The past few years have seen much ado about ESG — shorthand for “environmental, social, and governance,” a trio of non-financial factors that have become priorities for the public, investors, and regulators. But as ESG has begun to shift from a talking point to a regulatory mandate, consensus has given way to controversy, polarizing debate over its very definition, reliability, and benefit.
On one hand, pension funds, endowments, and institutional investors including BlackRock, the world’s largest asset manager, have cemented ESG priorities into tens of trillions of dollars in investment decisions. On the other, some notable figures are crying foul. Billionaire deal-maker Carl Icahn has called ESG the “biggest hypocrisy of our time.” And Tesla CEO Elon Musk has added fuel to the fire, tweeting out that “ESG is a scam.”
Beyond the tit-for-tat, the future of ESG weighs heavily on the climate. In coming years, the world must invest trillions of dollars annually to decarbonize everything — from power grids and transportation to buildings. ESG frameworks and ratings, if done correctly, can help guide investment into vital sectors that will accelerate the transition.
Despite the high stakes, the ESG debate has lately grown more confusing as it expands. In this article, we explain what ESG is, highlight its limitations, and answer some basic questions about how ESG fits into the energy transition.
ESG: One, None, and 100 Thousand Meanings
Here are the basics. ESG covers a broad range of impacts, from GHG emissions to human rights and business ethics. ESG frameworks structure corporate sustainability agendas and evaluate risks and opportunities related to key issues.
In the Global North, almost every company now publishes a sustainability report: in 2020, 92 percent of S&P 500 Companies and 70 percent of Russell 1000 did so. ESG-branded assets are growing and are expected to reach $50 trillion by 2025. This investing trend has brought on the development of hundreds of ESG rating tools to evaluate stock market indices, funds, bonds, and other financial tools. ESG ratings aim at scoring companies based on a selected set of sustainability criteria. These ratings are used by investment firms and investors who want to screen and align their portfolios.
This boom has led to a Tower-of-Babel information ecosystem, with no way to verify underlying data. Despite good intentions, ESG ratings have received well-deserved criticism when black-box frameworks defy common sense — such as when Exxon Mobil was added the S&P 500 ESG Index on the same day that Tesla was removed. Without a harmonized approach to developing ratings, data providers interpret data differently and develop mismatching scores.
It doesn’t take a sustainability professional to notice that something isn’t working right. Accuracy aside, most ESG metrics end up not being material to the performance of the entity and do not show where the business impacts lie. Consider a bank setting a Scope 1 decarbonization target — which would include little more than emissions from corporate-owned vehicles — instead of committing to decarbonizing its portfolios. This nonsensical approach might not raise a red flag in most ESG ratings systems. If ESG will drive change in the real economy, it needs to be built on impact rather than financial materiality.
All too often, companies take advantage of the ESG status quo by ticking certain boxes that relate only obliquely to sustainable or responsible business, while pressing on with business models that are fundamentally at odds with a livable future. But things are slowly changing.
From Voluntary Efforts Toward Compliance-Based Sustainability Reporting
Governments are moving toward mandatory disclosure of corporate sustainability. Examples of recent progressive legislation include:
- The French Duty of Vigilance Law, adopted in 2017, requires large companies under French jurisdiction to submit an annual vigilance plan for their own activities, as well as those of their subsidiaries, direct and indirect contractors, and suppliers.
- The German Act on Corporate Due Diligence in Supply Chains, adopted in 2021, established mandatory human rights and due diligence, including environmental destruction across the supply chain.
- In the United States, the Securities and Exchange Commissions (SEC), is considering mandatory climate disclosure and ESG disclosure for investment advisers and investment companies.
These regulatory changes are helping raise the bar on ESG accounting, supported by growing public skepticism toward ratings systems.
Sustainability and the Corporation: The Future of ESG
Since sustainability entered the orbit of financial markets in 2006, the ESG trend that started in the business world began to shift to its current state of debate.
Now, almost two decades later, most corporate net-zero commitments and human rights due diligence processes are still weak, with most companies unable to measure their emissions correctly. The divide between real economy impact and financial sector’s hype around ESG has grown apart. Nevertheless, sustainability strategies still attract the investment of “responsible investors.” Signatories of the UN Principles for Responsible Investment grew from 63 to 2,450, now representing over $80 trillion in assets managed with the integration of ESG principles.
But ESG has become very misaligned with what it was initially set out to do: keep business on track with sustainability. The lack of verified information oriented toward profit-making rather than impact has impeded progress on corporate accountability, leading to inaction and confusion. It is time for corporate sustainability to come back down to earth.
ESG needs greater clarity and transparency so that corporate commitments can translate to action and impact. What are the tools we have to make this happen? We need to let data follow the goods. Digitally enabled solutions can improve visibility into supply chains and corporate operations. This is what RMI is working on as part of its mission to deliver a clean, prosperous, zero-carbon future for all — with the aim to improve GHG tracking while not leaving the rest of sustainability behind. Digital tracking can change the current system that relies on information being transferred like in a “game of telephone.” It can provide verifiable and trusted ESG information that helps companies measure progress on their goals and investors to make responsible decisions.
If done correctly, the flow of trustable ESG data at the product level can ultimately create markets where commodities are differentiated based on a commonly understood set of sustainability criteria. And ESG can channel finance toward products, solutions, and portfolios that are truly climate aligned.
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