Necessary but messy? The status of ESG practices
Greenwashing allegations and commitments to implement ESG into organisation processes have risen in parallel by a great deal over the last couple of years. This December started with allegations against the world’s largest money manager group, BlackRock. The allegations are directed towards a failure to deliver on their sustainability commitments and the fact that they had ‘changed positions several times on investing in thermal coal production’. In May 2022, Deutsche Bank has come under fire for labelling hundreds of billions of its assets as “ESG integrated”, without meaningful action by relevant fund managers. UNPRI notes in its 2020 Annual Report that 3,038 investment groups signatories are now part of a collective AUM to integrate ESG into their processes which can be considered a broad and vague commitment that is hard to hold accountable in a measurable manner. These apparently contrasting trends highlight the drive of an industry to appear sustainable yet maintain regulations and practices which are loose, messy and loopholed.
The 2020 paper ‘Aggregate Confusion’, finds that the divergence among six of the most prominent ESG indices is substantial and is mainly driven by measurement divergence, yet their correlation is in fact lower than the one among credit ratings agencies’ scores. While this divergence which is created by rating agencies measuring the same attribute using different indicators appears to be the main driver of disparities among indices, there are two others to take into account. One being weight divergence: different views on the relative importance of attributes. Another is scope divergence: ratings are based on different sets of attributes. Both of these are also important factors pertaining to divergence. This demonstrates that there is no consistent or universal method of valuation of ESG performance of companies, funds and portfolios. In addition, companies have different impact on environment and societies based on the activities each carry out. These impacts are not considered by indices, which judges on overall aggregate performance across all indicators. This translates into difficulties to understand the real value of ESG practices, which might lead to underinvestment in ESG implementation activities as well as removing incentives to improvement actions.
Given the fact that ESG ratings diverge widely, applying them to strategic decision-making proves very challenging and creates room for its exploitation by companies and investors for goals other than those regarding sustainability.
The ESG case is mis-used by enterprise leaders by using them to explain and justify their performances. On one side, ESG-driven choices emerged as a plausible way to cover CEOs underperformance. For example, the widely regarded sustainability efforts of Danone CEO Faber – efforts which drove the company to be one of only ten companies with an 'AAA' score in 2020 – have been mentioned when discussing his demise and as a driving factor of a rather flat performance. However, according to a recently revised paper, firms with missed earnings also have lower ESG scores. On the other side, corporate managers use the sustainability narrative to attract socially aware consumers, employees, and investors, therefore affirming their standing for the sustainability cause. In other words, the behaviour of both of these leaders’ fail to recognize and acknowledge the impact of ‘social innovations on competition and economic-value creation’, as well as the ‘powerful connection between company strategy, social purpose, and economic value.’
ESG factors are also used by companies to attract investments in a way that does not improve the environment or the welfare of customers, employees, suppliers, and communities. In certain instances, firms have linked the pay of CEOs to ESG metrics to get capital providers to overlook the delivery of shareholder value, previously evident in the link between pay and performance.
Despite all the above practices depicting a rather grim picture of the use of ESG principles and metrics, there are still examples of success stories linked to the ESG phenomenon. The 3 biggest passive investors – BlackRock, Vanguard and State Street – started campaigns in 2017 to increase the gender balance across industries. These led to more women in board positions as American corporations added “at least 2.5 times as many female directors in 2019 as they had in 2016,” and an overall different approach in the selection of candidates, that went beyond pre-existing networks. This example highlights the disruptive positive influence that a single type of player (corporate investors in this case) can have in the behavioural change and shifting of big firms’ practices. Additionally, it shows how the combined use of marketing strategies and clearly identified ESG indices can leverage a positive societal and/or corporate transformation.
Thus far, ESG monitoring remains lacking in its foundation: reliable, clear, and agreed metrics as well as a clear-cut way of using them. As in the examples above, the ESG indices have been used in many instances to justify mismanagement practices or underperforming managers, away from the objective they were meant to support the delivery of. As a result, this calls for a review and uniformization of methodology with which indices are created. Furthermore, there needs to be stricter accountability of pledges. Yet what is likely the most crucial is a behavioural change in the attitude of big market players including companies and investors when it comes to the use of ESG concepts.