Head of Alternatives Association Calls for ESG Label to Be Dismantled
The environmental, social, and governance investing movement has an impressive array of goals — and that could be a problem.
As politicians, policymakers, and corporate leaders gather in Glasgow for COP26, the ESG (shorthand for environmental, social, and governance) label has begun to dilute progress and, in my opinion, should be dismantled. Nearly two decades removed from its coining, the fever pitch has become overdone. And I don’t mean the relentless focus on each of the underlying aspects — for which the CAIA Association and I are tireless advocates — but rather the somewhat arbitrary mashup of the three. Would this aged and unsightly Frankenstein of a concept make even Mary Shelley grimace today? With ESG investment products, certifications, standards, and data sets proliferating daily, I believe that this medley of mayhem has become a hindrance to further advancement.
Consider a few examples: Should racial diversity on corporate boards be compared to activities such as water conservation? Should employee safety offset carbon footprint? Should our children’s social media protection be hampered by efforts to reduce income inequality? I think if we’re honest, today’s amalgamation of and competition between such a broad array of material sustainability goals seems odd. And disagreements over how to calculate, measure, and weigh these factors further cloud the issue. Some are binary asset value risks (fossil-fuel dependence), some are return-on-capital accelerators (leadership diversity), some are legal and regulatory risks (employee safety), and others are simply moral best practices. These challenges are both daunting and worthy of attention in their own right, but I fear that the catchall mentality of our ESG ecosystem is beginning to impede progress and veil priorities. It’s no wonder that ESG investment strategies struggle to show performance persistence, greenwashing is rampant, and ESG ratings are largely uncorrelated.
If we are attempting to measure everything, we are actually measuring nothing.
“ESG” was coined in a 2004 United Nations study that precipitated the creation of the now ubiquitous UN Principles for Responsible Investment. At the time, the attention investment professionals and corporate leaders paid to climate change, gender diversity, and healthy labor practices was anemic. The world needed a tool by which to confront the status quo of hyperfinancialized capitalism, which sought to optimize profit at the expense of social outcomes. Combining these vital and neglected factors into a single thematic construct fostered a powerful and much overdo global pep rally that took unsustainable business models to task. While we still have much work to do in all of these disciplines, the ESG moniker has resulted in significant progress.
But as stakeholders increasingly align around the materiality of these issues, the original ESG platform has become unhelpful, and it’s clear that a new phase is necessary. Perhaps the most significant advance in our profession’s treatment of sustainability would be to simply stop isolating these considerations. A large U.S. public pension fund CIO recently told me that “ESG will have arrived when we stop talking about it.” I wholeheartedly agree. Katie Hall, founder of Hall Capital Partners, said it well on Ted Seides’ podcast: “The ESG moniker means different things to different people. We use ‘full consequence investing.’ If the manager is evaluating the sustainable use of human, financial, and physical capital in the businesses they are investing in, they are going to do the right thing.” In other words, these factors should be inherent and integral to due diligence and security evaluation, not a satellite exercise that orbits the investment process.
Once the ESG label has been removed, analysts should apply a financial-statement lens to each of these material issues. Depending on the industry, business model, and time horizon of the sustainability risk, explicit adjustments and confidence degrees can be applied to the pro forma income statement and balance sheet. After all, this was never about values, but rather value. It’s about time that material considerations are elevated to primary and exclusive attention, rather than buried in a complex soup.
So where do we go from here? I believe our profession’s task is threefold:
1. Retire the ESG moniker once and for all. As mentioned above, the greatest impediment to solving any of these challenges is the convenience of combination. Let’s bury this mashup for good and simply begin holding organizations and investment professionals accountable. Once we do, we can begin to track progress and the integrity of data much more genuinely.
2. Fully integrate sustainability factors. Much lip service has been paid to integration, but that’s antithetical to maintaining a spotlight on the ESG protagonist. Talent diversity is inexorably linked to better decision-making, incremental return on equity, and equity performance. Analysts should treat it as table stakes in their recommendations and be willing to award higher multiples (and confidence) to future earnings. Similarly, as our digital footprint becomes ever more critical and vulnerable, data privacy should be a paramount feature of any business model. Facebook’s recent revenue and share-price, not to mention reputational, tempest is evidence of this.
These inputs, among many others, should be part of a new, broader mosaic that should determine and define the stability of cash flows. Specialized metrics, disclosures, and standards will flourish if analysts are encouraged to focus on one specific element of this narrative, rather than trying to judge advancement across a multitude of issues. These considerations should be weighed as importantly as new product introductions, competitive dynamics, and regulatory changes in valuation modeling.
3. But retain the prominence of climate. At the risk of contradicting this entire piece, I still believe that a dedicated team focused on assessing the risk profile of climate sustainability is necessary. The sophisticated systems thinking that requires a combination of economics, climatology, agriculture, and engineering still demands a separate overlay on asset class teams. APG’s new ESG indexes based on proprietary data sets and Wellington Management’s partnership with Woodwell Climate Research are examples of value-added surgical strikes that better price the long-term risks of their pools of capital. More famously, the partnership between CalSTRS and CalPERS and Engine No. 1 to unlock atrophy within Exxon Mobil Corp.’s board is a strong defense of dedicated resources to continue engaging our global fossil-fuel addiction.
The well-intended but clumsy ESG phase has run its course. It’s time to make these issues a natural part of the investment management process and give them the substance they deserve. Our clients deserve better. Cue the ESG funeral.
John L. Bowman is executive vice president of the CAIA Association, which administers professional credentials and develops thought leadership for the alternative investment industry.