A recent paper by researchers at the Rock Center for Corporate Governance at Stanford debunk several myths around ESG. Given that companies use ESG in decision-making, and regulators are increasing their focus on ESG, the paper is timely. I summarise the seven myths:
- We Agree on the Purpose of ESG: Despite the near-universal push for ESG, consensus does not exist about the problem ESG is expected to solve. There are three lines of thought: (a) it helps reduce the short-term behaviour of managers; (b) Capitalism is focussed excessively on shareholders, and ESG helps shift the focus on stakeholders; (c) ESG is synonymous with corporate responsibility.
- ESG Is Value-Increasing: It is widely believed that ESG improves outcomes for all. Research shows that the outcomes are varied (either producing long term benefits or increasing costs) and very dependent on the setting.
- We Can Tell Whether a Claimed ESG Activity Is Actually ESG: It is often difficult to tell whether the initiative is ESG. Many ESG activities are closely aligned to a company’s existing business model and indistinguishable from standard business decisions to maximise shareholder value.
- : A Company’s ESG Agenda Is Well-Defined and Board-Driven: According to the authors the decision-making process is not as well defined. A study by PriceWaterhouseCoopers shows that only two-thirds of corporate directors said that ESG is linked to their corporate strategy, and only a quarter felt that the board understood ESG risks. Another study showed that a little over half of directors and executives felt that their boards understood ESG risks.
- G (Governance) Belongs in ESG: ESG advocates describe the “G” in ESG as involving board quality, appropriate compensation, accountability to ownership, and ethical business practices. While these are required of a company that pursues ESG, they are also required of companies that place little or no emphasis on ESG. The need for governance quality is universal among organisations.
- ESG Ratings Accurately Measure ESG Quality: Despite perception to the contrary, ESG ratings developed by third-party agencies have only a weak (if any) association with corporate outcomes such as performance, risk or, failure thought to be indicative of ESG quality. Each rating provider uses a different number of input variables, and measuring them and combining them is a significant challenge.
- Mandatory Disclosure Will Solve the Problem: Many believe that more disclosure will solve market participants’ problems in assessing ESG quality. While the output of this effort might increase information quality at the margin, the cost of doing so will not be trivial. Increased reporting also opens up companies to litigation.
A clear understanding of the underpinnings of ESG enables better ESG decisions and reflecting on them is essential for ESG practitioners.