Navigating the Complexities of ESG

In recent years, Environmental, Social, and Governance (ESG) themes have taken center stage in the business world. As of  October 2022, 8,000 firms globally have aligned themselves with the United Nations Framework Convention on Climate Change’s Race to Zero campaign, and Bloomberg Intelligence anticipates that by 2025, investments in ESG assets could exceed $50 trillion.

However, as with any emergent paradigm, the ESG framework is not without its challenges. A pressing concern is the lack of a universally accepted definition of ESG and a standardized way to measure compliance with ESG goals. These ambiguities have led to greenwashing, a practice where companies portray themselves as environmentally responsible without substantive actions, and to inconsistencies in  companies’ ESG ratings.  At its core, the challenge with ESG is its conflation of concepts that are fundamentally distinct.

In a new paper, we examine three issues that underline the difference between E on the one hand and S and G on the other.

A Comparative Analysis of the ESG Dimensions

A first difference involves the “excludability” of a product or service: Whether others can be excluded from consuming or gaining access to it and the benefits of any efforts to improve it. Environmental resources, such as air, fisheries, or forests, are generally not excludable because, to varying degrees, they are open to all. This can lead to the tragedy of the commons, where the absence of exclusive benefits and property rights leads to an unsustainable use of the resource. Because an organization cannot exclude competitors from benefiting from its efforts regarding E – efforts to reduce the organization’s carbon footprint, for example – it has little incentive to pay for those efforts. By contrast, initiatives within the S and G spheres, such as enhancing workforce diversity or fortifying shareholder protection, yield direct, exclusive advantages to an organization, creating an incentive for the organization to undertake them.

A second difference involves the time horizon for a return on investment. For investments in the S and G dimensions, that horizon is typically shorter. For instance, introducing on-site daycare facilities for employees, an investment in the S dimension, translates to tangible benefits like reduced absenteeism or improved employee retention in the short term. For the G dimension, refusing to receive kickbacks or introducing accounting transparency produces rapid returns on investment. Environmental endeavors, however, take longer. The immediate costs associated with environmental conservation occur long before any benefits, leading to the tragedy of the horizon. This phenomenon underscores the challenge of aligning short-term leadership goals with long-term environmental imperatives.

Finally, adding to the complexity is the heightened uncertainty surrounding the environmental dimension, especially in the context of climate change. While the S and G dimensions are supported by empirical evidence of what does and doesn’t work, the environmental dimension is riddled with uncertainties, complicating business planning.

The E vs. S and G Dilemma

The interplay between the E on the one hand and S and G on the other further complicates the landscape as they often conflict. A business practice that benefits the environment (E) might, when viewed through the lens of society (S) and governance (G), be deemed a detriment. For instance, if a company shuts down a high-emission division or facility, laying off its employees, the decision might serve the environment, but the newly unemployed workers would likely not see this as either socially responsible or sound management. Another scenario might involve investing in a developing country with lax environmental standards to reduce costs and boost shareholder returns. In this instance, the positive social and managerial results – creating jobs and increasing profitability – could come at the expense of the environment.

Within nations, policy makers face similar dilemmas: Environmental measures can affect social groups. For instance, the French carbon tax, though environmentally motivated, was met with resistance due to its disproportionate impact on lower-income individuals. In a similar way, many renewable energy projects, while environmentally beneficial, can pose social challenges, such as displacement of local communities. Therefore, governments must take into account the tradeoffs between E and S and G.

This is also true across nations. Internationally, the challenge is to ensure a “just transition,” where environmental measures do not inadvertently disadvantage vulnerable populations. The discussions around the loss and damage fund at the international environmental conference, COP27, highlight the global recognition of this challenge.

Addressing the Multi-Objective Problem of ESG

Governance can serve as the bridge, mediating the potential conflicts between the environmental and social dimensions both for public and private sectors decision makers. For instance, Denmark’s strategy of offering “heat cheques” to lower-income households in response to rising energy prices presents a balanced approach.

How can businesses navigate this ESG landscape? Company leaders find themselves in a quandary, torn between their fiduciary duty to shareholders and environmental mandates. However, these firms could resolve this dilemma by instigating a profound shift in the mindset of their boards and shareholders.

Primarily, they should restructure executive incentives, notably bonus packages. Deutsche Lufthansa provides an illustrative example, where 15 percent of the executive board’s bonus is contingent upon environmental metrics. Moreover, companies ought to be more transparent and candid about their ESG achievements. They must also recognize that the three ESG components can be contradictory. Therefore, they should tailor their ESG strategies to ensure a balanced approach that takes all three components into account.

Furthermore, business leaders have an important role to play in supporting environmental regulation. Universal regulations can level the playing field and ensure that companies making individual efforts toward sustainable practices are not penalized on the market. This is one way to avoid the tragedy of the commons. Recently, oil company BP has shifted from opposing to supporting the imposition of a cap on carbon emissions, recognizing the collective benefit of this restriction.

In addition, technological solutions, both for mitigation and adaptation, are pivotal. While renewable energies are ready for deployment, challenges like cost, infrastructure limitations, and market competition have hindered mass adoption. Historically, policymakers and companies prioritized mitigation due to external pressures. However, the combined approach of both mitigation and adaptation is crucial for climate resilience, as showcased by companies like Unilever.

Finally, addressing global challenges like climate change requires collective action. This collective ethos is embodied in partnerships like the Consumer Goods Forum and The Fashion Pact, which showcase the power of industry collaboration. The ESG framework, while comprehensive, requires a nuanced approach, given the unique challenges and opportunities each dimension presents. By delving deep into these intricacies, businesses can chart strategies that not only have an impact but are also sustainable for the long haul.

This post comes to us from Christos Cabolis, chief economist at the International Institute for Management Development (IMD) World Competitiveness Center; Maude Lavanchy, a research fellow at IMD; and Karl Schmedders, a professor of finance at IMD Lausanne. It is based on their recent paper, “The Fundamental Problem with ESG? Conflicting Letters,” available here.

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