To understand the various twists and turns that have led to ESG gaining so much popularity, let us travel back in time. It was in 1970, that Milton Freidman proposed his now famous, doctrine, “the only social responsibility of business is to increase its profits”. His doctrine established the primacy of shareholders over all other stakeholders, such as the community and employees. The Friedman doctrine has influenced generations of business leaders and normalised the single-minded pursuit of profits by businesses (even though historically businesses have bowed to gods other than profits – such as religion, family and society).
This exclusive focus on profit maximisation and shareholder value has had huge negative impacts on the environment and society. This is because the costs of ignoring ESG responsibilities, such as emissions, layoffs, pay gaps, are externalised to society. In the 50 years since Friedman, there has been a crescendo in the voices of dissent highlighting these negative effects and advocating for businesses to have responsibilities beyond profits. As a result, terms such as “corporate social responsibility”, “triple bottom-line”, and “sustainability” have gradually been entering the popular lexicon.
Although these different labels have waxed and waned in their popularity, the core idea that underpins all of them is that businesses have a responsibility to society beyond profit maximisation. ESG is the latest milestone in this journey. ESG aims to ensure that stakeholders can make informed choices about doing business with firms, and punish those with lower ESG scores.
ESG investing has gained significant traction in the last couple of decades. According to the Global Sustainable Investment Alliance, the size of the ESG market in 2022 is around $35.3 trillion. Powerful investors such as BlackRock are pushing firms they manage to report on ESG. This is a far cry from the Friedman dictate and is leading many pundits to prophesise that ESG are the three letters that will save the planet.
In theory, stakeholder pressure for greater ESG performance can be a powerful lever for change, but in practice ESG is fraught with problems. Before ESG can save the planet’s soul, we need to urgently address some fundamental problems in ESG measurement, disclosure and impact. If we fail to address these issues, ESG will end up being dismissed as another passing fad; part of the greenwashing of industry.
Problems with measurement (what shall we measure on?)
Currently, there are a plethora of ESG indicators. Firms can choose to report on the Global Reporting Initiative (GRI), Sustainable Development Goals (SDGs), or a wide array of consultancy score cards. There are about 700 metrics across more than 60 categories, which makes comparing ESG performance across firms extremely hard.
ESG ratings across different assessors match up less than 50 per cent of the time. In fact, firms can improve their ESG scores simply by reporting on a different set of measures. The European Union is currently pushing for ESG standards, as is the United States, but again these ESG standards do not match up.
Problems with disclosure (what data shall we show?)
Levenstein famously remarked that “statistics are like bikinis; what they reveal is suggestive, but what they conceal is vital”. ESG is beset with similar problems.
For example, there are three types of greenhouse gas (GHG) emissions: Scope 1 includes direct emissions (such as fuel combustion by company vehicles); Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the company; Scope 3 includes all other indirect emissions that occur in a company’s value chain.
Ironically Scope 3 emissions are responsible for 90 per cent of emissions in many industries and yet less than 50 per cent of firms report them.
Problems with impact (can ESG really save the planet?)
A fundamental problem with ESG is that it measures the risk that environmental and social challenges pose to businesses rather than the risk that businesses pose to the environment and society.
Flawed measuring and disclosure mean that despite measuring and reporting on ESG, businesses can continue to externalise harm to society. As a result, the bigger question of impact (businesses cannot survive on a failing planet) remains unaddressed by the currently flawed ESG measuring and reporting.
What then is the way forward?
If ESG is to have a meaningful impact, we need to urgently standardise the measurement and disclosure of E, S and G.
This will need regulatory levers. Without regulatory standardisation of ESG measurement and disclosure it will continue to be hijacked by vested interests – leaving it of little use in its intended purpose of saving the planet.
Also, businesses and governments will need to understand the unique ESG paradox: ESG issues demand immediate and urgent action now, but they must be willing to wait long term for the gains to materialise.
This ability to move beyond a focus on quarterly performance and simultaneously think both short-term and long-term requires a fundamental shift in business leadership.
Associate Professor Sukhbir Sandhu will share her story about her journey from life in India to her world-leading research here in Australia at the Newday Leadership Summit 2022. In a world where change is the only constant, Sukhbir will discuss how leaders can navigate from “knowledge to wisdom” in their pursuit to address grand societal challenges.