It is no secret that I am skeptical of the usefulness of ESG as an analytic tool and even as an intellectual concept. As I have contended, there are fundamental disagreements about what ESG actually means, and the idea that it can be objectively measured and quantified is illusory, at best. Now, in an October 21, 2023, Financial Times op-ed column (here), NYU Business School Professor Aswath Damodaran argues that ESG is “beyond redemption” and it may be time to administer last rites.
Damodaran’s column is primarily focused on ESG as investment approach or philosophy, but much of what he says is equally applicable to ESG in its many other guises, as well. In describing the origins of ESG, Damodorian says that it was “born in sanctimony, nurtured with hypocrisy, and sold with sophistry.” Damodorian makes a point about ESG that I have made myself on my occasions, that is, that the problem with ESG is just trying to figure out what it measures, since that has “changed over time, and reflects its revisionist history.”
In its origins, ESG “started as a measure of goodness,” but investment salespeople soon figured out that “goodness has limited selling power,” so they “switched gears” and argued that ESG was “an instrument for delivering higher returns without concurrent risk.” This “higher returns” theory worked well in recent years, “mostly because of ESG investors’ abhorrence of fossil fuels” and “embrace of technology firms.” However, the Russian invasion of Ukraine “changed the calculus” and sector funds “underperformed.” ESG advocates changed gears again; advocates moved on to claim that higher ESG scores lead to less risk and lower costs of capital. Because both claims are “questionable,” the advocates now contend that ESG’s “primary purpose is disclosure about material issues.”
As Damodaran notes, it serves ESG advocates “to keep the definition amorphous,” allowing advocates to continue to argue that it has not been correctly defined or implemented. But, as Damodaran writes, “the truth is that ESG scores today measure everything – consequently, they measure nothing.”
As for the consultants who argue that ESG scores are indispensable, based on the assertion that improving ESG increases value, the consultants are “opaque about the pathways for delivering it.” The assertion that ESG increases value, Damodaran contends, is “false”; the truth, he says is that higher ESG scores can increase value at some companies, primarily smaller or niche companies, while decreasing value at other companies where it adds to costs while doing nothing from revenues. Improving ESG for many companies “makes scaling up more difficult, has little or no effect on profitability and is as likely to decrease value as to increase it.
As for the theory that improving ESG will make companies less risky, Damodaran notes that if an asset is less risky, it should lower expected returns. So, advocates contending that improving ESG will make firms less risky are “directly contradicting other claims that investors will earn higher returns if the invest in high ESG companies.”
Damodaran contends that once you strip ESG of its “good for value” and “good for investors” arguments, the “only argument left is that it is good for society, and there too, ESG is destined to fail.” The pressure to maintain ESG scores is unevenly applied, more to publicly traded companies that to private businesses, and more rigorously in some geographies than in others.” The application ESG disciplines to each of the three pillars of ESG, Damodaran says, has come up short. While I may or may not entirely agree with everything he says on this score, he is not wide of the mark when he questions the inclusion of governance in the G pillar of ESG; “its presence,” Damodaran notes, “has always been puzzling,” since it seemingly replaces traditional notions about corporate governance.
Damodaran concludes by saying that ESG is “beyond redemption, a testimonial to the consequences of letting good intentions overwhelm good sense and allowing the selling imperative to define and drive missions. May it RIP.”
It is nothing new for questions to be raised challenging the ESG orthodoxy. However, much of the erstwhile discussion of these issues has been completely politicized, as a result of which whatever dialog there might have been becomes just another front in our never-ending culture wars and yet another topic on which political polarization makes just about any kind of rational conversation impossible.
Damodaran may or may not have a political agenda, but whether or not there is a political element to his position on ESG, his primary arguments are based on company performance and financial and operational efficiency. To that extent, his contentions make a useful contribution to the dialog.
I think Damodaran unquestionably is correct that because ESG as a concept is so amorphous and because it has tried to carry the weight of too many social, business, and financial goals, the expression itself has itself ceased to be useful, if it ever was. I have long thought that all would be better served if the three pillars were detached and considered separately, as they each involve different considerations and each involved separate issues.
I think it is particularly important to separate out the issue of climate change from the whole ESG dialog. Climate change is separate from many of the social justice issues that are typically lumped together under the S pillar. Climate change is also an issue that companies can disregard only at their peril. Both the increasing prevalence of extreme climate events (and the corresponding threat they represent to business operations and financial performance) and the rapidly changing regulatory and political environment represent significant challenges and risks to every business, and the challenges and risks will only increase over time. Whether or not the various climate change disclosure regimes regulators are promulgating now get the issue right, the fact is that every business should be seriously considering how changing climate conditions could affect the business itself, as well as the business’s customers, suppliers, vendors, and competitors.
And so while I agree that “ESG” as a catchall phrase and concept meant to express a host of divergent issues and concerns undoubtedly has outlived its usefulness and should be retired, the sooner the better, that does not mean that the concerns lumped together in the expression can simply be disregarded. In particular, I don’t think any business today can ignore the threat that climate change may represent, and climate change considerations should be part of the long run strategic plan of every business. While I happen to think that this consideration is, in fact, important because it is, as Damodaran, “good for society,” it is also important because without it no business’s long-term strategic plan is complete.