ESG: A Case Study in Failure vs Value Management

Criticism of ESG isn’t new, but this criticism now includes how ESG is undermining its own goals. Is ESG rapidly approaching a reckoning? It ought to be. It is confusing and confused; it fails to properly engage businesses; it is working against its own aims.

November 2023 has been a challenging month in the world of ESG (Environment, Social and corporate Governance).

Or at least it ought to have been.

Most recently, a senior ESG executive at Deutsche Bank’s Private Bank has argued that sustainability funds should be able to hold shares in big oil due to the relatively poor performance of such funds.

But even more significant was an earlier Fortune piece.

Having examined 235 ESG stocks, it reached similar conclusions about their performance, but – crucially – it also highlighted that ESG metrics are counterproductive in achieving ESG goals:

Institutions have become increasingly skeptical about ESG ratings–and rightly so. In our recent research, we show how the inclusion of ESG metrics in assembling a portfolio can lead to unintended consequences.

Criticism of ESG isn’t new – Elon Musk described it as a “scam“; the FT asked if it is a “classic mistake” – but this could be (and mostly was) brushed off as ill-informed, contrarian and short-termist.

After all, if ESG performance were to lag behind that of traditional stocks and approaches, that might well be the price we need to pay for the greater good of ESG goals.

However, if the current approach to ESG is actually inhibiting the achieving of ESG’s stated goals, that ought to be a different matter altogether, and criticisms should no longer be so easily dismissed.

The Deutsche Bank and Fortune articles therefore highlight several key questions for ESG proponents:

  • What is causing ESG-related performance issues, both relative to traditional approaches and – even more importantly – on its own terms?
  • If ESG is failing, what would an alternative Value Management approach look like?
  • How likely is the world of ESG to embrace such an approach?

To begin answering these questions, we need to first remind ourselves of how we’ve got to where we’ve got to with ESG, and what that looks like.

The Roots of ESG

There are few that would deny that there are serious environmental and social problems in today’s world – often on a global scale – and that these need to be addressed with (often-increasing) urgency.

“Sustainability” is the umbrella term that has then emerged here (albeit a term unhelpfully used interchangeably with “sustainable development”; the former is an outcome, the latter a process, and the difference matters).

In 1987, the United Nations (UN) report on sustainability, Our Common Future, introduced a commonly-accepted foundational definition:

“Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”

Fast forward to the present-day and the sustainability “landscape” is defined by, and around, two broad “poles”:

  • The UN’s 17 Social Development Goals (SDGs), which describe and target global and general issues – such as poverty, climate and inequality – and are self-described as a “blueprint to achieve a better and more sustainable future for all”, with a distinct focus on government policy and legislation.
  • ESG (our focus here), which is more focussed on the contribution of the private sector and investments, and which consists of principles and practices that have been set out (by numerous parties) to define operation – and reporting on that operation – with respect to good practice and the “greater good”.

What ESG Looks Like: Complications

The “greater good” is often framed in reference to the SDGs, but there are immediately three complicating factors.

Firstly, the reach and scope of ESG continue to grow.

Only this year, the European Union’s Corporate Sustainability Reporting Directive (CRSD) came into force, requiring all companies of over 500 employees (and EU-based subsidiaries of non-EU companies) to report in detail on sustainability matters (or face penalties for not doing so).

It will also require reporting on “business strategy and the resilience of the business model”, and demands information on “intellectual, human, and social and relationship capital”.

Perhaps even more significant is how ESG Standards – including the CRSD – are increasingly suffused with issues like the gender pay gap, racial diversity and analysis, minority board representation, equity and social value.

Regardless of the importance of these things (which is a topic of often bitter debate), the key points are that ESG is a moving target, it is reaching into ever more sensitive and more fundamental areas, and it is widening in scope (potentially going outside even the scope of the SDGs at points).

Secondly (and perhaps unsurprisingly, given what we have just seen), there are many different ESG frameworks and – whilst a formal standard is being developed by the newly-commissioned International Sustainability Standards Board (ISSB) – that often makes it difficult to know where to start.

