July 12, 2022
By The Delphi Group’s David Photiadis, Senior Director, Garrett Jones, Director, Sustainable Finance, and Adam Schwarz, Senior Consultant, Sustainability and ESG Reporting
ESG has had a rough go of it lately. The headline-grabbing Elon Musk tweeted that ESG is a “scam” after Tesla was de-listed from the S&P 500 ESG Index. A recent article in the Globe and Mail suggested that the “ESG craze” has negatively impacted oil and other commodity prices, thereby serving as a contributor (among many) to our current economic blues. And at the macro level, no less than the U.S. Supreme Court recently ruled that the U.S. EPA could not, in essence, pass regulations that would help them combat climate change.
But here’s the thing: debating the merits of various ESG ratings schemes and whether ESG is or isn’t here to stay is just a distraction. The argument about whether environmental, social, and governance issues matter to companies is over. As we laid out in the first installment of this series, trillions of dollars are pouring into ESG investments because investors see strong ESG scores as linked to lower risk, increased resilience and higher profitability.
And you know what? They’re right. All the research points to the fact that acting on environmental, social and governance issues isn’t just the “right thing to do” (usually when things are good). It’s linked to value creation, higher returns, a lower cost of capital, and much less risk. ESG is becoming shorthand for a well-managed and high-performing company. This matters to investors, sure, but it also matters to customers AND to employees, who currently have their pick of jobs and – more often than not these days – are looking to work for companies that are one of the good guys.
Now, for sure there are legitimate criticisms and needed debate around ESG in practice: the intricacies and effectiveness of ESG ratings; the criteria an investment fund should meet to be labeled as “ESG” or “sustainable”; and critically, how well does ESG performance deliver on the promise of improved social and environmental outcomes. These are, however, growing pains for an industry that is finally getting the attention of decision makers (after more than two decades of urging…)
Given all the noise around ESG right now, we’d like to share three tips to help you cut through the static and focus on what’s most important – for your organization, for society, for our planet.
Tip 1: Think beyond ESG investing to impact
At the heart of the questions around inconsistent ESG ratings is the notion of impact. Are these companies having a positive impact on the planet while also generating returns? Is ESG investing, in effect, too good to be true?
In some ways, the answer seems to be yes: while these investments are generating returns, the data is also showing that the growth in corporate commitments in no way corresponds to a positive impact on our planet and society – with GHGs being a case in point. Some research even suggests that some companies in ESG portfolios have worse environmental and social performance than their non-ESG counterparts.
To understand how and why this apparent contradiction exists, it’s important to recognize that there is a difference between a company’s ESG performance and the ESG performance – financial or environmental and social – of an ESG investment portfolio. These portfolios are usually made up of company equities in mutual funds or ETFs put together by various financial investment firms and brokers and sold to retail investors as an “ESG fund.”
There is no standardization currently for what can be labeled an ESG investment, and every fund has its own methodology, investment focus and criteria for what types of companies it includes. That’s why you can invest in a portfolio of companies focused only in, say, renewable energy, or those who have climate action pledges; or you can invest in a broad ESG fund with companies in all sectors – including oil and gas and mining, who may all have very different ESG impacts but have demonstrated some degree of ESG performance according to whatever financial institution built the fund.
This is also where ESG ratings come into play. ESG ratings are prepared for and sold to investors to inform their investments decisions. ESG ratings, in turn, have their own methodologies and scoring systems, which tend to have a risk-oriented perspective – that is, the ratings favour companies that have lower risk exposure to ESG-related risks (based on their individual methodologies) compared to other companies in their sector.
These ratings do not prioritize, generally speaking, whether the companies are delivering ESG impact per se, beyond the extent that a company’s impacts contribute to lower financial risk. In other words, great that a company has a carbon reduction plan to and minimizes paying excess carbon taxes. Achieving deep decarbonization or shifting business models to avoid producing GHG emissions? Not as much of a concern.
This gets to the heart of the difference between ESG and sustainability, and why ESG is catching so much heat on the impact front. Given its origins, ESG is about reducing risk to protect profit. It covers a vast range of issues as it refers to essentially all non-financial risks and there is no universal set of definitions.
A Breakdown: Common ESG issues
While ESG and sustainability are now interchangeably used, sustainability is fundamentally about creating a future in which business – and all of life – can prosper, not about creating short-term returns by minimizing environmental and social risk. The fundamentals of why operating sustainably is good for business haven’t changed – if anything, the risk and opportunities posed by climate change alone make this a no-brainer for most organizations. As our CEO recently shouted from the LinkedIn rooftops, short-term returns are nothing in comparison with what happens to long-term value if we don’t address societal issues and our impact on them.
