the financial value.
The state of our environment, social responsibility and good governance are three huge issues of our time. Rolling them up into the nebulous concept of ‘ESG’, may well have had its day.
* Do we speak the same language? A Market Survey on the Future of ESG Ratings, 2° Investing Initiative (an international, non-profit think tank working to align financial markets and regulations with the Paris Agreement goals), 2022