ESG (Environmental, Social, and Governance), is an acronym we see and hear constantly, but few of us really understand. It has also become a political flashpoint with some claiming it is killing commerce, and others holding it up as our best hope to save the planet. The truth is somewhere in between. It is important to understand what ESG is and is not, and to consider the unintended consequences to avoid, like pulling capital from companies that most need clean technology investments, and the complementary efforts required to achieve the desired environmental and social good.
ESG is a framework used by investors to assess the performance of a company’s business practices related to environmental and social issues. The environmental criteria focus on a company’s impact on the natural world, primarily in terms of greenhouse gas emissions, but also factors like water use, waste, natural resource depletion, and climate resilience. The social criteria revolve around equitable relations with employees, customers, suppliers, and the community. Governance includes corporate leadership, executive pay, auditing and controls, and shareholder rights. ESG provides investors with a glimpse, but not a full picture, of how well a company is addressing sustainability risks associated with regulation, societal trends, and the natural world. ESG reporting tends to focus on the “E,” with less emphasis on the social and governance.
According to research by Morningstar Inc., Barclays Plc, and others, investment funds with an ESG screen tend to outperform similar conventional funds over the medium- to long-term, and to provide superior risk-adjusted returns. A recent survey of CFOs and CIOs in the U.S. and European Union (E.U.) found 81 percent of asset managers say ESG has become a higher priority over the last 12 months. However, the increased focus on ESG is not delivering the results at the pace and scale required to reverse the impacts of climate change we are already experiencing. A recent article by the Harvard Business Review1 laments that while entities like the Securities and Exchange Commission and the European Union muddle through bureaucratic processes to standardize ESG reporting, actual greenhouse gas emission reductions continue to fall well below the seven percent (or more) annual reductions needed. The authors suggest we need to pivot regulatory action from input-based disclosures to outcome-based impacts.
A fundamental flaw in the reliance on ESG to meet climate goals is the misalignment of ESG investments with greenhouse gas reduction potential. This is because in companies where sustainability-minded investors funnel money, they generally already have low emissions. While higher-polluting companies, which green investors choose to “punish” or avoid by withdrawing funds, are the ones which need investments to finance their transition towards sustainability.
Kelly Shue,2 PhD, professor of finance at the Yale School of Management, along with her students have studied this phenomenon and offer an important perspective. Dr. Shue’s research classifies the 20 percent of firms with the lowest emissions per unit of output as “green” firms and the 20 percent with the highest emissions as “brown” firms. The remaining firms in the middle are much closer to the green firms than the brown in terms of comparative emissions. Essentially, one-fifth of companies are responsible for the overwhelming majority of emissions from global commerce.
The green firms tend to be service firms (financial, consulting, software, etc.) which do not pollute much, while the brown firms are dominated by energy, agriculture, transportation, and manufacturing companies. When the green firms receive increased investment from ESG they continue to not pollute, but they are not well positioned to develop and deploy new green technologies to reduce emissions. When investments are withdrawn from brown companies, they will tend to tighten their belts, reduce investment in innovation, favor cheaper raw materials and energy sources with higher environmental impacts, and seek shortcuts to compliance with regulations, likely increasing their GHG emissions. This is a missed opportunity, as a one- or two-percent reduction in emissions by the brown companies would roughly equal to the total combined emissions of all green firms. What if more sustainable investment was directed toward helping brown companies to adopt cleaner technologies and shift toward renewable energy and resources? This would result in more rapid progress toward climate goals, while demonstrating competitive advantage for progressive companies, and spurring other companies to get on board.
We all continue to eat food, live and work in buildings, use energy, and rely on various forms of transportation, primarily produced by brown companies regardless of whether they receive ESG investments or not. While there is value in ESG, we also need a new approach to investment and regulation as a carrot and stick to help the brown companies rapidly transition to a low carbon economy.
Investor organizations like Engine No.13 are taking up this challenge. They harness the collective power of shareholders as active owners to encourage companies to make the green transition, including re-shoring manufacturing closer to customers, and electrifying their operations to benefit from low costs, renewable energy. This investment will have a ripple effect, for example spurring long overdue investment in the aging electrical grid and making our economy and communities more resilient to disruptive shocks and stressors, including pandemics, climate change, and global economic turmoil.
As building materials account for at least 11 percent of global greenhouse gas emissions, investment in greening the entire building materials supply chain, especially steel, aluminum, glass, insulation, and concrete is needed. These industries have tremendous potential for GHG reduction and between increasing consumer demand and new regulation, including “buy clean” mandates and California’s new building code setting embodied carbon limits for materials, companies that commit to a sustainable transition will find competitive advantage and attract investment to drive innovation.
ESG is part of the solution to climate change and serves as a guide to sound, green investment, but we should not assume that alone will get us to the reductions needed.
Notes
1 Read “ESG Investing Isn’t Designed to Save the Planet,” by Kenneth P. Pucker and Andrew King, published on August 1, 2022. Visit https://hbr.org/2022/08/esg-investing-isnt-designed-to-save-the-planet for more.
2– For more on Kelly Shue, PhD, professor of finance at the Yale School of Management, visit https://som.yale.edu/faculty-research/faculty-directory/kelly-shue.
3 Consult https://engine1.com for more information.
Alan Scott, FAIA, LEED Fellow, LEED AP BD+C, O+M, WELL AP, CEM, is an architect and consultant with more than 35 years of experience in sustainable building design. He is director of sustainability with Intertek Building Science Solutions in Portland, Ore. To learn more, follow him on LinkedIn at www.linkedin.com/in/alanscottfaia/.