This is ultimately why for most companies focused on sustainability and ESG, the heat ESG is feeling right now doesn’t translate into a pull back of corporate action. It’s just noise that will settle as financial markets standardize ESG ratings (which, yes, will take a while).
Okay, but what about the “r” word? Well, operating sustainably is as important in a tough economy as it is in a robust one. Cutting costs and reducing risks can help make you more recession-proof. And research backs up that ESG performance can help companies financially through tough times. In a tight labour market like the one we’re in now, employers with robust diversity and inclusion practices can more effectively attract and retain talent while reducing risks related to market uncertainties and inflationary pressures.
The real debate about ESG and impact shouldn’t be about rating agencies and which ESG fund does better than another. The ESG investment and ratings world is maturing and, while becoming more complex, its evolution does not change the fundamental need for companies to focus on improving their ESG/sustainability performance. Companies that have actual sustainability strategies and build sustainability into their business philosophy and operating practices do deliver environmental and social progress and see improved financial performance over the long term.
The question we should ask regarding ESG impact is really “is this enough and are enough companies doing it?” The short answer is “no” – not if we are serious about addressing climate change, ecosystem and biodiversity preservation, and enhancing equality. We’ll dig into what to do about this in a future post, but the answer isn’t “improve ESG ratings and disclosure” (although reshaping sustainable finance will help).
Tip 2: Focus on ESG strategy, not disclosure
Every company needs to understand and define for themselves what ESG/sustainability issues matter to them and to their stakeholders (in sustainability speak, what issues are material to them). These priorities are determined in part by the size and scope of the risk, but also by the size and scope of their impact/influence.
It’s typically not as many issues as you would expect and tends to correspond with the size of the organization. Knowing which issues are material to you and where they can make a significant impact reduces the complexity of ESG and fuels a much more straightforward conversation around specific issues. For example, your company’s approach to climate change, and/or GHG emissions; your justice, equity, diversity and inclusion (JEDI) strategy; your safety record, etc. The conversation includes defining the issues on the ESG spectrum that are already long integrated into your company’s operations due to compliance, and where you see an opportunity for differentiation (like developing new products with sustainability attributes or leading your industry in sustainability action).
Beyond that, companies need to determine how far they are willing/wanting to go to have a measurable impact and establish objectives to achieve that impact. This is very different from a disclosure-oriented strategy, which is largely based on gathering and reporting data that is requested by third parties. This approach is mainly reactive and doesn’t stimulate much action until regulators step in – and, as we’ve laid out, doesn’t always correspond to positive societal impacts.
Ultimately, disclosing ESG issues is just the tip of the iceberg. It’s the first step towards developing a strategy that addresses the key ESG risks and opportunities for your organization and determines where you can have the most impact.
Tip 3: If you operate in the U.S., it’s whole different playing field
Lastly, when it comes to the ESG backlash, it’s important to acknowledge that the U.S. and Canada have very different baselines and cultural realities when it comes to ESG, and that makes a big difference when it comes to corporate action and positions. In the wake of the latest Supreme Court rulings and political partisanship in the U.S., many companies are having to publicly come out with positions and/or policies on same-sex marriage and abortion/contraceptive care, and on climate action. Expectations on companies are exacerbated because they have had to take an out-sized role in civic life due to their federal and state governments exiting these arenas.
Societal expectations here are very different. Canadian companies can rely on the fact that they have a more progressive government and can “follow the law” as a minimum standard of ESG. There is also far less backlash – corporate or political – on taking actions to address issues like climate change, health care, diversity or simply basic environmental compliance.
The deep polarization in the U.S. political sphere carries into corporate ESG and sustainability in a way that is very unlikely to occur in Canada. A broad-based, mobilized backlash has not materialized in Canada, primarily due to widespread public support. In fact, Canadian companies are more likely to be pressed harder to address climate change and inequality than the reverse. This means that Canadian companies cannot be complacent and have to navigate a business world where expectations at home are far different than many of their business partners to the south.
Returns and long-term impact matter. Mainstream ESG ratings will become better over time and favour those who put in the effort to curb their impact and have a positive one. We need to move past questioning the purpose of ESG and realize that corporate citizens have a responsibility to their shareholders and stakeholders, and that these responsibilities are not mutually exclusive. The real leaders in our economy have the ability to think at a micro and macro level and find the balance between short-term returns and long-term value creation. Are you ready to be a leader? Then we want to work with you.
David Photiadis is a Senior Director, Garrett Jones is Director of Sustainable Finance, and Adam Schwarz is Senior Consultant of Sustainability and ESG Reporting. For more information on how The Delphi Group can help you meet your ESG disclosure and net-zero goals, reach out to David at firstname.lastname@example.org, Garrett at email@example.com, or Adam at firstname.lastname@example.org.