The hot topic in the financial press, the corporate world, and the legal arena these days is “ESG.” This portmanteau expression – ESG — is meant to encompass a plethora of diverse and unrelated concepts, ideas, and concerns. The reality is that it is hard to say simply what “ESG” means; and not just “ESG,” but each of the three pillars, E, S, and G, are subject to the same definitional imprecision. Yet everyone continues to act as if “ESG” is a known, specific, and identifiable thing, that can be measured and assessed. The result is a false sense of precision, and a great deal of very sloppy thinking.
These issues are well-discussed in Cydney Posner’s August 8, 2022 post on the Cooley law firm’s Pubco blog, entitled “What’s Wrong with ESG Measures?” (here). Posner’s article discusses in the detail the recent research paper issued by the Rock Center for Corporate Governance at Stanford University entitled “ESG Ratings – A Compass Without Direction” (here).
Posner begins her post, after introducing the recent Rock Center paper, with a sidebar quoting from a July 21, 2022 article from The Economist magazine (here), in which the article’s author notes that “ESG suffers from three fundamental problems.” First, it “lumps together a dizzying array of objectives,” as a result of which it “provides no coherent guide for investors and firms to make the trade-offs that are inevitable in any society.” Closing a coal mine, for example, might benefit the climate, but it would be harmful to workers and suppliers. Ignoring these conflicts, the article’s authors suggest, “fosters delusion.”
Second, the ESG industry’s second problem is that it is “not being straight about incentives.” Insisting that good ESG behavior can be more lucrative overlooks the reality that it can be profitable for companies to externalize costs. As a result, the “link between virtue and financial performance is suspect.”
The third issue is that “ESG has a measurement problem: the various scoring systems have gaping inconsistencies and are easily gamed.” The Economist article’s authors note that “Credit ratings have 99% correlation across rating agencies. By contrast ESG ratings tally little more than half of the time.” The article concludes by suggesting unbundling the three letters, E, S, and G, and instead focusing solely on emissions.
Posner begins her review of the Rock Center paper itself by quoting the paper’s observation that demand for ESG information – from institutional and other investors, companies, regulators, and other stakeholders — is so great that it has “outstripped the ability of suppliers to supply the depth, detail, and accuracy of data required. This is perhaps due to the immense number of factors that plausibly fall under the heading of ESG, the difficulty in measuring ESG factors, and the daunting challenge of determining their impact.” The usefulness of ESG ratings is also impaired by the “lack of comparability across firms, lack of standards, the cost of gathering information, and a lack of quantifiable information.”
The Rock Center paper Posner reviews includes an extensive analysis of the various rating tools. The analysis makes it apparent that the various ratings evaluate a wide variety of inputs, which are then weighed in their importance for E, S, and G, and also for the overall pillars of E, S, and G in relation to one another.
As Posner observes, “it’s not hard to see why there are consistency issues across the rating firms.” These consistency issues in turn result in low correlations across ESG rating providers. Posner cites in another sidebar some analysis from the Wall Street Journal, which reported that it had analyzed ESG ratings from three ratings agencies for 1,469 companies and found that 942 were graded differently by different firms. The Journal article stated that “nearly a third of the companies that were deemed ESG leaders by one or more rating firms but labeled as ESG laggards by one or another rater.” Only about a third of the companies, the article found had consistent scores, as a result of different methodologies, and the attribution of different weights to issues, such as environmental or social.
The rating disparity not only creates confusion about the right way in which companies’ practices should be viewed. There is a deeper problem. Posner cites research showing that there are “minimal relationships between ESG ratings and environmental and social outcomes. The research showed that, for example, an upgrade in an ESG rating might be “driven by check-the-box practices, such as conducting an employee survey that might reduce turnover, and rarely for substantial practices, such as actual reduction in carbon emissions.”
