ESG and its discontents

At the end of last year, Phillip Morris was included in the Dow Jones Sustainability Index North America for the second consecutive year. That a company which sells 700 billion cigarettes a year can be included in an index that ostensibly tracks firms that score well on a variety of metrics broadly referred to as environmental, social, and governance (ESG) factors on the face of it seems questionable.

By 2025, ESG assets under management are anticipated to exceed $50 trillion, according to Bloomberg Intelligence. Investors are increasingly using ESG metrics to assess where to drive their capital. Yet, while huge sums of money are flowing into assets deemed to be ESG compliant, there’s significant issues with how these metrics are determined. Ratings agencies as well as those responsible for compiling some of the most popular funds have different definitions of ESG, and subsequently different views on how and what to measure.

This haphazardous approach to ESG has meant for striking anomalies such as the inclusion of companies like Phillip Morris in sustainability indexes. Such anomalies occur because, contrary to popular belief, ESG ratings typically measure a company’s exposure to ESG risks. As a result, even a company that is the source of significant social harm – i.e. tobacco makers – can still get a reasonable ESG score, if rating agencies consider they’ve taken adequate steps to mitigate those risk factors, for example.

These conflicting ratings, due to a lack of standardization in measuring and disclosure requirements, don’t only generate questionable outcomes but have also opened up an opportunity for more sinister uses, like greenwashing. Greenwashing refers to a company's practice of amplifying their ESG efforts to accrue its benefits without doing any of the meaningful work. Or worse, using ESG to hide their efforts of outright fraudulent behavior. The Volkswagen emissions scandal is perhaps the clearest demonstration of such practices, but by no means the only one.

In the wake of the war in Ukraine, these concerns about the misuse of ESG have been further substantiated as more than $8.3 billion worth of Russian government bonds and companies had been included in ESG funds.

ESG’s taxonomy problem

These serious concerns around greenwashing are part of a wider issue that continue to plague ESG. Greenwashing itself as a term is exemplary of this issue: ESG has increasingly become a byword for sustainability. The social and governance components of ESG are at best overshadowed, if not all but ignored. Certainly, the seriousness of the environmental issue facing us warrants meaningful attention and action. Yet, if such attention comes at a cost to social and governance considerations then at the very least we ought to question whether there’s a need to jettison the ESG label.

One reason this issue has arisen is that each of the categories are by themselves wide spanning. Environmental considerations, for instance, exist across a business’s entire value-chain. Likewise, there are numerous potential inputs and considerations for measuring a company’s social impact. The outcome of this has been a growing focus on selectively using ESG considerations. And that selective usage is creating a perverse incentive model that rewards shiny initiatives to sustained and long term impact.

This wider taxonomy problem, as well as the practical issues especially around greenwashing, point to the need for sustained conversation around ESG. Without having clear definitions around ESG and how we measure it we will continue to struggle to differentiate show from substance.

In the coming months we will be releasing a whitepaper precisely with the aim of resetting the conversation around ESG. Money20/20 is where fintech conversations happen, and invite you to join in this ESG discussion via our social dialogue with the authors directly, as well as via our social media channels.