This is not an ESG article

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  • Picture of Rebeca Minguela
    Rebeca Minguela
  • Economics and Finance
  • Enterprise
  • Climate change
  • Institutional reform

The case for taking a scientific approach to an often misunderstood framework

When Magritte painted the image commonly known as ‘This is not a pipe’, he was asking us to reflect on the gap between language and meaning, even our perception of reality itself. Similarly, this is not an ESG article. It encourages readers to reflect on the communication, perceptions and facts around the environmental, social and governance (ESG) frameworks adopted by many businesses and investors as a synonym for sustainability and social and environmental impact.

Like ‘The treachery of images’, as Magritte’s painting is also known, when it comes to sustainability, we must accept that individuals will interpret this in different ways and not allow this to prevent us from pursuing a better world. The evidence shows that, despite variations in interpretation, most people care about sustainability. Whether as investors, consumers, voters or regulators, people want a more sustainable planet, a more equitable society and improved wellbeing, and they need and want the information and tools to take that into account in their capital allocation decisions, whether through their purchases, individual investments, pensions, charitable donations or how their taxes are spent or invested.

If you search ‘ESG’ online today, you find nearly 400 million entries and over 50 million articles. In July 2022 alone, 5 million articles about ESG were published online. Look a little closer, though, and you find that over 6,000 of these articles mention ‘ESG scam’ or ‘ESG backlash’, including accusations of greenwashing and misleading marketing. ESG is now a highly charged topic, raising complex social and political questions about its place in responding to the most profound problems we collectively face.

To make progress, we need to refocus the conversation on what is important by taking a more scientific approach. Of course, people’s definitions of a good society are largely subjective, based on religious beliefs, personal values, political priorities and so on, but we should use fact- and science-based strategies to find a solution that also accommodates that subjectivity.

The right question and . . . the ‘wrong’ ones

Albert Einstein is reported to have said, “If I had an hour to solve a problem and my life depended on the solution, I would spend the first 55 minutes determining the proper question to ask, for once I know the proper question, I could solve the problem in less than five minutes.” We need to focus on formulating the right question – on understanding the real problem – if we are to find a solution.

The central question in play is how do we achieve a more sustainable planet and a more equitable society? This is a problem of resource and capital allocation, so we need to make sure that in every decision (our purchases, company and government budgeting, investments, etc) information about sustainability and social and environmental impact is considered. Key follow-up questions should include: How do we measure sustainability? How do we bring the right information to the right decision-makers at the right time?

Unfortunately, we are distracting ourselves with multiple other ‘wrong’ questions and criticism of ESG (and sustainability more broadly) that are not only irrelevant to the main problem but also generate confusion. What follows are some examples.

Does ESG measure sustainability? Not necessarily. Often, too much is expected of what was originally defined merely as a framework to help investors and companies weave environmental, social and governance metrics into financial analysis, not to measure sustainability or actual impact. There has been such an unhealthy and confusing proliferation in the use – and misuse – of ESG, that even ESG-industry scion Paul Clements-Hunt called the ESG hype “a whirligig, a frenzy, a marketing mania”. ESG has become a catch-all term, and the backlash is understandable.

Rather than asking whether the ESG framework, intended to measure financial risk, actually measures sustainability, the right question would be, how do we accurately measure sustainability and bring it to the decision-makers? To shift the debate, we need to keep educating people about what ESG is and what it is not, use it only for what it is intended, and avoid mislabelling ESG as sustainability or impact.

Does ESG correlate with financial performance? The answer here is the same as regards other financial variables: it depends. Multiple analyses exist, often yielding conflicting conclusions. This does not mean they are wrong, but they are either too broad to result in conclusive findings or else focus too narrowly on concrete methodologies, topics or industries and therefore their findings are not applicable to all the ESG-labelled financial products. For example, they might – not surprisingly – find correlations in emissions for utilities, governance for banks, or social metrics for companies heavily reliant on human capital. There are also research papers that simply restate what we should already know, such as a recent study from the Organisation for Economic Co-operation and Development saying that “the correlation between ESG scores and climate performance is low”. Well, of course it is. ESG is not just climate.

But if we return to the ‘right’ question – how do we achieve a more sustainable world? – the answer is not necessarily tied to any correlation of ESG with financial performance. Some people might care about sustainability but only if it brings higher financial performance, and some might not. Sustainability should be included in financial analysis, but also should be an additional dimension analysed and communicated separately, based on the objectives and preferences of the decision-makers, because, as we have already established, people do care about it. But I believe sustainability and performance are possible: when investing in public markets, there are almost 60,000 listed companies, so it should be feasible to find a diversified portfolio of 500 companies that can achieve the same financial performance as the S&P 500 while also being more sustainable, no matter the specific personal or scientific definition of sustainability.

