
Over the past several years, various individuals—from experts and public figures to casual pundits—have declared the death of ESG and have done it with much noise and enthusiasm.
The ESG backlash follows a period of oversized enthusiasm five years ago. If it were a debate among experts this could have been viewed as a natural normalization, a swing back to the middle. The ESG backlash, however, is no longer an expert or scientific issue. It has entered a black-and-white territory of politics.
As a result, we might be approaching the point where we are about to throw away the baby with the bath water and bury the ESG concept instead of the ESG label.
Let me explain.
There is nothing inherently wrong with the concept of ESG.
When used as a framework for companies looking to reduce risks arising from their interactions with the environment, their communities, or how they govern themselves, ESG is a valuable framework for self-assessment, gap analysis, and taking action by putting relevant internal control mechanisms.
The problems arise when the ESG concept is reduced to a single-number score or a label. And especially when investment decisions are based partially or entirely on that single-number score or single-word label. It is no coincidence that the most serious ESG backlash comes from the financial sector.
There are tons of issues with this reductionist approach. Let’s examine some of them:
The "E", the "S", and the "G" Do Not Belong Together
Grouping Environmental, Social, and Governance factors together makes little sense if these are later combined into a single score.
The problem arises when well-run companies (with high G scores) in polluting sectors (think Big Oil) score much higher in their total ESG score than companies that create environmentally transformational products but are still rough around the edges in terms of Governance (think Tesla).
The ESG framework is meant to evaluate risks to the company arising from external factors, in which case the inclusion of Governance makes a lot of sense.
To most people unfamiliar with the concept, however, the ESG score is just a synonym for a company that does good. By extension, including a heavy polluter in an ESG-labeled fund or portfolio seems confusing and just wrong, thus discrediting the ESG concept.
ESG was hijacked by the Quants
The rise of quantitative analysis has transformed the financial world, bringing data-driven precision to investment decisions. However, when quants, turned their attention to ESG, the framework’s original intent began to warp. ESG, designed to offer a holistic view of a company’s environmental, social, and governance practices, was reduced into a single numerical score under methodologies incomprehensible to us mortals.
This reductionist approach has led to oversimplification, where complex, nuanced factors are squeezed into tidy data points that can be easily compared.
The result is a landscape where companies can game the system, achieving high ESG scores through selective metrics, resulting in an erosion of the public's confidence in ESG.
ESG lacks focus
While ESG, as pointed out earlier, is a useful framework for companies to assess operations and potential risks, the ESG score cannot identify an outperforming company on any specific issue - human rights, biodiversity, gender equality, climate change prevention and adaptation that might be especially important for an investor.
Sustainability-minded investors often look for the impact of their investments and are increasingly interested in allocating their investments according to personal values and specific impact areas, a practice that the ESG score was not designed to capture.
The Alphabet Soup of ESG Terminology Must Go
Last but not least, the confusing alphabet soup of ESG terminology should gradually simmer down into a clearer, more intuitive, and, to say it outright, more human language.
The Way Forward
While the ESG label may be too far gone, the underlying principles of Environmental, Social, and Governance considerations are more relevant than ever.
More clarity about what ESG is and is not, needs to enter the public knowledge.
This may require the retirement of ESG labeling practice and, probably the replacement of the ESG acronym.
Decoupling of ESG and impact and the introduction of distinct impact-measurement frameworks that focus on measuring the specific outcomes of a company's products and services need to replace ESG in certain investment decisions.
By addressing the current shortcomings and refining the approach, ESG can continue to play a crucial role in promoting sustainable and responsible business practices
How can we help?
uIMPACT is a full-service provider of sustainability assessment, reporting, and management services. We help companies report on CSRD, SFDR, and EU Taxonomy and meet the sustainability expectations of partners and investors.
Small and medium-sized companies can benefit from our intuitive web-based platform for ESG screening and SDG alignment assessment to effortlessly start their sustainability journey.
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