Environmental, social, and governance (ESG) criteria are a set of standards for a company’s behaviour used by socially conscious investors to screen potential investments. Chances are, you’ve heard and seen these 3 letters somewhere even if you do not think of yourself as an investor. Chances are, you also heard the different opinions about it. Wherever you stand yourself, it’s worth to understand this criteria a bit better and that’s what I will aim to help you with in this and future ESG related articles as well as standalone visuals.
To start, what each letter stands for? Environmental criteria consider how a company safeguards the environment, including corporate policies addressing climate change, for example. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights. The concept has been around for nearly 2 decades, officially coined in 2004 with the publication of the UN Global Compact Initiative’s “Who Cares Wins” report. However, its real rise to the popularity came following the coronavirus pandemic. Whilst I myself jumped on an ESG train a few years earlier, it took me some time to familiarise with the set of standards, how it works in practice and if it’s actually useful and beneficial for what it supposed to represent — the environment, the people and the shareholders.
The main use case of such criteria is to screen investments based on corporate policies and to encourage companies to act responsibly. Many mutual funds, brokerage firms, and variety of advisors now offer investment products that employ ESG criteria, however the rapid growth of such investment funds in recent years has led to claims that companies have been insincere or misleading in touting their ESG accomplishments.
We can take a look at the examples of Pepsi and Coca Cola. Both companies get high ESG scores from the biggest ratings firms in the market. They are also typically amongst the largest holdings for ESG funds, largely because they rank high on parameters such as corporate governance and greenhouse gas emissions. However, their core businesses involve the manufacturing and marketing of addictive products that are a major cause of diabetes, obesity, and early mortality. Pepsi and Coke leverage their power to prevent taxes and regulation on their businesses and fund large amounts of research to divert attention away from the health impact of their products. With the cost of diabetes now over $300 billion annually in the United States alone, the human and economic harm caused by these companies may outweigh their economic contributions.
Another case is that of Big Tech. Companies such as Alphabet (Google), Amazon, and Meta (Facebook) also tend to be among the largest holdings for ESG funds. They often get high ESG ratings because they are predictably low producers of greenhouse gas emissions. But few would consider them to be good corporate citizens. Amazon has deplorable labor practices and engages in predatory pricing. The business models of Facebook and Alphabet involve algorithms that have made dangerous hate speech and misinformation ubiquitous across the internet, and the companies’ products have been tied to an increase in mental health issues in young people. All three firms have been labeled by academics, policymakers, business leaders, and attorney generals as monopolies that threaten the existence of a well-functioning free-market system. If a company’s core business model does so much harm, the cover-up through “good behaviour” on other parameters shouldn’t be this easy.
To rectify the problems and quantify the true impact of business behaviour on ESG factors, an entirely new ratings system is required—one that measures the economic, human, and environmental costs of “market failures” caused by corporations. Market failures should include: monopoly or monopsony, where a seller or a buyer, respectively, has limited competition or outsized power; negative externalities, where a third party is directly harmed by the business; or environmental damage, such as decimated forests, polluted oceans, or our emissions-clogged atmosphere. To add to the latter, carbon credits have already (in my humble opinion) proved to be pretty much useless and incredibly misleading, allowing companies to pollute now with a better prospects in the future.
Under the above proposed system, a company would not get a high aggregate score if it performed poorly on a single factor with significant societal or environmental costs. For example, a company that produced food products that assaulted human health would get a low score even if it was governed well and environmentally responsible.
Market failures are so pervasive today that most corporations rated in this manner would likely receive low ESG scores, greatly reducing the number of ESG investment opportunities. The whole system—and the lucrative management fees that investment firms capitalizing on ESG investing charge for “conscious capitalism”—could grind to a halt.
Maybe that’s just what we need. For far too long, CEOs have followed a “growth at all costs” mindset to maximize shareholder value. Despite ongoing catastrophes and injustices, they are being cast in a positive light through an ESG ratings system that obfuscates the nature of their corporate citizenship. To be true ESG leaders, they will have to pay workers more, make products that are less addictive, and increase their costs to protect the environment. In other words, they might have to sacrifice on profit. Being true to ESG will not come so easy, as all things worth something.