We often speak about the importance of information in making decisions--and how not all information is of equal value. At Motive, we dedicate ourselves to providing information consumers need to be able to make good choices. In doing so, we also take in a lot of information from a lot of sources. As previously explored, the elements of format and quality are of paramount importance when considering the value of information content and sources. Although we take in a lot of information, the majority of the sources we access are focused on ESG data. So what is ESG?
ESG is a universe of information which explores corporate Environmental (E), Social (S), and Governance (G) performance in relation to longer-term financial performance.
The impact a company has on the local environment, its efficiency in using natural resources, and its waste minimization and diversion strategies, are all but a few examples of insights relating to environmental performance. How a company treats its employees, its stakeholders, and the communities it engages with--from diversity and equality, healthcare, employment contracts, representation, accountability structures and practices, supply chain rights and responsibilities, and so on--are all examples of insights relating to social performance. Lastly, how a company is governed, including the structure and culture of its board of directors, its investments in innovations, its share structure, disclosure practices, lobbying practices, and accounting practices are but a few examples of insights relating to governance performance.
In short, in ESG:
- The E represents a company’s impact on the planet;
- The S represents a company’s impact on people;
- The G represents how decisions are made, by whom, and to what end within the company.
As a universe of information, ESG exists as criteria, metrics, data, insights, analyses, opinions, forecasts, disclosures, and so on. Across any and all variations of format, ESG is a type of focused information reflective of corporate performance in nearly all things above and beyond what has traditionally been considered by accountants and financial analysts.
Financial information has long been portrayed as being representative of the ‘health’ of a company--to know the revenues and expenses of a company was to gain insight into how well a company was being, and was likely to be, managed. This perspective worked as long as you ignored the fact that the revenues and expenses of a company are actually connected to real-world people and places.
Traditional financial information is sufficient to get a snapshot of a company’s well-being if you pretend that the company exists in isolation of everything else. If you understand ‘labour costs’, for example, as a simple number on an accounting ledger then this simplification of a company can hold. But if you think of ‘labour’ as being a complex series of relationships between people--actual people as beings in their own right--and not simply as a ‘labour input’, then it quickly becomes apparent that the abstraction of traditional financial modelling does not hold. It is in this sense that ESG was born.
A Brief History of ESG
ESG has grown in popularity and practice precisely because of the shortcomings of such narrow traditional perspectives. ESG has grown to complement financial analysis by including nearly all other aspects and attributes of information relating to a company’s structure, culture, operations, sustainability, and societal impact. ESG is often referred to as extra-financial information--that being information which is above and beyond that provided by traditional financial reporting and disclosures.
ESG has blossomed of late as a universe of information and as an industry sub-sector in its own right. It began as an investment framework which has now grown into its own broad Business & Society ideology. Some trace the beginning of ESG back to the 1960s and the popular emergence of Socially Responsible Investment (SRI) in the era of apartheid South Africa, but this connection is more in spirit than in practice. ESG more accurately emerged at the turn of the millennium.
ESG was initially a concern of institutional investors. These are organizations which serve as agents for a broad distribution of beneficiaries. In particular, institutions such as pension funds, insurance companies, and sovereign wealth funds take in payments, contributions, or premiums from clients and citizens and invest these in capital markets so as to be able to pay-out prescribed sums to beneficiaries over a longer time horizon.
These institutions are unique in that:
- They are the fiduciary agents of beneficiaries and not the owners of the funds actually being managed;
- They often manage significantly-sized funds in the hundreds of billions of dollars, sometimes exceeding $1 trillion USD (such as the Government Pension Fund of Norway);
- They manage funds over timelines measured in decades not years.
These conditions combine to expose these institutional investors to a particular risk landscape--namely, they must achieve a mandated rate of growth while being exposed to both immediate and long-term global economic, political, and environmental risks and with constraints, when compared to most other types of investors, in how to respond to such risks.
It is precisely these conditions which allowed for the emergence of ESG. The United Nations, led by a concern for social justice, human rights, and environmental sustainability along with an acknowledgment of the growing impact and power of corporations and an awareness of the unique position of global institutional investors, catalyzed two key initiatives in the early 2000s (although, it should be noted, building from research and advocacy stretching for many years leading up to this point). The first, in 2004, was to unite a group of global financial institutions and companies to explore how capital markets could better adapt to a changing world--in terms of both risks and responsibilities. The report Who Cares Wins is the first large global effort to use the framework and terminology of ESG. This global compact of companies and institutions endorsing the report would remain and grow to be what the UN has now developed as The Global Compact.
