ESG is a dead end. Do we care?
ESG is a dead end. Yet, there is an increased demand for ESG investments as investors seek to incorporate socially conscious principles into their portfolios without sacrificing performance. Jyoti Banerjee investigates regenerative concepts as a better way of addressing our degenerative failures in investment and business.
During this week’s British Academy presentation on measuring corporate purpose, panellist Elena Flor discussed the varied forms of ESG reporting carried out by one of the Italian companies she is a director of:
Global Reporting Initiative (GRI), because that is the kind of sustainability reporting that listed Italian companies carry out
Sustainability Accounting Standards Board (SASB), because the company’s American investors want that
Taskforce on Climate-Related Financial Disclosures (TCFD) reporting on climate issues
Plus, there was an expectation that they would need to support the requirements of the EU Taxonomy.
Fellow panellist Jasmine Whitbread responded that a company she is on the board of currently collects over 2000 points of data for its sustainability reporting.
All to feed the ESG machine.
It’s not unreasonable to ask exactly what about the world we live in has changed because companies now track thousands of data points about their sustainability impacts? The fact that we are in deep environmental and social distress across the planet should be evidence enough that our efforts in ESG and sustainability are too little, too late.
Yet, there is an increased demand for environmental, social and governance (ESG) investments as investors seek to incorporate socially conscious principles into their portfolios without sacrificing performance, while others seek hidden jewels and better risk management. Among asset managers, there is a rush to take a leadership role in ESG investment, particularly when it comes to carbon, though they lag consumers in the drive for change. The Net Zero Asset Owner Alliance was soon responded to by the Net Zero Asset Managers Initiative. Race to Zero has brought many investor networks and initiatives together to demonstrate their net-zero commitments.
Governments and regulators are also starting to act, and regulatory intervention will inevitably increase. New Zealand and the United Kingdom have both set out indicative pathways to mandatory TCFD reporting, while the EU Sustainability Taxonomy Regulation offers an EU-wide framework for fostering environmentally and socially sustainable economic activities. ESG is becoming hardwired.
Does it matter that ESG is a dead end?
The move to ESG is a clear signal that the market has begun to recognise the convergence of societal and commercial value. For many, this is long overdue. However, the problem with the entire ESG construct is that while investors make their investments in projects that are 'less bad', they are still increasing overall degeneration through unsustainable extraction of natural resources, accumulation of various forms of pollution, altering the conditions for life on earth, and destruction of biodiversity. Even when a long-term horizon is sought in investment decisions, the short-term operation of the entire system undermines those decisions. Incremental micro-steps by individual organisations will not change the system’s outcomes.
Current investment approaches that seek to incorporate some form of environment, social or broader economic impact (referred to collectively as ESG here), suffer from multiple short falls including:
ESG metrics are typically related to the enterprise, and increasingly an enterprise’s business partners, rather than the impact of the enterprise on earth’s systems. Even when they take systemic impacts into account, they disregard their limits and the earth’s carrying capacity.
The ESG based investments usually rely on micro-metrics and self-disclosed data, which doesn’t necessarily incentivise change and can be open to “greenwashing.” Some high-profile examples have emerged which risk discrediting the ESG system and worsens reputational risk for some companies.
ESG metrics without qualitative information is often not helpful in understanding the performance of a company. Conversely, qualitative information without proper metrics is regarded as pure storytelling, which too fails to hit the mark.
Often ESG data is presented without any granularity regarding bioregional impacts.
ESG information is often provided at entity level, and often misses out on upstream and downstream impacts.
The metrics of two companies could look very close to each other but their business models could be quite different from each other resulting in quite different impacts. Such information is usually missing in the metrics.
ESG metrics are usually presented in isolation from each other. The interactions between them are often completely missing. Cumulative effects matter – ESG doesn’t consider the health and resilience of the system as a whole. The financial crisis provides a powerful example of this. Each individual firm was supposedly healthy and resilient but there was no account taken of the cumulative effects between them, so no one noticed the whole system was at risk – which brought down the individual entities within it.
