People are Asking…Does “ESG” Actually Matter?

People are Asking…Does “ESG” Actually Matter

Okay, we admit it. The title of this article may qualify as click-bait. Why would we, a company with “ESG” in our name, ask whether ESG actually matters?

Of course, the things the letters E, S, and G stand for matter to businesses. Climate change and the rapid loss of biodiversity clearly matter – they are affecting economies everywhere. No one disputes that the people who form the backbone of any company, and the communities that create and support economic activity, matter. Clearly, oversight, risk management, and accountability in business, not to mention the boards that act on behalf of shareholders, matter. It seems silly to argue otherwise.

We actually borrowed part of this title from an article by McKinsey Sustainability that discusses the struggles “ESG” – as a concept, an input to investment strategies, and so on – is facing at this moment in its evolution. McKinsey points out that objections to ESG overlook the fact that businesses have (and must continue to have) a social license to operate. That is, stakeholders must perceive that a business or industry is acting in a way that is deserving of society’s trust.

McKinsey states that criticisms of ESG fails to adequately account for the importance of this social license. Let’s assume that businesses exist to create value for their shareholders. If a business fails to address externalities—defined as “a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services involved”—it erodes the company’s social license to operate, and its ability to pursue its strategies and create value are imperiled. As we have always said, ESG is ingrained in the way a business operates. So, failing to consider ESG when making business decisions, and in analyzing a company’s value, ignores critical factors that affect long-term viability.

McKinsey groups the main objections to ESG into four categories – and before we go any further, we note this is just a summary and encourage you to read the full article:

1. ESG is not desirable, because it is a distraction

Critics argue that ESG gets in the way of what businesses are supposed to do: “make as much money as possible while conforming to the basic rules of the society,” according to renowned economist Milton Friedman. Viewed this way, ESG is a public relations exercise and a way of profiting from stakeholders’ desire to “help the world” (note the implied sarcasm). ESG may be good for a company’s image but is not a core component of its strategy. 

2. ESG is not feasible because it is intrinsically too difficult

This criticism of ESG holds that striking the right balance in implementing ESG among multiple stakeholders is simply too hard. Pursuing financial returns is at least objective. But figuring out how to do that while considering multiple stakeholders who may have mutually exclusive goals is difficult. For example, if a company increases salaries that can decrease near-term profits even though it may reduce employee turnover, improving efficiency and profitability over a longer period. Who makes the call about which stakeholders to serve? And what evidence should be used to support those decisions?

3. ESG is not measurable, at least to any practicable degree

A third objection is that ESG cannot be accurately measured. The differences in weightings and methodologies across ESG ratings is a reflection of this problem (that’s why OWL ESG created our Consensus Scores). The same can be said for definitions used by organizations including the Global Reporting Initiative (GRI) and the International Sustainability Standards Board (ISSB). This has led some large investors to develop their own methodologies that draw from a variety of inputs (including ESG scores) – we do not see that as a bad thing, but it takes time and effort.

4. Even when ESG can be measured, there is no clear relationship with financial performance

The fourth objection is that ESG’s correlation with outperformance, when it exists, could be explained by other factors. Furthermore, causality is virtually impossible to prove. We note (this is not from McKinsey) that even though research does not consistently show a relationship between stock price returns and ESG ratings, that is far from conclusive evidence that ESG doesn’t matter. It says more about the challenges of using ESG ratings and the extent to which funds labeled “green” or “sustainable” engage in greenwashing than it does about whether applying ESG principles in managing companies and analyzing investments makes sense.  

As McKinsey points out (and as we have written ourselves) ESG has to be viewed within a larger context. For example, many countries need to strengthen their energy security due to Russia’s invasion of Ukraine. That will lead to increased fossil fuel use in the near-term, which seems “un-ESG”. That is causing critics to cry, “ESG investors who want penalize energy companies are saying that people should freeze this winter.” But true ESG (at least in our view) is not that heavy-handed – it is a realistic part of a strategy to further a company’s and investors’ goals.

ESG metrics, reporting, definitions, standards, etc., can be complicated and at times frustrating. However, as McKinsey points, by questioning the value of ESG altogether managers are likely to miss critical aspects of what it takes to ensure that a business endures—with societal support, in an environmentally viable way. That’s what “sustainable” means. Although it has its problems, McKinsey concludes that the concepts ESG represents are essential to modern corporate decision-making and warns about real risks for companies that fail to apply these concepts, saying “If companies, particularly those with significant externalities… hold out for perfect data and a ‘flawless’ rating process, they may not have a business in 20 to 30 years.”

At OWL ESG, our mission is to support those who need information to make informed decisions about companies’ ESG practices, on a stand-alone basis and relative to its peers. Contact us to learn how our ESG scores, analytics, and bespoke solutions can meet your needs.