Risky businesses: the ESG doublespeak

The uncomfortable truth

The audience was stunned. During his presentation at the FT Moral Money event on 19 May 2022, Stuart Kirk, the head of responsible investments at HSBC Asset Management, was adamant: “Climate change is not a financial risk that we need to worry about.” He was right, of course. Was he shining a light on widespread hypocrisy?

The separation of profit and planet is by design. ESG investments are rated on how the operating environment may affect profits, not the reverse. The financial data and media company Bloomberg puts it neatly: “[ESG] ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”

Fighting climate change is one thing, measuring and assessing the climate risk to a firm’s profits is another. While ESG investing might be a way to measure risks to corporate cash flows, it is no way to advance planetary sustainability. Asset managers are trained, incentivised, and bound to maximise their client’s returns. Is it naïve and unreasonable to expect them to put public interests ahead of their clients?

$3.5 trillion Estimated annual investment required to battle climate change over the next 30 years

Despite its popularity surge, many suspect ESG investing will not address our generation’s urgent challenges. Consider the battle against climate change: estimates are that humanity will need to invest an average of $3.5 trillion annually over the next 30 years. That’s an amount presently invested in assets managed according to many ESG criteria, but unfortunately, these are funds dedicated to assuring returns for shareholders rather than positive outcomes elsewhere.

Knowing the score

It had all started so well. In 2004, the Secretary-General of the United Nations wrote to over 50 CEOs of major financial institutions. He invited them to participate in a joint initiative to find ways to integrate ESG into capital markets. Following the 2005 UN-sponsored report, ‘Who Cares Wins: Connecting Financial Markets to a Changing World’, the idea that embedding ESG considerations would lead to better societal outcomes reached the world’s attention.

In practice, ESG programmes are structural to how the company operates, therefore hard to implement and expensive. For some companies, the benefits outweigh the significant costs, like gaining favour from sustainability-oriented investors and consumers. But for others, they don’t. CSR activities are easier and cheaper. These can improve external relationships without troubling what the company makes or how. The focus is on corporate philanthropy or partnerships with community groups. CSR is good for the brand but not foundational to running the company. It is nice but additive and occasional.

Independent ESG scores provided by third parties take some of the complexity out of evaluating a company’s behaviours. However, the scoring business is unregulated, and each provider uses a different method. Rating agencies differ in almost every approach to ESG scoring, from the factors they weigh to the formulas they use.

What is considered a good score varies, and fossil fuel companies can have better ESG ratings than makers of electric vehicles. In its 2021 Impact Report, Tesla said, “Current ESG evaluation methodologies are fundamentally flawed. To achieve acutely needed change, ESG needs to evolve to measure real-world Impact”. If you’re looking to make money, ESG scores matter.

If you are looking to help the planet, much less.

The authenticity gap

It was time to blow the whistle. In February 2021, Desiree Fixler, Group sustainability officer at Germany’s top asset manager DWS, claimed the firm made misleading statements about its ESG credentials. She got fired. The authorities’ subsequent investigation into greenwashing forced the firm’s CEO Asoka Woehrmann to resign in June 2022.

ESG is in high demand. According to Bloomberg Intelligence, the global ESG market currently adds up to about $40 trillion. The acronym generates hundreds of millions in fees, with the label now being slapped on everything from loan products to investment bonds. The fees for managing ESG funds is typically higher, making them a timely answer to tightening margins. Sometimes, the premium is unwarranted. In February 2022, investment advisory firm, Morningstar, removed the ESG tag from more than 1,200 funds because they did not “integrate [ESG factors] in a determinative way.”

In April 2022, billionaire activist investor Carl Icahn said Wall Street’s ESG efforts might be the “biggest hypocrisy of our time”, with firms cashing in on the feel-good acronym without concern for actual impact. If ESG is to be more than a marketing ploy to raise money, investors must “back up their words with actions,” he said.

It’s hard to blame the casual observer for believing that ESG investments are helping to save the planet. Annual reports and marketing materials make lofty statements about corporate aspirations.

But the authenticity gap has profound consequences. The impression that the money needed to tackle global issues is upcoming undermines the necessary regulatory reforms and public-private partnerships that would make a difference.

Coming clean

Blinded by a thicket of ESG metrics and ratings, managers can miss the point of why they are measuring in the first place: i.e., to ensure that their business endures. A precondition for sustaining success is to manage externalities. The expression is entering common parlance. That is because people care. Companies may conduct their operations in a seemingly rational way, but if they assume that their operations don’t have ripple effects or that there won’t be a public erosion of trust by failing to address them, their prospects may be unachievable.

Corporate sustainability plans should include how stakeholders perceive the business and ways to prevent or manage potential reputational controversy. This can create a moral hazard. Sometimes, it may be more advantageous to sugar-coat the status quo or create false impressions about the underlying business model.

Greenwashing is inherently linked to the question of integrity or the lack thereof. Mandatory and voluntary disclosures are adequate up to a point. Regulatory systems only work when people want to abide by them. In their account of the ‘G’, too many ESG reports omit how the board of directors creates a culture of sustainability. In this respect, all relevant stakeholders should be considered, from employees to suppliers to customers. It is revealing how annual reports tend to gloss over disclosures like ‘stakeholder engagement’, ‘s.172’, and ‘risk management’ with boilerplate statements.

The emergence of ESG reporting has often gone in hand with hypocrisy. This creates a reputational risk. To manage it, annual reports should be frank about the meaning of ESG data and ratings; they should also put more effort into integrating sustainability and outcomes into their narrative.

If you’d like to discuss this, or any other subject, please get in touch with Richard Costa, Senior Corporate Communications and Reporting Consultant at richardc@gather.london

We’d love to know what you think.