ESG assumes that markets work as intended: that companies with the best environmental credentials attract the most investment. In practice there are so many reasons why markets fail to function properly: externalities, competitive posture and a degenerative context in which all companies operate.
The upshot is that we have plenty of data about companies, but we are unable to use this data to derive meaning about their systemic impacts. We focus on value creation when in practice such a focus masks massive destruction of systemic (and ultimately entity) value. ESG does not offer a compelling vision of an alternative system, or a direction we need to take.
Rethinking ESG
At North Star Transition, we seek a systemic view. We want to see environmental and social signals that help us truly understand impact from a systemic perspective. We propose that, given the current levels of environmental harms and threats, and the need for market participants to survive, an economy (or system) needs to be regenerative. What would a future regenerative economy and financial system look like?
We can differentiate between degenerative and regenerative outcomes:
Degenerative
Do harm: current mainstream finance fosters resources extraction; waste accumulation, increasing social tensions
Do less harm: ESG investment, but degeneration continues, albeit at a slower pace
Individual efforts to drive positive impact: impact and other “responsible” investments which seek to contribute to a better world or at least limit harm, but cannot work in isolation resulting in, for example, accumulated carbon continuing to rise, and inequalities continuing to grow
Regenerative
Repair and reset: investment in a system that is circular and self-enriching
Reframing: systemic questions that need answering
I note that Elena Flor, when asked a question during the British Academy presentation, felt that the right response to the current alphabet soup of ESG reporting is the introduction of still more alphabets: IFRS, the acronym for the International Financial Reporting Standards. Of course, IFRS has weight and heft in the financial world, unlike any of the ESG standard setters. So I can understand her keenness to see IFRS get involved in sustainability reporting, something it has only recently started showing after years of reluctance and denial.
But international financial standards have only and always been about single companies. What is the point of adding yet another entity-level and investor-centric reporting approach that will not help identifying systemic impacts? Nor will such an approach assist us in reinternalizing negative externalities, as discussed by my colleague Olivier Boutellis here and here. We need systems thinking, not more of the same. I am afraid the alphabet soup of possible standard-setters gives me zero hope.
To apply a regenerative lens on investing and business, we need to ask a different question at the outset: what drives healthy outcomes for the system, and what are the impacts on that system from the actions and activities of the companies we wish to invest in? In effect, such an approach reverses the investment thesis from bottom-up to a new systemic relationship: the entity to the whole system, and the whole system back to the entity. The key investment decisions start with information about the health and resilience of living systems.
Questions that need answering in such an approach include:
What are the material factors that drive the health and resilience of living systems? Complex, interconnected, multi-loop feedback systems are difficult to understand and model, often operating in counter-intuitive ways and involving emergent behaviours, not derivable from the properties and state of their component parts.
Fiduciary issues: how does the health and resilience of a living system affect the fiduciary responsibilities of asset owners and managers on behalf of their beneficiaries? Equally, what are the fiduciary duties of asset owners when their assets impact the health and resilience of a living system?
Time horizons: investors consider three years a long horizon. Yet we must address in the next ten years the destruction that has been wrought on a geological scale over the last fifty years. Problems in long horizons usually emerge when the responsibility / authority / accountability relating to an organisation is vested in individuals who are prepared to accept that “children can be held accountable for the sins of their parents.”
Incentives: in an industry where incentives are often weighted towards day-to-day business priorities resulting in short term, high volume, transactional behaviour, how can we shift momentum in favour of systemic outcomes?
The shift from degenerative to regenerative will not happen in an instant: how do we accelerate a transition from one system to the other? But what happens if we don’t shift? How do we manage the risks inherent in these different speeds of transition?
How do we ensure everyone plays their part, stopping free riders and containing rogue actors?
I would venture to say that there isn’t a single person on Planet Earth who would know how to answer these questions in a meaningful systemic way right now. That does not mean we should not start the process of addressing these questions, and seeking a regenerative way of shaping the future of investment and business. At North Star Transition, we are deeply appreciative of Martin Luther King Jr’s insight: “Most times the way isn’t clear, but you want to start anyway. It is in starting with the first step that other steps become clearer.”
Anybody interested in taking a first step?