For example, the WEF sets out its stall for being best-placed to unify and drive the ESG agenda and claims that it stands behind “…the world’s plan for peace, prosperity, and a healthy planet”; meanwhile, the EU instead claims that it is the best-placed to act.

And these are just two of the big players.

Thirdly, whilst there is considerable overlap in content between the SDGs and ESG – e.g. on issues such as diversity and climate – and whilst ESG is frequently held up as a means to act in accordance with the SDGs and make progress towards achieving them, they aren’t the same thing, and there are often conflicts between the two camps.

Indeed, some in the SDG camp have even stated that “[ESG] approaches are insufficient – and no longer future-fit…“, which is pertinent when considering that ESG be proving an impediment to achieving its own goals.

These three complicating factors are only the start, though, because ESG also fails to adequately engage business, and it also fails on its own terms.

ESG: Failing to Engage

Making the confusion that we’ve just looked worse is that whilst claims are made for business in terms of the impact they can have, it is at best unclear as to what that looks like or what the incentives might be.

On the one hand, business is acknowledged to be crucial – at least as a contributor or partner – given its scope for “direct and indirect influence and impact” on many environmental, economic and social levels.

On the other hand, even with ESG – as compared to the UN SDGs, which sit at a level “above” what most businesses can directly aim at – sustainability hasn’t been presented in a compelling way to business.

At best, we see the argument that business operates in the same environmental and social context as everyone else – so will be profoundly impacted by issues there – and assertions made that society expects “better”.

As we shall see, a strong and direct value-based case for businesses to engage with sustainability can – and arguably should – be made, but one of the most striking things in the world of ESG is just how little effort seems to have been expended in doing so beyond this general and indirect case.

Claimed opportunities and benefits for business are more often than not “away from the negative”, such as staying on the right side of government policy, avoiding penalties, pre-empting the circulation of misinformation, being able to influence rather than be subject to the agenda, and so on.

Even more “positive” reasons are also discussed in mostly general and indirect terms, be that reputational benefit (e.g. through philanthropy), social licence to operate, scope to innovate, attracting and retaining staff, risk reduction (e.g. in supply chain dynamics) or simply general economic and market improvements.

Meanwhile, it is acknowledged that most companies do not have sufficient incentives, time or resources to engage, with many having only “limited” resources at their disposal, such that they are unable to afford the “necessary” changes, with most (according to Mark Carney’s book) not obtaining any “sustainable competitive advantage”.

After all, it is acknowledged that business is often being asked to set aside or defer its own interests, and business is exhorted to “look beyond” short-term financial gain and also to negotiate the tension between doing the “right” thing and shareholder pressure towards prioritising profits.

The sustainability agenda is therefore on top of what business is already doing, creating costs and typically not conferring any clear benefits – at least for those making all the changes, paying the consultants and doing the reporting.

Of course, some may not be motivated at all by what benefits them, and instead wish to pursue a more noble goal for its own sake – altruism or legacy, perhaps – but if this is the call to action, this isn’t made clear, and neither is the cost to business adequately factored in, which may well outweigh noble intent.

Even when that “loss” is priced in, though, there is evidence growing that ESG – at least as currently conducted – is self-defeating: why?

ESG: Failing in its Own Aims

The answer is because of how ESG is falling into all the classic traps of traditional command-and-control approaches.

It does so in two ways.

Firstly, ESG is to be driven top-down by policy, legislation, enforcement and penalties.

These things of course have their place, but the WEF says that ESG information “should be assured”, and the European Parliament has stated that CSRD information should be “subject to a mandatory audit”.

A huge certification industry is springing up, spearheaded by the “Big Four” consultants (who are acknowledged WEF partners, such that PwC’s intention to boost its workforce with 100,000 ESG specialists doesn’t sit comfortably here), and it is therefore no wonder the WEF says that “[t]he ecosystem is buzzing with activity.”

Indeed, you could be forgiven for wondering whether the main beneficiaries of ESG are at this point: society and the environment or a particular subset of businesses and consultancies who are best-placed to push, and profit from, ESG?

