A sideways look at economics
Is there any three-letter acronym that gets bandied around as much, is as poorly understood, and annoys people on both sides of the political spectrum as much as ESG? In today’s blog I explain the problems with grouping an ill-defined mass of hard-to-measure environmental, social and governance factors into a single score. Some of the criticisms of ESG are unfair. But being realistic about what ESG can and cannot do, what it is and what it isn’t, is key to using this information in a positive way. I propose six ways to make ESG better.
Give climate change the space it deserves
Climate change threatens life on earth. Is it right to think about this alongside social and governance factors? I mean, whether a company takes actions to prevent widespread death is surely more important than having an internal career development policy. Take the E out of ESG, I’d say. Or take climate-change mitigation efforts out of E, and treat them as a priority in their own right. That would keep the proponents of S, G and other environmental issues happy, and lead to fewer misunderstandings.
Upweight emissions in E
Despite my desire for this to happen, it is unlikely that the E in ESG is going anywhere soon, which means that I’ve still got problems with ESG. The biggest of those is that most E scores give the same weight to a host of other environmental factors (such as having a policy on biodiversity) as they do to actual reductions in greenhouse gas emissions – which is the thing needed to prevent life-threatening climate change. I’m all for the corporate sector making a positive environmental impact, and measuring this where possible. But under some scoring systems, companies could have outstanding E credentials, yet continue to pump out large quantities of the CO2, which, if they continue, could warm the world to a level where millions, or even billions, of people could die. If E scores are to be considered useful in the context of the 2015 Paris Agreement goal, reducing emissions need to be their focus.
Acknowledge sectoral differences
Some E scores are better than others, but even in the good ones there is a problem: emissions are treated the same, regardless of the sector. This encourages companies and investors to take the easy wins, or things that would happen anyway, instead of identifying and allocating money to firms trying to fix problems in hard-to-abate sectors. Yes, taking an easy win is better than taking no win at all. But failing to distinguish between sectors means that too much money chases too few easy wins (like a utility investing in renewable electricity) and too little capital goes to solving the hard problems needed to tackle climate change (like building low-carbon aircraft). This skews incentives, distorts asset prices and is economically inefficient.
Admit the lack of consensus on S and G
If society cannot agree on socially optimal policies, should we expect the corporate sector, investment community and ESG rating providers do this? As it happens, I personally consider many of the things used in S and G methodologies desirable, but if politicians or society cannot agree on them, we should be wary about what an S or G score can tell us. Investing in line with your own values is fair enough, but a good ESG score might not always align with your values or those of society. How much diversity on a board of directors is optimal? How should this be decided? Should a company encourage their staff to specify pronouns in their email signatures? Is it right to invest in a company that manufactures weapons? What if those weapons are being used to defend Ukraine? And what if they are being used in the conflicts in Ethiopia, or Yemen, or Iran?
Seek out quality data
Even if we could all agree on what makes good S and G, there are serious challenges to measuring these things. To create scores, we want to use things that are quantifiable. But a lot of S and G information is unquantifiable or available for some companies and not others. Inconsistency of data across firms complicates comparisons. In some cases, the missing information is estimated using complex models or artificial intelligence. That might be better than doing nothing and it probably gives useful information. But, as with any estimation or forecasting, things are going to be wrong and sometimes very wrong, meaning that some companies that are given bad ESG scores, may, in fact, be good corporate citizens and vice versa. Human judgement is still needed.
Keep it real
In the US, some companies and investment managers are coming under fire from both sides of the political spectrum for their ESG policies, lack of ESG policies and/or their approach to ESG investing. Some of this criticism may be warranted and linked to the problems above, but some of it makes no sense. How can an investor not consider ESG factors if the E contains climate-change mitigation efforts, when climate mitigation efforts relate to the energy transition, which is quite likely going to be the largest redeployment of capital in history? Most of the world’s major economies have pledged to reduce their carbon emissions to net zero by mid-century or shortly after that. It would be a dereliction of duty for a corporate leader or investor to fail to consider how these pledges will affect their business. One solution is simply to call ESG investing something else. We are not ESG investing, we are doing ‘considerate’ investing. Call it what you want.
Despite everything I’ve said and ESG being used as a political punchbag, ESG is here to stay. I see these as ESG growing pains. In fact, such high-profile public squabbles should ultimately enhance the debate about what ESG actually is, and what it can – and cannot – do. While some ESG numbers are better than others, even the good ones should be considered as a guide. The same is true for any model. Sometimes, the devil is in the detail, even for well-intentioned things like ESG.
Recognising the issues above with respect to E scores, Fathom has developed an alternative quantitative framework to score companies on purely their decarbonisation efforts and the consistency of these efforts with the Paris climate goal. This framework is focused on emissions and emission changes. It benchmarks companies’ performance against sector-specific decarbonisation pathways, themselves created by Fathom using an economically efficient and quantitative way of allocating the global carbon budget. Stay tuned, or get in touch, for more on our framework.
 Having a policy on such a thing is good, in my opinion, but the mere existence of a policy gives no information about the quality of that policy or whether or not the company is taking any actions to follow the guidance in that policy.
 The reality is that we don’t know what the effects of climate change will be for sure, but if you think such talk is hyperbole, I recommend reading Risky business: the climate and the macroeconomy. 2020, where the analysts at JP Morgan (hardly radical tree-huggers) said that ‘catastrophic outcomes [due to climate change] where human life as we know it is threatened’ could not be ruled out. For more see: https://www.bbc.co.uk/news/business-51581098; https://www.who.int/news-room/fact-sheets/detail/climate-change-and-health; https://www.ipcc.ch/report/ar6/wg2/; https://www.pnas.org/doi/10.1073/pnas.1910114117; https://www.forbes.com/sites/dishashetty/2021/07/30/climate-change-would-cause-83-million-excess-deaths-by-2100/.
More by this author: