Following the onset of Covid-19, ESG became a hot topic as the ‘next big thing’. With that growth, it attracted both pretenders and detractors. The change in the tone of reporting about ESG has led to some hand-wringing about its future. A UK-based portfolio manager broke down the issue into two parts: “When it comes to “the three-letter acronym ‘ESG’ — people don’t want to talk about it as much because of the news flow from the US. But from an investment perspective and what we do internally, it has never been more important.”
The more circumspect interest in the three-letter acronym — used at various times to combine very different topics into single ratings — is leading to questioning about the most effective ways to implement after a frenzied boom where execution quality varied widely. The introspection is useful to reset expectations because promises around ESG had become too broad, at various points described with a broad brush conflating it with financial materiality, positive impact and values-aligned finance.
With some important consolidation within the standard-setting landscape in the formation of ISSB — which produced investor-oriented standards for sustainability and climate disclosures — ESG is being anchored around financial materiality. Because financial materiality varies so widely sector-to-sector, a deeper focus on the investor viewpoint is also removing some of the expectations for ESG to be seen as a solution on its own.
A case in point is the ESG success of tobacco companies in increasing their ranking by focusing on their operational performance on environment, social and governance metrics regardless of the harm their product creates. Pushing a company up the rankings on its operational ESG performance shows clearly how separate financial materiality can be from impact materiality or values-aligned finance. Investors focused on the latter two characteristics will often exclude tobacco because of the health damage its product creates.
The contradiction of tobacco companies getting high ESG scores doesn’t discredit those scores, but it should shine a spotlight on what they can and can’t deliver on their own. Business models that focus only on maximizing short-term private financial returns regardless of the social consequences are unsustainable however high the returns. Those returns reflect a transfer of value from those in society harmed by negative economic, social or environmental impacts to those exploiting the opportunity.
The balance in responsible finance isn’t found by ditching ESG for impact-oriented financing or solely by focusing on values-aligned finance. It will end up with a diverse financial system made up of participants focusing in different magnitudes on financial materiality and impact on other stakeholders, and in integrating their own values into decision-making.
One way to reconcile these different characteristics will be to view ESG as a tool to understand company operational properties that create or destroy value. Impact materiality will highlight sources of risk or opportunity that impact the sustainability of different businesses, and values-aligned finance is how different people weight the issues that they value. It’s an end-point that can support some consistency at the company reporting level while acknowledging that the way the reported information is used will vary widely.
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