What is ESG?

Taylor Gray, Ph.D.
|
March 24
|
6 min read

In this post

What is ESG?

The seven inconsistencies in understanding ESG

Russia's war highlights the shifting contexts of ESG

What is ESG?

ESG is big news now…but what exactly is ESG? Based on recent news articles and op-eds invoking the ESG acronym for all sorts of issues which we never expected to be discussed as ESG, it is fair to assume that the answer to this question may not be as widely understood as the popularity of the term itself.

So here it is, our answer to this question: ESG is an analytical framework relating corporate Environmental, Social, and Governance performance to specific outcomes, typically corporate financial performance. It is a broad understanding of how a company’s operations, culture, and structure influence performance and the world around it.

As an analytical framework, there are various approaches to ESG, but the most common is the incorporation of what is traditionally referred to as extra-financial information into a determination of how a company is positioned to benefit from or be exposed to changing social, political, economic, and environmental landscapes over time.

We say ‘extra-financial information’ as some data and insights are important to understanding a company’s positioning in markets and society, and hence anticipated performance, yet are not included in annual or quarterly financial statements. ESG has developed as the catch-all for this. It’s not that a company’s Scope 3 carbon emissions (an example of E-focused data) are intrinsically linked to the number of independent directors on the audit committee (an example of G-focused data), but rather that these two data points may be useful in understanding corporate performance but are not included in financial reports.

ESG originated from the interests of institutional investors, and most notably those with long-term investment horizons. To this day, ESG is still dominated by the interests (and vocabulary!) of the investment industry, but things are changing fast. In short, ESG is concerned with using more data to develop a more complete understanding of how a company operates and how a company is likely to operate within the changing world we each anticipate. It is a lens into the Business & Society relationship.

ESG holds great promise:

  • Want to optimize long-term investment returns?

  • Want to minimize portfolio volatility?

  • Want to develop an enduringly successful business?

  • Want to meaningfully engage with all stakeholders?

  • Want to marshal the forces of capitalism toward a better world?

Great! ESG can help you do that…yet it should be noted that ESG cannot do any of this on its own. ESG is effectively the application of specific data within a purposeful decision-making process. The actual purpose of this process depends on you and not on ESG.

There are a few additional elements which should be pointed out because they seem to keep resurfacing and are certainly muddying the waters:

  • Issue #1: ESG is not a product. You do not invest in ESG, rather you invest with ESG. It is not an asset class but rather an analytical framework applicable to all asset classes. ESG is an analytical framework to understand assets of interest, but it is not an asset itself. There is no ESG Company or ESG fund, there are only companies or funds whose ESG profiles align with your own decision-framework.

  • Issue #2: ESG is Objective. ESG data can be incorporated into a decision-making framework, but it is your decision-making process, and not the ESG data, which determines value. ESG is neither good nor bad, rather it is how you interpret the ESG data and to what end which determines the outcome. If I anticipate future value being linked predominantly to carbon emissions, then ESG data allows me to anticipate underperformance from ExxonMobil, but if I anticipate future value being linked predominantly to workforce diversity and inclusion, then ESG data allows me to anticipate outperformance from ExxonMobil.

  • Issue #3: ESG is context-dependent. ESG relates corporate performance to social, environmental, economic, and political developments…and anticipated developments. In this sense, it is highly context-dependent. Consider how ESG data about water intensity becomes much more important in times of prolonged drought, or how data about Scope 3 emissions from employee commuting or Scope 1 emissions from corporate fleets become more interesting now that work-from-home and virtual engagement alternatives are common-place.

  • Issue #4: ESG is not product-level. ESG relates to corporate operations, culture, and structure as a whole. Product sustainability, health & safety, or specific supply chain dynamics factor into this but do not exist as stand-alone ESG. Interest in product-level impact is growing among consumers, and product impact factors into ESG but ESG is not interchangeable with product impact. Product data builds into corporate ESG data, but corporate ESG data is more than just the sum of product data.

