When can a three-letter acronym as promising as ESG become a four-letter expletive? When it’s mischaracterized! With the growing drumbeat around climate change and diversity, equity, and inclusion, ESG skeptics are quick to call it “woke”- the cussword du jour- accusing their political opponents of not pursuing their goals legislatively or at the ballot box! Corporations yielding to the call to action by those on the other side of the political aisle are boycotted and condemned for allegedly forsaking their fiduciary duty of maximizing shareholder value. So much so that ESG naysayers were quick to blame Silicon Valley Bank for its negligence in managing interest rate risks of its held-to-maturity assets, distracted by its sustainability goals.

Adding to their ire is the torrent of capital flowing ($230 billion in 2022 alone Source: Morningstar) into ESG investments, an asset class in its own right, managed by a growing class of investment managers who reward companies that adopt essentially clean-energy practices (and also those that don’t i.e. green-wash) with a share of the investors’ wallet. In part, this funneling of money into stocks/bonds of such companies is also driven by asset managers positioning ESG funds as gateways to fulfilling investors’ growing desire to do good for the planet while doing well financially.

Lost in this ESG-din and gush of capital, is the connection between environmental, social, human, governance considerations and pure business economics and in turn shareholder value creation/maximization.

For example, when a data-center manages its energy mix by replacing electricity from the grid with more renewable energy to create operating efficiency, what comes across is a politically motivated clampdown on fossil fuels costing oil and gas workers and coal miners, their jobs. Similarly, when a media company builds a diverse workforce by promoting racial/gender diversity in its ranks to reduce labor turnover and enhance employee engagement and labor productivity, it is perceived as giving more jobs to minorities at the expense of others. In other words, such sustainable practices and their potential impact on revenues, costs, assets, liabilities and cost of capital escape the anti-ESGers.

Moreover, the chorus around climate change and diversity has been so loud that it drowns the call to address a myriad of other sustainability issues. For context, IFRS’s International Sustainability Standards Board lists 26 sustainability issues across five dimensions each manifesting differently across 77 industries that can potentially present risks (and opportunities-yes!) to any business beyond just climate change and DEI, two issues that get all the attention. Sustainability issues also include risks from human rights violations, business ethics violations, unintended consequences of product quality, deceptive selling practices, IP infringement, critical incidents, systemic risks of say financial systems/utilities, data security and consumer privacy (that could potentially also cover inherent risks of ChatGPT).

For sustainability to sustain itself as a strategic framework to create business efficiencies and mitigate risks through E/S/G considerations toward boosting bottom lines, it’s time to hit the reset button.

Firstly, companies and their investors alike owe it to themselves as well as to ESG skeptics an explanation as to how their businesses/investee companies measure up to their industry-relevant sustainability issues (beyond just environment and diversity issues) both on pre-defined quantitative and qualitative metrics because of their financial repercussions. This assumes even greater importance in a new era of higher inflation/interest rates, re-globalization, changing demographics, disruptive technologies, etc. where businesses are even more compelled to create competitive advantages for themselves by reducing cost, building economic efficiencies, lowering cost of capital, innovating new products/solutions, etc. Companies are more likely than ever to factor in environmental, social, human, product-lifecycle, supply chain, governance issues and more, beyond Porter’s five forces, to improve their future free cash flows, assets, and liabilities. In other words, their financial performance is likely to be subject to a lot more than is reported today in companies’ financial statements.

Since conventional financial statements do not fully reflect a company’s holistic financial picture and outlook, equity investors are likely short-changed if they cannot accurately price how sustainability issues and negative externalities (unpriced social costs) specific to a business, impact its value creation. By the same token, lenders could be handicapped in their credit (pricing) assessment of a business’s risk of default and loss-severity. It therefore becomes imperative for everyone (including ESG skeptics) to gain a full understanding of all-round factors that present immediate and future risks as well as those that create opportunities and value for any business and its shareholders.

Hopefully, the recently announced Corporate Sustainability Reporting Directive (CSRD) in EU and the forthcoming Taskforce on Climate-related Financial Disclosures (TCFD) will help shed more light on the financial implications of a subset of sustainable factors.

Secondly, if responsible companies pursue sustainable practices of their own volition to create competitive advantage(s) for themselves, government efforts would probably be more purposeful in enacting further supportive legislation, regulations, subsidies, taxation, incentive programs (e.g. Inflation Reduction Act, EU Green Deal), etc. as is expected in free market economies. For example, banks should no longer have to be told to do more for climate change if they already sense decarbonization as a sunrise industry they want to lend/invest into for economic gains e.g. JP Morgan’s recently announced investment into carbon removal.

Thirdly, if asset managers were to proxy vote on shareholder proposals demonstrating the connection between companies’ industry-relevant sustainable practices and the consequent material impacts on financial performance, they probably would draw less flak for pursuing any political agenda. Their investor-clients would also gain additional insights into how their investment returns are not compromised but incidentally also bring good to people and the planet by inducing sustainable practices like sending less food-waste to landfills/converting into biofuels or supporting ethical and fair labor practices in the supply chain.

But investors who want to purposefully align their capital to missions like promoting decent work and economic growth, or reducing poverty and inequalities, or for that matter even climate change, find impact or thematic investments as a more impactful strategy to deliver on their intention/vision. Mandated to address global structural issues across environmental, social, and economic dimensions (as in UN Sustainable Development Goals) in return for complexity, illiquidity and inefficiency premiums, impact investments (~$ 1.2 trillion in global assets and growing) is an investing strategy distinct from the strategic framework ESG provides to improve financial performance. So, when a private debt impact fund lends to a renewable energy project or provides micro credit to solve racial/gender inequality, it’s mandated to achieve those goals while targeting risk-appropriate returns. In other words, better clarity of investors’ objectives and investment actions would help remove the cloud of “mission creep” that surrounds the ESG construct.

Therefore, if companies and investors alike, recharacterized ESG investing as a strategic framework to reduce risks and maximize profits by improving business efficiencies through E/S/G considerations with inherent benefits to people and the planet, rewards of sustainability can be sustained over the long haul while dispelling doubts for the ESG skeptics.     

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

May 25, 2023

The above content is intended for sophisticated audiences as in institutional investors or accredited investors. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.