Today businesses, markets, and investors are increasingly obsessed with the environmental, social, and governance (ESG) arena.
Public companies trumpet ESG credibility, investment firms are unveiling ESG products at dizzying rates, and investors are constantly being told it is a moral imperative to invest in ESG products. Human nature attracts us to embrace ESG as a virtue. Yet media, environmental groups, academia, and Wall Street firms adore ESG, which is a sure tip-off to its potential hazards.
ESG presents a conundrum: is it “doing well by doing good” or instead does it stand for “enabling stakeholder graft”? With trillions of dollars at stake, the conundrum warrants an honest and fair assessment. Cue the Ennio Morricone soundtrack, because the ESG craze has components that are good (Blondie), bad (Angel Eyes), and outright ugly (Tuco).
The Good (Blondies)
Let’s be unequivocally clear: ESG focus for individual companies, particularly ones that operate in environments with risk, can be an effective tool to garner market recognition, reduce risk, and create value.
The key to ESG effectiveness is transparently laying out performance and targets for tangible and measurable metrics that correlate to the E, S, or G. This sounds obvious, but is unfortunately a rare thing in the world of public companies.
To illustrate, take a natural gas company operating in Appalachia. Effective ESG management would include:
- a percent reduction in annual fresh water usage that can be measured year-on-year (falling under E);
- a defined portion of annual spend or employee hires that hail from economically disadvantaged communities within the stated geographic operational footprint of the firm that can be itemized year-on-year (covering the S); and,
- straightforward reporting of how stock ownership has grown in magnitude and tenure for directors and executives over time (addressing the G).
Add to these three examples similar metrics and you start to see how ESG can be utilized by companies across a range of industries to clearly express performance in risk management, long term value creation, and across stakeholder groups. By the way, a key to effective ESG management is that companies don’t just report how they performed for the prior year across these metrics, but also their near-term targets (as in the next few years, not twenty years out). State a standard that can be tracked, and then deliver actions and performance that back it up.
The Bad (Angel Eyes)
Although it may be politically incorrect to say so, the truth is much of the ESG complex has become a racket. Investors are being duped on a grand scale while certain corporations and investment firms obfuscate and make a killing, respectively.
Let’s start with ESG shenanigans in corporate America.
Beware whenever you hear a company making a big splash about an unmeasurable and opaque target well into the distant future. Take the multi-billion-dollar industrial or energy firm committing to “net zero carbon” in some far-in-the-distant year when much of the current executive team and board will likely not be alive. No one knows how such a metric is calculated and if the path to zero carbon is even scientifically viable (it’s not). Plus, the target date is set so no one running their mouths today are accountable for seeing it through.
Companies that engage is this type of PR stunt increasingly risk violation of SEC regulations dealing with false and misleading statements. If these executives said something similarly baseless about future cash flow or net income aspirations, they would need a criminal defense attorney. But if it falls in the squishy world of ESG, it not only receives a pass but is applauded, even when such ESG talk is becoming more and more material to capital markets.
Worst of all, corporate titans waxing poetic at Davos about how their companies are going to be net carbon zero by 2050 often corelates to poor ESG performance today.
Undefined, non-measurable targets decades in the future provide cover to shift attention from the troubling, tangible, and harsh realities of right now. You see it everywhere.
Amazon talks about its fleet going electric by 2035 while today it imposes harsh labor practices on its employees and contributes to deforestation with ubiquitous use of cardboard. Apple harps how it will be net carbon zero in coming years while its supply chain relies on an oppressive Chinese state that squashes human rights and its FoxConn contractor installs nets around its facilities to prevent exhausted workers from committing suicide. Patagonia brags about its refusal to sell its apparel to financial institutions that invest in the fossil fuel industry, yet its products are carbon-derived and its murky supply chain is traced to third world epicenters known for sweat shops.
Then there is the investment firm looking to use ESG as a convenient vehicle to shove high-fee products down the throats of everyone, from mom-and-pop investors to multi-billion-dollar pension funds.
Wall Street is creating new ESG funds and products at the rate of trillions of dollars each year. Investment firms seeking to lure well-intentioned investors can mislead by touting how their high-fee ESG-focused funds beat traditional portfolios. However, reality shows many ESG funds struggle to match the performance of simple, low-fee index funds on a consistent basis. Be wary of firms rolling out ESG-friendly titled funds with no meaningful difference in their holdings compared to non-ESG funds, conning guilt-ridden investors in a multi-billion-dollar charade of wordsmithing and subpar returns.
Finally, there are the massive institutional investors, such as index funds and pensions, demanding that public companies they invest in meet ESG criteria. The demanding institutions hold shares in hundreds, perhaps thousands, of public companies all over the map and in every imaginable industry. Such institutions realize the influence they hold over public companies and want to do the right thing by using their influence to promote the worthy aspects of ESG.