  • Issue #5: ESG is not Sustainability or Impact or Social Responsibility. With the growing interest in ESG, it is often used as short-hand for Sustainability or Impact or Socially Responsible Investing. ESG holds great promise, but it is disingenuous to represent it as something other than what it is. ESG data can be engaged to assist in determinations of Sustainability or Impact or moral alignment, but is none of these on its own. These former are respective moral determinations whereas ESG is data (See Point #2). Sustainability, Impact, and Social Responsibility are subjective determinations, ESG data are objective inputs. Just as in a bakery, many different treats can be baked from the same ingredients--the trick is in how you combine them.

  • Issue #6: ESG is not a choice. All companies have ESG data and profiles whether or not they choose to optimize it, acknowledge it, or disclose it. A third-party can derive ESG data about any company. Companies do not choose to have an ESG profile, but they can choose to optimize their ESG profile. You can ignore your shadow, but you can’t escape it.

  • Issue #7: ESG now cuts both ways. ESG links corporate performance to changing social, environmental, political, and economic settings. Traditionally, ESG was approached to better understand how a company could benefit from or be exposed to such changing settings. Today, ESG data is also being engaged to better understand how companies are contributing to such changing settings. ESG is now a fuller reflection of the Business & Society relationship.

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In the Real World

Can Markets Provide a Definition?

One way to define what ESG is is to look at what is included in ESG equity portfolios and identify the shared characteristics therein. This is exactly what Morningstar did and they can now report that ESG is…Everything!?!? Yup, looking at the Russell 1000 index, we can see that all except for 21 of the index’s 1,013 companies are included in at least one large-blend ESG strategy, and all with the exception of 1 of the excluded companies are among the 25 smallest firms in the index. If we thought ESG was synonymous with Sustainability, Impact, or Social Responsibility, then this is a failure, but if we accept that ESG is objective data to be used in any number of decision-making processes, then this is a success.

What This Means for CSOs:

Your job is to optimize your ESG performance and it is important to note that there is no standard external benchmark against which to optimize. We recommend staying focused on a strategy that is meaningful to your own company and allowing other market participants to act on your data as they see fit. Transparency and clarity in your mission will go a long way to ensuring your ESG data is understood in the appropriate context from which it emanates.

Are Weapons ESG…is ESG a Weapon?

Russia’s war in Ukraine is forcing many observers to reconsider formerly resolute principles. For so many, weapons manufacturers were to be excluded from any ESG consideration, but current unprovoked aggressions are seeding doubts on this front. It would seem weapons as a source of violence and destruction are bad, but weapons as a source of protection and defense are good…even when we are talking about the same weapons. Context matters, and context is always shifting.

Similarly in the Oil & Gas sector. Oil is out and renewables are in…at least that was the general trajectory until now. Energy independence from Russia has become Priority #1 and that means boosting domestic oil and gas production. Oil as a source of climate change is bad, but oil as a source of economic independence is good. Context matters, and context is always shifting.

Lastly, over 450 Western-based companies have left Russia. Some due to concerns over safety, some due to fear of entanglement with economic sanctions, but most in response to overwhelming consumer and shareholder demand. Those companies that have not left are now facing calls for boycotts and online ridicule escalating toward reputational disaster. Free markets, consumer sovereignty, and shareholder profits are all the idols of capitalism until capitalism turns its sights on human rights and the protection of democracy…and it isn’t always clear when that tide turns. Context matters, and context is always shifting.

What This Means for CSOs:

By optimizing your ESG profile, you are acting on the Business & Society relationship. Importantly, note that this relationship is perpetually evolving. Develop a strategy meaningful within your own context but certainly do not lose sight of the changing contexts around you.

In the end, ESG is not a product or an outcome, rather it is a new framework for making sense of the Business & Society relationship. There is so much more that can be said about ESG, but this newsletter is already getting too long. We are focused in this space and will have more to say in our next edition, in the meantime, please connect with us on Twitter and LinkedIn, or from our website to continue this discussion in greater detail.

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