[I sense I’ll be writing many times about ESG vs. sustainability in some fashion. There’s so much noise on the topic and a lot is wasted. This appeared in MIT Sloan Management Review a couple weeks ago.]
If 2021 was the year ESG became mainstream in the financial world, then 2022 was the year things got bumpier. And everything around ESG points to 2023 being even more intense.
Before diving into why, let’s define terms. ESG is not sustainability. ESG — the acronym stands for environmental, social, and governance — has been mostly focused on screening companies as investments, largely by understanding how a business is affected by environmental and social issues (with an additional focus on whether a company has good governance in place to manage those risks and pressures). Sustainability is a much broader idea, focusing on a company’s role in society, how it creates value by managing its environmental and social impacts (both positive and negative), and how its actions affect a wide range of stakeholders.
On the ESG front, there are two different forms of backlash going on. First is the political theater, mostly in the U.S., of the “anti-woke” movement. Some right-wing governors and attorneys general are unhappy with investors that have, for example, set goals to get to zero carbon emissions in their portfolios. They say the investors are progressives and “politically motivated, anti-free market, anti-family.” With much fanfare, some U.S. states are pulling funds from high-profile investors like BlackRock (although the billions withdrawn are not likely to seriously worry companies with trillions under management).
“Pleasing stakeholders and serving the common interest, including the planet’s, is how to create value today. It’s better business.”
The absurdity of calling investors and ESG “woke” is a longer discussion, but I’ll quote BlackRock’s CEO, Larry Fink, on the subject: “Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke.’ It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper.” Unfortunately for Fink, he’s getting pressure from all sides now — some people say he’s greenwashing — but he’s not wrong on this fundamental point: Pleasing stakeholders and serving the common interest, including the planet’s, is how to create value today. It’s better business.
We should never underestimate the potential for politically motivated attacks to change how companies behave. Vanguard, for instance, showed a weak backbone when it recently abandoned a global accord on net-zero carbon targets for investments. Reuters credited “pressure from Republican U.S. politicians” for Vanguard’s action. And things will only heat up as we head toward another U.S. presidential race (lord help us). But the roots of the sustainability movement are too deep now to get fully derailed. (More on this below.)
There is a second backlash to contend with. The investment community’s skeptics are getting louder again. They question ESG investing, asking, in essence, “Will ESG funds outperform ‘regular’ funds?” For a few years before and during the pandemic, ESG funds did do better. Then, in 2022, they didn’t. A major reason for both trends is that ESG funds are tech-heavy, and tech skyrocketed early in the pandemic — and then got slammed.
With the inherent levels of irrationality and unpredictability in the stock market, asking “Does it outperform?” is a bad question, especially if you’re looking at a short time frame. It’s also a question that isn’t asked about other investment strategies. No new fund designed to invest in tech companies or health care players, for example, has to prove that it will always outperform. The only thing that, with high certainty, consistently outperforms index funds that track the market is … well, nothing, really.
But the questions about ESG will continue, in part because huge swaths of the investment world still don’t get it. Last year, an executive at HSBC declared that this ESG thing is mostly bogus — and, oddly, he was the head of sustainable investing. He didn’t last long. A recent Financial Times article also provided a typical and deep-seated view from the financial world: The authors declared that “investor altruism … will take a back seat to cold hard returns in 2023.”
The assumption is that using ESG as an investment screen is just philanthropy, but it truly is not altruism. The investors that get it understand that ESG gives a critical view on the risk of a business and helps gauge how resilient or ready for a low-carbon future a company might be. The Financial Times authors went on to cite the incredibly tired argument from Milton Friedman that the core purpose of a business is to serve shareholders. It’s clear that if the ESG movement disappeared, a lot of investors, many C-suite execs, and, apparently, some financial journalists would breathe a sigh of relief. Finally, they’d say, we can get back to business.
“The real work of sustainability — not just filling out endless ESG questionnaires — will continue.”
This is the fundamental disconnect. Sustainability is good business, and the forces driving it are not going away. The real work of sustainability — not just filling out endless ESG questionnaires — will continue. Companies pursuing a sustainability strategy will be working toward zero carbon, addressing human rights issues in their supply chains, innovating products and services to satisfy customers that want more sustainable options, engaging employees and other stakeholders in the mission and purpose of the company, partnering with peers on shared problems, and much more.
Stepping back, it’s clear that the sustainability movement is, if anything, accelerating. For example, the percentage of S&P 500 companies including ESG metrics in compensation plans rose to 70% in 2022, up from 57% just a year earlier, with measurements of carbon footprint and diversity and inclusion growing the fastest.
This shift is not just a fad or driven only by media attention. The underlying drivers of change — big, sweeping trends — are real, growing, and unavoidable. First, there are clear existential threats to humanity, particularly climate change and inequality, and these problems are already costing business and society real money. The cost of doing nothing is rising. Second, the cost of action has dropped exponentially, especially in clean energy and transportation. But third and perhaps most importantly, norms are changing. Stakeholders, especially young customers and employees, increasingly want companies to act. These are the gigatrends ultimately driving all the attention on sustainability. When societal norms and values change, they don’t easily go back.
I’ve been working in the overlap of business and society for 20 years. I’ve seen a lot of ups and downs in people’s interest in environmental and social issues. But the challenges we face are no longer theoretical models to debate. They’re here now — and the generations taking over the workforce know it. ESG will get banged around for political points and by investors annoyed by the whole thing, but the underlying work to move to a thriving future will continue to accelerate.
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