Making the case for an ESG upgrade

“Has ESG hit its sell-by date?” To kickstart edie’s Climate Finance Week, Steve Varley, EY global vice chair – sustainability, looks to find out.

Making the case for an ESG upgrade

“Has ESG hit its sell-by date?” is a question I’ve read and heard many times, from the corridors of COP26 or Davos, to my day-to-day meetings with clients.

My answer? No, but it does need an upgrade.

How did this well-intentioned concept get to this point? As far as journeys go, it’s a short one. The term ESG – environmental, social and governance – was set out to help companies and governments clearly demonstrate how they were responding to rising public pressure over climate change. It was popularised by the United Nations (UN) in its 2004 “Who Cares Wins” report, designed to define the role that finance, and business could or should play in addressing critical global issues. At the same time, investors spotted the huge potential growth in funding the transition to a low-carbon economy.

The result? ESG became the fastest-growing segment of the asset management industry. Since its inception as a framework, ESG funds have grown year on year by 53% and hit $2.7trn in 2021.

The problem was that the way businesses and governments tried to embed the concepts of ESG was too fast and too disorderly.

The scramble to “do good” led to an investment framework with no clear direction. Stakeholders have been unable to agree on the data used to measure performance, regulation is inconsistent, and, fundamentally, there are divergent views on the purpose of ESG. The result is that companies are saying and reporting more, but not always doing more.

However, while I can understand the criticism, I don’t think it’s time to throw it away.

The challenges facing ESG are a product of its immaturity and I’m confident they can be overcome. But the reality is that there is no time to start from a clean sheet of paper. The need to improve ESG information has never been more urgent, and time is of the essence.

So how do we upgrade and reset a concept that is so widely used and engrained in business? Here’s a five-point plan.

  1. Stop using catch-all ESG data that groups things together too simplistically.
    There’s a fair argument that we should continue broadening what constitutes ESG. Whether that includes carbon emissions, LGBTQIA+ rights, doing business with aggressor countries, gender diversity, or tax transparency – this broadening definition makes it difficult for investors and other stakeholders to be on the same page. Further to that, we need to reset what we think of as an “ESG leader”. Companies should not be measured on one letter alone. At the same time, the weighting of ‘E’ vs. ‘S’ or ‘G’ criteria, as well as components within those categories, is often too opaque.
  2. Develop a clearer understanding of what ESG information should be used for.According to a 2020 survey, 71% of investors said they want to make a positive social impact as part of their investment objectives. This response rate was even higher for millennials at 75%.
    Despite this, today’s disclosure frameworks and ESG ratings typically don’t gauge a company’s impact on society, but instead, measure its relative exposure to various internal and external financial risks and opportunities. This needs to change.
  3. Introduce independent assurance, and enhanced reporting rigor and standards.Assurance is a key facet in increasing trust in the quality and accuracy of sustainability information. It is encouraging to see the International Sustainability Standards Board (ISSB) recommend reporting standards, and that mandatory assurance requirements for sustainability disclosure rules are being considered by the US and the European Union (EU). I hope we see others follow suit.
  4. Agree on what terms like “green” actually mean.
    Taxonomies outline the parameters of what we mean when we talk about ESG, and having these in place could help clear up much confusion. For example, a lack of clarity on which activities and assets can be defined as green has long been identified as a barrier to scaling up green finance. While it is encouraging to see progress in the EU and China on this, we must see more.
  5. Bring emerging markets to the table.Emerging markets should be brought into the ecosystem by removing or lowering barriers, so they can benefit from private capital. For example, emerging economies will account for a large majority of the world’s greenhouse gas emissions by 2050, yet they have less resilience to be able to adapt to the impacts of climate change and are in the areas most likely to be severely affected by climate-related events. Attracting capital to activities that do not just slow climate change but mitigate its consequences is essential.

To put these recommendations into practice, ESG needs to evolve and requires an ecosystem approach, including close collaboration from the many players who shape this space.

These stakeholders need to collaborate as ESG reporting and disclosures, taxonomies, ratings, and data and modelling capabilities all mature.

We cannot keep debating ESG and its use as a framework, it’s time that we prioritized making it work – there’s no time for anything else.

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