Introduction.
Ever since the financial services industry started decades or even centuries ago, there have been many trends that have appeared and become fashionable.
Some of these have stuck around and have provided real benefits (such as passive investing and liability investing) while others have never really stuck and eventually disappeared from view.
The latest trend is ESG (Environmental, Social and Governance) which seems to be taking up a large amount of time and space in the industry.
However, what exactly it’s ESG and will it provide the benefits, hoped for?
So what exactly is ESG?
At a simple level, ESG means using a set of factors to measure an organization’s holistic capability against a range of variables to observe how well ethically they are running their business (as opposed to just focusing on financial measurements). Please see below:
- Environmental factors cover firms implementing strategies and policies to try and control climate change or “go greener.”
- Social factors relate to factors to ensuring organizations are socially responsible both internally within their organization and externally with their suppliers, customers, and other stakeholders. It covers areas such as ensuring there is diversity across workforces, any impact on communities is managed, anti-slavery policies are implemented, human rights are managed, consumer protection is in place, and animal rights are considered.
- Governance factors relate to an organization’s management. It covers factors such as having an appropriate management structure, risk/control policies and processes implemented, and fit-for-purpose as well as all staff being remunerated appropriately and fairly.
In effect, ESG could be viewed as some sort of “ethical credit score.
The challenges of implementing ESG.
At a holistic level, ESG sounds perfect because ensures organizations provide both financial and non-financial returns. But implementing and measuring ESG is far from easy:
- To measure ESG timely and accurate data is needed for investment decisions. Firms need accurate data (both quantitative and qualitative) on organizational ESG performance. This is challenging for two reasons: (a) firms have to provide the information themselves and they are unlikely to provide unflattering data and (b) organizations, especially large ones, have long global supply chains and it will be hard to obtain accurate data for this as well.
- in addition to the data issues above, there are multiple ESG measurement models available which could create inconsistency and confusion for investors (especially if the outputs are wildly different). Although having said this different models will be required to cope with different industries and global dynamics. This area is still relatively immature.
- There is no single set of global ESG regulations. ESG needs some solid and robust regulation in place with a set of repercussions for failure to comply. (It is amazing how ethical and green people can be if there is a fine or prosecution hanging over their heads). The EU recently launched (March 2021) a new piece of regulation called the Sustainable Finance Disclosure Regulation (SFDR) to help with ESG assessment. However, SFDR is still in the early stages of implementation so it is unclear how well this regulation will work.
- Organizations (especially public ones), have a very short-term focus. To improve the ESG performance of an organization a large amount of work is required. For example, organizations need to fix their internal operations as well as work with their suppliers and customers to improve theirs. This will take years (if not decades) to implement and will cost money which will impact profitability. Unfortunately, due to the current short-term focus on financial returns, organizations may not be willing to make these changes.
Therefore will ESG provide the benefits hoped for?
While I think we all agree that the underlying concept of ESG is a good idea, it is still immature and will take some time to become fully fit for purpose.
However, this does create the following three immediate problems:
- ESG could provide a false sense of security because people believe that if an organization’s ESG assessments are good then they are green socially responsible, ethically run and so on.
- Secondly, ESG just becomes a ‘box ticking’ exercise. Organizations are under pressure to comply with ESG so they need to ensure that ESG assessments are good. This can be done in two ways: (a) by improving their operations or (b) by cherry-picking data and models to give the required results. Therefore, organizations say that they have a good ESG rating but the underlying activities and behaviours are still not that great.
- Thirdly, how seriously is ESG taken by end investors? Many investors say they are concerned about ESG. But I suppose the ultimate question is, if an organization is performing well in terms of ESG but poorly in terms of financial returns, then will investors continue to invest or sell and move to investments that provide a better financial return (even if the ESG assessment is poorer)?
Conclusion
The concept of ESG is a good idea because organizations need to improve their environmental, social and governance behaviours to ensure they contribute to the future of society.
However, the key issue is how to accurately and reliably measure an organisation’s ESG assessments. This will require both good data and, reliable and valid models.
Until these are in place (which could take several years) people need to understand that ESG is still a work in progress with several critical flaws.
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