The second, in 2005, was a legal review of ESG commissioned by the UN Finance Initiative considering the implementation of ESG framework. The Freshfields Report, as it would come to be known, set the stage for the framework to evolve into a broad-scale ideology. Investigating the legal foundations of ESG implementation, the report determined that not only was ESG investing not a breach of fiduciary duty by financial institutions, but to ignore elements of ESG in investment decision-making may in fact itself be a breach of fiduciary duty.
"It turns out that the impact a company has on the world is actually correlated with how well it performs in the world markets."
The early Global Compact and Freshfields Report would combine to serve as the foundation for the UN Principles for Responsible Investment (UN PRI), emerging in 2006, which united institutional investors--and today many other asset managers and intermediaries more broadly--in an applied understanding of ESG. This development would serve as the legitimizing stroke of the framework.
These early initiatives effectively demonstrated that a company’s long-term financial performance was correlated with its environmental, social, and governance performance and as such it was imperative that financial institutions--mandated to maximize returns--take such ESG considerations into account within their investment decision-making processes. How a company treats its employees, how it manages supply chain dynamics, how it accesses and develops the natural resources it needs, how it engages with regulators, collaborators, and competitors are all factors which present risks and/or opportunities to longer-term corporate development and hence financial performance--and are also all factors absent from traditional accounting disclosures and financial analyses.
ESG, as an ideology, took hold not necessarily because caring for the impact a company has on the world is the right thing to do, but also, and perhaps most importantly to the players at the table, because it made good business sense. It turns out that the impact a company has on the world is actually correlated with how well it performs in the world markets (shocking!). Today, countless academic, industry, and consultant efforts have been developed to guide and influence the development of the ESG ideology and practice. Yet exactly why ESG should develop in the first place and why market actors should embrace it is perhaps best summarized in the early writings of Professor Gordon Clark and Professor James Hawley, along with their respective associates. (Note: I highlight the work of these two individuals not as over-shadowing that of all others but rather because it was quite influential in my own formative thinking of ESG).
"Once considered to exist only on the fringes of the market, incorporating ESG information into investment decision-making has gone mainstream."
Emergence of an ESG Industry
As institutional investors turned their interest to ESG, the demand for information and services accelerated and an entire ESG industry emerged. At first, this ESG sector would serve the fledgling needs of larger institutional investors but then quickly evolve into its own bringing new services, products, and perspectives to market. Today, ESG is no longer reserved for large institutional investors as ESG-oriented mutual funds and exchange traded funds (ETFs) now make it easy for retail investors of all sizes to invest accordingly--with these funds seeing record inflows in 2019 and again possibly in 2020. The value of assets now applying ESG criteria is estimated to be $40.5 trillion USD globally. Once considered to exist only on the fringes of the market, incorporating ESG information into investment decision-making has gone mainstream.
Most importantly, the practice and the industry of ESG is entirely built upon data. All investors, from institutional to retail, need information about companies so as to be able to relate performances across various ESG criteria to financial performance. The practice of ESG is one of measurement and an entire sub-industry--ESG data providers--has grown to meet the demand. From voluntary reporting and mandated disclosures by companies, voluntary and mandated disclosures by investment professionals and service providers, and data verification and development services by third-party providers, there is now a veritable global market and universe of ESG data.
The growth of the ESG industry has been fueled by an increasingly competitive race to to provide accurate and actionable data--and to do so in ever more detail. With investors seeking to mitigate risks and to act on opportunities--and to do so competitively amongst themselves--they create a demand for ever more refined data products. Most ESG data providers arising to meet this demand are now measuring--and verifying and validating--company performance across many hundreds of individual metrics relating to environment, social, and governance performance. The leading edge of this competition among data providers is now pushing into the arena of developing artificial intelligence to make sense of the ever increasing universe of information being developed. The environmental, social, and governance metrics of all publicly-traded companies and many private companies are now measured many times over, and continuously so.
ESG through to SRI and CSR...and on to Sustainability
The turn to popularity is also leading ESG to overtake the related concepts of Socially Responsible Investing (SRI) and of Corporate Social Responsibility (CSR)--at least in popular commentary and understanding.
"How people speak of ESG has shifted as it matured and expanded from an institutional investor framework to a much broader Business & Society ideology."
SRI is effectively as old as investing itself, although truly came of age in the 1960s. The idea is that your investments should reflect your values. Traditionally, this meant employing a negative screen in your decision-making process, or to not invest in companies which engaged in certain things with which you did not agree.