One question that many of us in the field often hear from corporate executives is the why companies that perceive themselves to be “good” on ESG aren’t rewarded in the financial markets (or, in my world, in their D&O insurance premiums). Posner cites an interesting Harvard Business Review article entitled “ESG Reports are Not a Replacement for Real Sustainability” (here). The answer, the author suggests, is that ESG efforts all too often are focused on reporting and disclosure and not enough on sustainability. While more ESG scrutiny is required, corporate leaders and investors who focus solely on ESG disclosures are missing the point. “ESG disclosure uses process-oriented output measures, such as whether a company has a policy on chemical management. These metrics, while necessarily broad, do not track performance. There’s big difference between a company that has a chemicals management policy, and one that has a bio-based dye that reduces waste and water use (and cost) and creates new sales opportunities.”
The Rock Center paper that Posner analyzes also found that the relationship between financial performance and ESG ratings is “uncertain.” While ESG ratings are meant to communicate information about the quality of a company’s ESG programs and its potential future risk, “it’s not clear at all,” the report’s authors state, that “these complex models either predict investment risk or return or capture or predict improvements in stakeholder outcomes.” The source of the failure is that vast array of methodological choices that the ratings agencies make.
The source of the failure may also be due to the sheer challenge of measuring a concept as broad and all-encompassing as “ESG. Is it possible, the authors ask, for companies to effectively report on the vast number of potential stakeholder-related metrics that would be required (carbon emissions, pollution and waste, human capital management, supply chain practices, and product use and safety, etc.).”
I have long wanted to publish a post entitled “We Need to Stop Talking About ‘ESG’ (Seriously. We Need to Stop.)” I have never had the guts to do it because I would be taking on the entire ESG industrial complex. However, Posner’s article, and the many sources she cites go a long way toward making this point.
It comes as no surprise to me that various attempts to rate or grade ESG are inconsistent. The fact is that there is no consensus on what “ESG” is. Indeed, we could all spend a very long and unproductive amount of time just discussing what the “S” in the ESG might be. Is it just Diversity, Equity and Inclusion? Is it #MeToo? Is it child labor laws or human trafficking laws? Is it, as in the case of the recent lawsuit filed against Unilever (and discussed here), an effort by a subsidiary of an international conglomerate to take a stand on issues that the subsidiary thinks involves what the subsidiary calls “Occupied Palestinian Territory?”
Which brings me to another important point that Posner’s article makes (along with the many sources she cites) – and that is that being “good” on certain ESG measures might not be good for financial performance. Indeed, the broad gloss among topics that the phrase “ESG” requires, as well as the broad and unsubstantiated presumption of what constitutes “good” ESG, oversimplifies that many trade-offs that the entire ESG mission may require. As The Economist article Posner cites points out, in the real world, an action that advance some ESG goals may well undermine others.
A point related to the lack of proven connection between ESG and performance is another concern that I have noted on this cite, which is that being proactive on ESG matters can actually produce risk. The Unilever example I referenced above is a good illustration; the company’s subsidiary believes that its policy relating to Palestine is a worthwhile “Social” initiative, but it has embroiled the company in a PR morass and also resulted in a securities class action lawsuit. Similarly, the lawsuit recently filed against Wells Fargo following shortcomings in the execution of its diversity hiring policy also resulted in a securities lawsuit. In other words, being “good” on ESG not only is not necessarily not a reliable predictor of future financial performance; being “good” on ESG may not mean the company is actually a better litigation risk. Indeed, as these examples show, companies that are proactive on ESG may actually face a heightened litigation risk.
There are a lot of problems here — too may to unpack in a single blog post. However, for me, all of these problems tie back to the fundamental concern that the expression “ESG” lumps together far too many disparate and unrelated topics. The result is that ESG doesn’t mean one thing; to the contrary, it means different things to different people. This means that conversations about ESG are all too often slipstreams of thought in different atmospheres, with no intellectual connection between them. At the end, what you get is a lot of superficial analysis – and not just superficial analysis, but superficial corporate practices and acts.
So maybe I will get around to writing that conjectured blog post entitled “It’s Time to Stop Talking About ESG.” But if we can’t stop talking about ESG, can we at least all acknowledge that there is a lack of consensus on what ESG is, which in turn makes ESG difficult to measure and difficult to serve as a basis of policy decisions? At a minimum, can we at least acknowledge what Posner has documented, which is that the ESG ratings, both as a group and individually, may not be reliable measures?