Now, of course, there are situations where it is entirely appropriate to legislate, police and enforce – e.g. eliminating slave labour – and certifications can be important.

But the sweeping sense of “necessity” and even “compulsion” within the ESG world is hard to reconcile with how its value has simply been asserted and not demonstrated.

Secondly, ESG approaches are overwhelmingly broad, detailed and formal, and they are virtually without exception all-or-nothing.

The WEF, for example, proposes 21 core metrics and a further 34 expanded ones – which are set to become the basis of the ISSB’s “comprehensive global baseline of sustainability-related disclosure standards” we already mentioned – and each metric has extensive commentary and a proliferation of references to external standards and documents (such as the TCFD, ISO Standards, etc).

The metrics include Paris Agreement-aligned greenhouse gas emission targets, the amount of phosphorus fertiliser consumed, the congruence of company lobbying with its stated ESG targets, monetary losses from fraud convictions, ESG as a factor in acquisitions and investments made, and megalitres of water consumed.

These are hardly core metrics in every sector, and hardly core metrics for most SMEs, regardless of industry.

However, all businesses are to nevertheless “disclose or explain” their response to each.

With SMEs arguably the powerhouse of business, it is bad enough that all this arguably favours the larger companies that have the resources to be better able to do so, and that are – perhaps not entirely coincidentally – openly said to be behind the development and propagation of the metrics.

But this is only the tip of the iceberg, because – even worse – it also creates huge scope for expense and waste: surely the opposite of “sustainable”!

So, when the EU states that its CSRD will cost billions and that EU companies “risk incurring higher reporting costs than non-EU companies”, it is highlighting an across-the-board issue: the way ESG is currently being done is typically cripplingly difficult and expensive.

And, to cap it all, focusing in on specific aspects of ESG can even clash with others – a good example being in Mark Carney’s book, where he discusses solar panels as a “straightforward” example of “impact monetisation”, and breaks down its financial saving in terms of CO2 emissions to conclude that this describes “the social impact for this activity”.

And yet what about the “social impact” of how the materials for solar panels frequently depend on slave labour amongst the oppressed Uyghur minority in China…?

A typical example of what happens when Complex, interlocking issues are isolated from each other in an attempt to “solve” them.

No wonder the way ESG is being pursued is leading to performance issues compared to traditional approaches; no wonder it is getting in the way of ESG goals themselves.

Happily, there is an alternative: Value Management.

Value Management: the Effective Alternative

The foundation of authentic sustainability – not the compelled or artificially manipulated “sustainability” of ESG – is the pursuit of value and its corollary, the elimination of waste, through cultures which harness Complexity.

This Value Management approach would systematically address all of the issues of the current sustainability agenda, informing and empowering from the bottom-up to drive sustainability as an emergent property.

It would mirror the emergence of the issues in hand, enabling like-minded individuals and organisations to coalesce around those issues and their solutions, whilst taking advantage of the information and connectivity revolution of today’s information technology.

As such, it would also be the organic and holistic way to overcome the self-interest that is often flagged in a sustainability context, but where the only answer proposed to date has been top-down control (which Value Management would then replace, complement or balance out as appropriate).

The Value of Sustainability

Value Management in the space occupied by ESG would begin with developing a true value-based case for engagement, both in general terms and then in establishing where the synergies are between a specific business’s culture and the various potential motivations for, and benefits of, a focus on sustainability.

We recognise that there are differences that make a difference here – rather than either simply asserting that sustainability is beneficial to all businesses or assuming that the benefits are the same for each – and we propose a knowable and consistent set of reasons why individuals and organisations might engage, organised into five broad categories:

  1. Intrinsic – truly wanting to “do the right thing” for its own sake:
  2. Market Profile – longer-term, bigger picture benefits that can provide synergy with 1.
  3. Opportunities for Change – short-term synergy with 1 and/or 2 that reinforces that drive
  4. Business Improvement – benefits that may occur as a by-product of engagement
  5. Risk mitigation – to avoid negative consequences, likely combined with a sense that this is all “required”, rather than “chosen”

(Note that this order largely mirrors the priorities of individuals committed to sustainability, but that the motivation for most business engagement is inverse to this order: something is clearly being “lost in translation”, and we don’t think this needs to be the case.)