SRI typically relied on broad strokes--such as to not invest in tobacco companies or companies that sell to militaries--but ESG, along with the universe of data that supports it, broadened this landscape. It allowed individuals to more carefully refine their values profile. With the abundance of data, investors could now invest in companies that reduced their greenhouse gas emissions year over year, or that had diverse boards, or pay equity, as examples. Beyond simply excluding certain industries or companies from your investment decision-making process, you could now choose to invest in one company over another, say Google instead of Facebook, for example, because the former has more aggressively adopted renewable energy than the former, or perhaps invest in both and actively engage and pressure for desired changes. ESG data has allowed SRI to evolve from a strategy of broad strokes to one of surgical precision.
As SRI makes ever more use of ESG data if is becoming increasingly clear that ESG--as a more popular ideology and framework--has subsumed SRI. Yet there is an important distinction: SRI makes use of ESG data, but ESG is not necessarily SRI. Most notably, SRI is normative whereas ESG is positive (or empirical). SRI begins with a determination of what is, and is not, acceptable, or of what is socially responsible--it begins with a moral compass and builds investment decisions from there. ESG is positive--it is a collection of measures of corporate performances yet with no compass as to what the measures should be or which should be more important than others. SRI is concerned with how things should be; ESG is concerned with how things are.
Similarly, CSR has long concerned itself with how companies should engage with communities and society more broadly. From philanthropy to programs, campaigns, outreach and so on, CSR has developed to a point of ubiquity--it is nearly impossible to find a company that doesn’t support, donate to, fund-raise for, or volunteer with one community program or another. Nearly every company today is eager to talk about how they 'give back' to the community.
On the cynical side, CSR is simply marketing to clean-up irresponsible or short-sighted business decisions and operations. On the optimistic side, CSR is a building block of stakeholder capitalism wherein a company should be managed for the benefit of all stakeholders and not only shareholders--CSR can create shared value, it is argued.
Even under the best of intentions, CSR has largely been governed by emotion and opportunity and hence perceived as extraneous activities to a company’s core activities (and often relegated to a company’s marketing and communication department). Yet this has changed with the emergence of ESG.
With shareholder interest in ESG, companies are now incentivized, if not actually mandated, to report on their impacts on the environment and society with a particular degree of detail and accuracy. With this pressure, CSR activities have begun to transition from being activities to engage stakeholders to now being activities to engage stakeholders which are material to shareholders. Through an ESG lens, CSR gains in decision-making importance within a company as it migrates from the realm of stakeholder relations to that of shareholder relations. This migration brings a higher degree of executive attention to CSR activities.
How people speak of ESG has shifted as it matured and expanded from an institutional investor framework to a much broader Business & Society ideology. With all stakeholders now joining shareholders within this universe of information, many commentators--and particularly those from marketing and public media bents--have shifted away from the clunky acronyms of ESG, CSR, and SRI and increasingly toward referring to everything under the banner of ‘sustainability’. Corporate ESG disclosures as well as traditional annual CSR reports and stakeholder engagement campaigns are grouped under the header of sustainability reporting, which brings greater visibility and engagement to the items therein yet also masks many of the distinctions between them. This is an important development and one which carries significant consequences, both positive and negative--and this is a discussion we will return to in far greater detail in a future post.
"As helpful as ESG data is in our mission, it is critical to remember how this information developed and where it comes from."
A Final Word
ESG is a universe of information and one born from a concern with risks and opportunities, and hence with a dedication to measurement. The phrase of ‘you manage what you measure’ is now often followed with the addition of the importance of ‘measuring what matters’. Decades of research and advocacy, and now of practice, have demonstrated that corporate environmental, social, and governance performance are significantly correlated with corporate financial performance. Armed with the knowledge that ESG matters, it becomes critical that it be measured. These measurements--ESG data--stand apart from previous variations of CSR and SRI information in their empirical foundations. ESG is a measure of what is rather than of what should be.
At Motive, we access various forms of ESG data from various providers, always with careful attention to the format and quality of the information we are engaging. As helpful as ESG data is in our mission, it is critical to remember how this information developed and where it comes from. The history of ESG data and of the industry which provides it may be invisible but nonetheless continues to shape it to this day. Although now addressed as a broader Business & Society ideology, and often under the header of 'sustainability', ESG was born, and matured, as an investment framework.
ESG data can be quite insightful and powerful when incorporated into decision-making, and we aim to unlock this potential in support of consumer choice...but as in the case of all information, it is best to understand what it is you are dealing with. Data is never neutral.
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