The Seven Myths of ESG

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:

  1. 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.
  2. 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.
  3. 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.
  4. : 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.
  5. 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.
  6. 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. 
  7. 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.

Labour and ESG reporting

Image: Pop & Zebra / Unsplash

While much of the focus on ESG in recent times has centred around the environment, labour has not received the kind of attention it deserves. While Health and Safety has been a common theme in most sustainability/ESG reporting, several other issues deserve a closer look. Much of the corporate reporting on these issues tend to be in narratives rather than quantitative. Analysing the non-financial reports, thus, becomes quite a struggle. For a start, some of the decent work indicators that ILO looks at 

  1. Employment opportunities: Proportion of non-formal employment; employment generation activities in the organisation and nearby areas
  2. Adequate earnings and productive wage: Average wages; Minimum wage as a percentage of median wage;   
  3. Decent working times: measured as the number of working hours; days of paid leave
  4. Combining work, family and personal life: Maternity protection; paternal leave
  5. Work that should be abolished: Child labour, forced labour
  6. Security and stability of work: Work tenure
  7. Equal opportunity and treatment in employment: Occupational segregation by gender; Female share in middle and senior management, the Gender wage gap
  8. Safe work environment: Occupational injury rate –fatal and non-fatal, time out due to work-related injuries
  9. Social security: Pensions and social security
  10. Social dialogues, workers’ and employers’ representation: Collective bargaining and union coverage; days not worked due to strikes and lockouts

There is a need to build standards around non-financial reporting of labour-related issues. Labour is an essential cog in the “S” of ESG and needs more attention and focus.

Corporate Boards and Net Zero

The shift to net zero is urgent, and boards have a critical role in guiding companies. Yet many of the board members have little training or background in sustainability. The boards need to reskill – something that we highlight in our book Shift: Decisions for a Net Zero World.

The table below presents a worrying picture. There is a need for a generational change in the board composition. Companies need to bring in a newer generation that thinks more about sustainability. There is also a need for board members to reskill themselves to be relevant. Board members need training on many aspects of ESG and sustainability. They need to understand the measurement and management of risks embedded in current ways of doing things and the reputational challenges involved.

The “G” in governance needs more a more skilled board team. That will help push the shift to net zero.

A Balance Sheet tells a Net Zero Story

Banks and financial institutions have almost zero emissions. So do most companies in the service industry. Their balance sheet can guide them in their journey towards net zero.

Let us take the case of an insurance company (hypothetical, of course). An insurance company collects money from its policyholders by way of a premium. The company then invests the money in various securities that earn them a return. Out of this, claims against fire, death, floods etc., are paid. The remainder is the profit for the insurance company.

In a simple version, the balance sheet of an insurance company has policyholders’ claims on the liabilities side and the investment in securities on the asset side.

So, what are the implications for net-zero?

Let’s start with the liability side. Policyholders are either individuals or corporate. The bulk of customers tends to be corporates. The composition of corporates and their emission profile indicates a risk to the insurance company. For example, suppose a  significant portion of policyholders are in the business of coal and oil. In that case, the dwindling future of coal and oil companies may impact the insurance company. Thus it needs to track the emission profile of its customers.

The asset side is equally important. To be genuinely net-zero, the insurance company will also need to minimise its investment in high carbon securities. If it holds equity shares of a company, then that company’s carbon emissions count. The same holds for debt securities. Investments in mutual funds would require tracking of emissions of constituent companies.

The shift to net-zero requires companies not asset not only the direct emissions but also indirect emissions. A look at their balance sheet will help.

Green Transition Metals and Net Zero

There are several metals critical to green technologies. Copper and nickel are called established metals. Trading in these metals has been taking place for over a century. Then, there are rising metals like lithium and cobalt where there is no established trading on exchanges.  However, they have become crucial for their role in green transition technologies. There is likely to be a rise in the demand for certain metals (nickel, copper, and manganese) for their role in a wide array of green technologies. Others like cobalt and lithium are limited to batteries.

The IEA’s “Net Zero by 2050” report estimates that the demand for lithium for use in batteries will grow 30‐fold to 2030 and is more than 100‐times higher in 2050 than in 2020. In addition, the total market size of critical minerals like copper,  cobalt, manganese and various rare earth metals grows almost sevenfold between 2020 and  2030 in the net-zero pathway.

The increased demand will need to be matched by supply. A study by IMF shows that many of the metals required for transition, at current production rates, will be inadequate to satisfy future demand. As a result, metals like nickel, vanadium, cobalt and graphite will likely be in short supply. The recent rise in commodity prices is a clear indicator of these shortages.

These metals form a few regions. For instance, the Democratic Republic of the Congo accounts for about 70 per cent of global cobalt output and 50 per cent of reserves.

While the scenario looks difficult, there are two imponderables. First technological change is hard to predict. Second, the speed and direction of the energy transition are likely to be dictated by policy changes.

The road for the shift to net zero will be tough. But it is the only road for the future.