If we return to the ‘right’ question – how do we achieve a more sustainable world? – the answer is not necessarily tied to any correlation of ESG with financial performance

Can we aggregate all sustainability or ESG dimensions into one number, or select just one dimension to make it simpler? The answer depends on your objective. With the growth of the ESG investing trend, various financial institutions, rating agencies and data providers have built company and fund scores aggregating various dimensions of sustainability and even different types of metrics (and a booming $1bn [£825m] industry in the process). ESG scores are combining quantitative metrics on various topics such as emissions, percentage of women employees, controversial coverage picked up in the news, policies and commitments. When measuring impact, the United Nations has proposed the 17 Sustainable Development Goals, including poverty, education and climate, and 169 separate targets. This raises the reasonable question of whether we aggregate such different concepts into just one number.

There is also growing support for making measurement simpler. A recent special report in The Economist strongly advocated for “measuring less, but better” and focusing on just one dimension (climate). The problem, however, is that this approach omits important social and environmental factors. We need to ‘measure more and better’ and, more importantly, bring the data and tools to the decision-makers, because, again, it is not only about measuring, but about providing access to the right information at the right time.

Complex problems require sophistication, not over-simplification. No one today would suggest that we focus only on one dimension when measuring other critical topics such as inflation or GDP, or when assessing credit risk, which started being measured several decades ago and now incorporates incredibly complex methodologies and calculation technologies. The sustainability and ESG trend has been evolving for over ‘just’ a decade, and companies only began routinely reporting metrics such as emissions a few years ago. We need to keep working to polish up something so young.

The right question is not whether we can or should aggregate all dimensions of sustainability into one number because, generally, we don’t really need to. In most cases the integration of sustainability can be both sophisticated and simple for the user without needing one magic number.

Should ESG and sustainability be more standardised and/or more regulated? The answer is: probably, but carefully (there are already more than 600 ESG reporting provisions and regulations globally). Again, as in other areas that require significant weight in decision-making (for example, inflation and GDP measurement, accounting, or financial disclosure) there needs to be standardisation and regulation for communication and reporting purposes. But we do not need a global standard to keep moving ahead.

The solution

While all these ‘wrong’ questions are reasonable to ask, the answers often fall into grey areas which can trap us in endless discussion instead of pushing us forward. The solution is to focus on the questions, and facts, which will get us to our desired outcome – a better world – faster, and to provide valuable information to all stakeholders so that, when they are making decisions about capital and resource allocation, they can take into account the trade-offs for society and the planet.

This means, first, we start by acknowledging that there is not just one objective and that is okay. A better world can be reached by various paths, and these should be bottom-up, distributed and decentralised in their efforts to get to a common goal.

Second, it requires understanding the differing objectives and preferences of decision-makers and providing them with accurate data, but also leaving room for incorporating individual viewpoints. For example, Exxon’s current emissions are a fact, but investors will arrive at varying assessments of those future emissions (just as they do with future revenues or valuation). A company’s exposure to animal testing is a fact, but one consumer might care about this issue, and another might not.

Third, and often overlooked, is the need to integrate sustainability information into current decision-making processes at the right time. Sustainability should be a fully integrated ‘add-on’ to existing platforms and user journeys. It should be built in, so that decision-makers do not have to go somewhere else to get the data they need. For example, investment managers who want to include sustainability in their investment decisions should receive pertinent information included in current workflows and platforms (eg asset servicing platforms, risk management tools, analyst financial reports). Individual investors or consumers should have sustainability information displayed to them within their investing or purchasing journey at the right time and in the right format. They should also be able to customise and filter information based on their own preferences, and always be made aware of the trade-offs – reliably and transparently.

Finally, we need to be extremely clear and transparent about what is true and what is not, including abandoning misleading, opaque or half-baked marketing and communications.

The good news is that through a more science- and fact-based approach, which leverages scalable technology, complex challenges can be solved. Decision-making tools and ‘add-ons’ for sustainability assessment are available and will get better, faster. These – along with a healthy dose of our collective human commitment – will empower us to reach our common goal of realising a truly sustainable world, not just a treacherous image of one.

Rebeca Minguela is the Founder and CEO of Clarity AI, a sustainability technology platform that uses machine learning and big data to deliver environmental and social insights to investors, companies, governments and consumers.

Follow Rebeca Minguela on Twitter here: @rebeminguela

This article first appeared in the RSA Journal Issue 3 2022.

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