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The ABC of ESG (Environmental Social Governance)

Updated: Jun 27, 2022

What is a socially responsible investing method like ESG if not an inflection point to what had been considered the truth for a long period of our market society?

Once, a far wiser man, said that discussing really meaningful things meant investigating those subjects which are a consensus among people. Subjects that are normally discussed and polarized, are often not the root problem, or even the right matters to be discussed. Deep, meaningful insights come from putting into perspective hermetic truths.

What is a socially responsible investing method like ESG if not an inflection point to what had been considered the truth for a long period of our market society?

When I went to school, there was one dogma above all else: the purpose of a corporation is to maximize shareholder value. That means increasing revenue, cutting costs, becoming more efficient, minimizing tax. Extracting the most out of each line of the balance sheet. A balance sheet that is indifferent to underlying long-term reality, of sustainable investing.

A modern approach to organizational management, created by Tanmay Vora based on ideas by Aaron Sachs, Anupam Kundu.

That is not to say that increasing revenue, and maximizing profits is not a good thing. It is after all the best way we have experienced incentive of progress, the search for efficiency led to unthinkable wonders of knowledge, connections, and development. But, it appears that under all of these considerations, and in the holy dogma of corporations, one question failed to be asked: under what long-term costs?

Corporations are not purely abstract entities, they exist in the real world, and both provoke and suffer consequences of this fact. We are meant to be guided by certain principles of social investment.

Therefore one might argue that the matters of environmental social governance should be key for driving shareholder value in the long term. Because it can only be sustained by also maximizingstakeholder value.

The study “The Impact of Corporate Sustainability on Organizational Processes and Performance” by Harvard Scholar Robert G. Eccles, together with Ioannis Ioannou, and George Serafeim, has shown that “high sustainability” companies overperform their counterparts in ROE, ROA, and other indicators. This study was conducted analyzing data from 18 years.

This approach has been the basis for several other proposals and literature, such as the “Doughnut Economics” by Kate Raworth, and more recently “Value(s)” by Mark Carney.

It is not all good news though.

With the promise of better returns aligned with responsible capital allocation, investors have been moving towards the ESG, and citizens have been paying more attention. Yet, a fundamental reality has not been completely appreciated in the enthusiastic motion: there is an inherent difficulty in measuring principles of responsible investment such as ESG.

The financial world has been educated to live off cartesian assessments. And feeding abstract concepts, that contribute to returns and society, into the model has been challenging. While ratings considering financial aspects tend to point in the same direction (S&P, Moody’s), ESG rating systems often have a low correlation between different assessments.

Divergence occurs due to the lack of established and enforced frameworks. The unreliable origin of data, as well as the shortage of transparency and obligation to publish certain indicators, lead to shallow analysis and low comparability.

ESG stands for Environmental, Social, and Governance. Investors are increasingly applying these non-financial factors as part of their analysis process to identify material risks and growth opportunities. (CFA Institute)

Some companies and initiatives have been pushing this idea forward and publishing both the good, the bad, and the ugly. Governmental bodies have also been active in promoting this change, in the EU regulations have stated the requirement Sustainable Finance Disclosure Regulation, as well as the Sustainability Taxonomy Regulation that should establish some grounds for further development.

The bottom line.

While the concept evolves, metrics and best practices are developed, the capital flowing to ESG funds gets allocated by the concepts of positive and negative filters for companies, available metrics, impact investments, and corporate engagement.

So, what is ESG?

There is an undeniable and unstoppable movement towards sustainability. Aligned with the recognition that this theme involves the environment – markets, firms, and society live in the real world after all; social – it has been proved time after time that creating a just society is the best route for progress; and governance – to ensure the right definitions of rights, responsibilities, and accountability from the firm’s decisions.

Some of it will eventually be quantifiable, some will not. Meanwhile, it is our job to rethink how we assign value and determine if the narrative has true substance.

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