This targets the focus of sustainability effort to where impact can be maximised, whilst minimising waste, and provides the antidote to the lack of clarity of how to engage with ESG, as well as its all-or-nothing, monolithic approaches.

It also approaches engagement through a business’s goals and culture, such that it is not just bolted-on as an extra – unaligned with a business’s values and interests, and therefore largely doomed to fail – which, given the stakes with many of today’s besetting issues, simply isn’t good enough.

Value: the Root of Change

Next, by adopting general Complexity-awarePeople-centred and Value-led principles of operation, Value Management would encourage true bottom-up change and impact.

This would be the true source of the innovation and change needed with these complex issues, and the corrective for the “command-and-control”, top-down default position that sustainability proponents have reverted to.

(Again, the issue isn’t “command and control” per se, but where it is the default and only approach; in most Complex situations, neither is appropriate.)

This is where it would also be crucial to understand value as a subjective, complex and emergent phenomenon that can never be compelled or fully predicted, and to adopt an approach where value can be nurtured, encouraged and harnessed, leading to true engagement, motivation and change through emergent innovation and best practice.

If sustainability to be framed in this way, it could be realised in the same two ways as any other value that is being pursued – i.e. by rigorously focusing on the specific goals and their implications, whilst also nurturing the general conditions most conducive to realising that value.

However, we keep saying “would” and “if” because there has so far been very little traction for Value Management in the space occupied by ESG space: is that likely to change?

Obstacles to Change

The Deutsche Bank and Fortune articles ought to serve as a wake-up call to proponents of ESG, but there is a lot standing in the way:

  • Policy and legislation often leaves little “room” for a flexible, creative approach, which would then often be “on top of” the existing mandated burden. (Better policy would help, but this isn’t the only issue.)
  • The huge vested interests of consultants, certifiers and standard-setters.
  • The hubris of those that insist that ESG in its current form is the only way.

And this last point is possibly the most telling, posing the greatest obstacle.

This is because it reflcets how the areas targeted by ESG are seen as problems to solve, areas to codify with requirements, and as having clear outcomes to define, measure and control.

This is how the WEF, for example, is able to claim (with no apparent hint of modesty or doubt)) that it has established what is required to harness “…the innovative, creative power of individuals and teams to generate long-term value for shareholders, for all members of society and for the planet we share” and that its standards reflect what is “considered to be the most important to society, the planet and the economy”.

This is why ESG is simply asserted as self-evidently valuable and necessary, and why it will likely continue to be, even in the face of contrary evidence – a combination of:

  • The human desire to simplify and solve things by breaking things into parts to deal with (the wrong kind of “simple” when it comes to complex challenges).
  • The confidence that comes with “being right”.
  • The tendency to deny issues, resign to things being hard or to double-down rather than rethink.

Indeed, one of the most striking aspects of the ESG world is how – even with voices and evidence to the contrary – sustainability is asserted to be gaining momentum, undeniably valuable and most certainly required; even ignored by businesses “at their peril”.

It is typically framed in terms of what “society” wants or even demands, with “emerging consensus” that it is crucial, and where companies are said to “need” it to build a licence to operate.

This is said to be due to “momentum in the market” and “expectations in society at large”, where “public understanding” of the purpose of business is shifting, and where society is “increasingly committed” to it.

And so, at least for the time being, it will only be the truly brave and insightful individuals and companies that take a principled stand that recognises that ESG isn’t working, and that adopts an alternative approach – one that doesn’t just better reflect their own interests, but one that better reflects all of our interests when it comes to those crucial and big issues that ESG claims to be targeting.

Are you and your company ready to be brave, insightful and principled when it comes to ESG?

Or are you happy to continue with an approach that isn’t working and that is – in a quite literal sense – costing the Earth?