Where is ESG headed?

Good-natured though it may be, the environmental, social and governance model has many flaws. Durham University law student Adam Jordan considers the recent criticism of ESG and why wannabe lawyers should keep an eye on its progress

Environmental, social and governance (ESG) factors are playing an increasingly important role in today’s business landscape. This shift in business models and priorities is premised on the notion that business (law firms included) must do more to tackle the world’s problems in order to attract investors.

Values-driven investors are using ESG criteria in order to best assess their investment decisions and these standards are particularly popular with millennial investors. The growth of ESG initiatives and investment approaches is quickening — investors and stakeholders are considering more than just profit, with ESG fund assets having grown to trillions of dollars within the last couple of years.

Among many others, the factors involved in these evaluations include climate change policies and biodiversity practices on the environmental front, social issues like diversity and labour and human rights, alongside corporate governance strategies concerning executive compensation and management structures. The Covid-19 pandemic has brought many of these issues further to the fore.

This growing level of direct corporate social responsibility finds itself in competition with the hugely influential shareholder theory propounded by economist Milton Friedman in the 1970s, which holds that a firm’s sole responsibility is to its shareholders. Most align a growing ESG movement with the rise of stakeholder capitalism, the proponents of which suggest that companies must aim to produce benefits for all stakeholders — not simply shareholders, but also customers, employees and communities.

Many that argue that ESG practices are valuable and worthwhile for companies both socially (for example, resulting in employee productivity boosts) and financially, particularly if ESG reporting standards improve over time, providing transparency for investors.

Companies have woken up to its growth and are taking ESG issues seriously — those that do not risk rising costs of capital. For instance, as recently reported in the Financial Times (£), the ‘Big Four’ accounting firms (Deloitte, EY, KPMG and PwC) are now hopping onto the “ESG bandwagon” in order to take advantage of the opportunities it brings.

ESG has done a good job of raising awareness, in the commercial world and beyond, of issues like climate change and corporate governance. Having said this, the model does have a number of flaws — for instance current reporting methods are neither totally transparent and accessible, nor are their metrics widely agreed upon.

Meanwhile, its critics, like Robert Armstrong writing for Unhedged in the Financial Times (£), often suggest that shareholders’ economic interests and the social good do not always align.

Armstrong argues that the ‘win/win sales pitch’ that ESG’s proponents deliver could actually be quite damaging as a result of its fallacious nature, and that ESG funds will never reach the size necessary to make genuine wholescale change to investors’ priorities, despite the trillions of dollars that now make up ESG assets globally.

This is particularly so given how influential Friedman’s shareholder doctrine has been — as Armstrong points out, companies are unmistakably designed to maximise shareholder wealth, so a radical shift in business models and priorities could be unworkable, especially as many are demanding that these sorts of changes occur quickly.

Armstrong makes these points in an article commenting on an essay by Tariq Fancy, the former chief of sustainable investment at BlackRock, which outlines some of the fallacies and dangers of the growth of ESG initiatives.

His essay is a long but worthwhile read that demonstrates the complexities of ESG in its current form. He argues that ESG practices have no real social impact, labelling it a “dangerous placebo”, whilst advocating for government regulation to solve these issues given their widespread and “systemic” nature.

His words have particular force given his previous position at BlackRock.

It is also notable that Japan, which has followed this model of stakeholder capitalism for quite some time, is suffering economically as a result, and is therefore seeking to break free from it, as pointed out recently in City A.M..

Equally revealing is the recent news that many of the UK’s largest investment houses have failed to reach ESG investing standards in a new UK stewardship code — only one third of applicants to the list were approved.

It is indeed questionable whether businesses are in a position to (help to) solve the world’s problems through ESG initiatives, given the entrenched purposes of these businesses, and their (limited?) capacity to deliver effective change in these areas — though it perhaps will not hurt for a company to be more environmentally and socially aware, so long as its raison d’être (profit) is not completely sacrificed.

In spite of ESG’s growth, there are many signs pointing to its potential undoing. Are these initiatives genuinely effective? Will reporting standards become transparent enough to ensure company accountability? Is the pursuit of this model of business actually worthwhile?

It is therefore difficult to know where ESG is really headed — for now, its rapid rise does not look to be slowing down, and improvements will undoubtedly be made. Nonetheless, good-natured though it may be, the ESG model — stakeholder capitalism, sustainable/responsible investing, corporate social responsibility, whatever it is to be named — has many flaws, and the case against it is also developing as recognition of its issues becomes more widespread.

Regardless, it is a topic worth keeping an eye on for those hoping to improve their commercial awareness and understanding of the changing business world — if criticisms do not stick, the momentum behind ESG means it is likely here to stay.

Adam Jordan is a third year law student at Durham University. He aspires to become a commercial solicitor.