Not surprisingly, many of these large institutional investors desire an easy and efficient way to screen ESG performance across their huge portfolios. They rely heavily on global frameworks and reporting mechanisms that claim to universally define good ESG behavior—therein lies the flaw.
Delivering and assessing effective ESG performance requires sweating numerous details unique to individual companies and industries. It is not a one-size-fits-all approach set by a static spreadsheet, designed by people who never worked in the trenches of the industries they judge; instead it is hard work requiring specialized knowledge of an industry or company.
The mammoth institutional investor may have the benefit of a glossy and sleek report touting its ESG veneer, but it won’t have the substantive ESG wisdom that reduces investment risk and boosts returns for their clients and beneficiaries. Often the application of these blunt tools for assessing ESG performance frustrates the worthy aspirations of the institutional investor.
The Ugly (Tucos)
Prolonged immersion in the bad of ESG leads to the ugly, as exemplified by the demise of Pacific Gas and Electric (PG&E) and WeWork.
For years, PG&E racked up ESG accolades from self-proclaimed ESG experts. Sustainalytics.com deemed the California utility an ESG outperformer, Corporate Responsibility magazine’s 100 Best Corporate Citizens ranked PG&E as the top utility in the nation, and Newsweek’s Green Rankings also placed PG&E at the top of the utility heap. The company boasted that over a third of its power came from renewables, which helped deliver a string of best-possible governance ratings from Institutional Shareholder Services (ISS). PG&E was the belle of the ESG ball, yet also severely dysfunctional.
The utility’s rap sheet over the past twenty years includes convictions for over 700 misdemeanors and felony convictions stemming from misleading regulators and the public about the state of a gas pipeline that ruptured and killed eight people. PG&E made attorney Erin Brockovich a Hollywood movie sensation when she represented clients who were eventually awarded over $600 million from PG&E stemming from contaminated drinking water. From 2012 to 2016 PG&E supervisors looked the other way as employees fabricated thousands of on-time results to hit internal targets for responding to excavation work around buried power and gas lines, accumulating over 170,000 violations of state law. Clearly, this was not a best-in-class track record for E, S, or G.
Then, in 2017 and 2018, wildfires raged across California and it was determined that over 1,500 fires, several of them catastrophic, were caused by PG&E’s poor maintenance practices, deferred safety upgrades, slow responsiveness, and obsolete equipment. More than a hundred lives were lost. Twenty-two thousand buildings were destroyed across 350,000 scorched acres. A company audit months after the fires found nearly 10,000 problems with power lines throughout its system. Before you knew it, the utility was facing tens of billions of dollars in liability. PG&E’s system is now subject to frequent rolling blackouts, delivering a third-world power grid to ratepayers. PG&E filed for bankruptcy, bringing home the reality of wiped-out investors despite all those shiny yet hollow ESG credentials.
The case of WeWork offers another cautionary lesson. The office space tech darling (at least for a period of time) boasted a $47 billion valuation in early 2019 and possessed one of the savviest investment firms on the planet as a major owner: SoftBank. WeWork was as ESG friendly as it gets, at least on the surface. The company’s founder and initial CEO, Adam Neumann, constantly spouted a potpourri of ESG missives including how WeWork “advances inclusion and equity in the global economy,” wanted “to build a world where no one feels alone,” and existed “to elevate the world’s consciousness.”
When the company was deciding which stock exchange to list its shares on before its planned IPO, Neumann sat the CEOs of NYSE and NASDAQ down to ask which one would ban meat and plastic in the exchanges’ cafeterias. Such a ban would curry favor with WeWork and land the exchange the coveted stock listing. NASDAQ practiced one-upmanship by committing to create a We50 index of companies practicing sustainability and won the listing.
Not before long, NASDAQ and SoftBank looked foolish as WeWork’s substantial financial woes and its CEO’s problematic public behavior peeled away the thin ESG veneer to expose a stark reality. Valuation plummeted from $47 billion to less than $8 billion, Neumann was ousted as CEO, the IPO was canceled, the company had to be bailed out by SoftBank to avoid ruin, and a reorganization to cut costs could not be effectuated because the company was in such dire financial straits it could not afford to pay severance. That’s what happens when public company governance behind the ESG posing is a nightmare of reality.
Finding the Blondies While Avoiding the Angel Eyes and Tucos of the Capital Markets
Effective ESG performance and assessment can help companies and investors competitively pursue profit in a capitalistic society. But beware the unscrupulous looking to lure capital or the naïve looking to ride moral high horses who abuse and misapply ESG for counterproductive designs. The quick and easy approach to ESG is a tempting mirage of sugary nothingness. Real ESG takes grueling work and endless effort; an infinite pursuit of perfection where the lucky capture it for only brief periods yet prevail over the long haul.
See the study “Valuing ESG: Doing Good or Sounding Good?” by Professors Bradford Cornell and Aswath Damodaran.