The cover of this week’s Economist consisted of three large letters – ESG. Environmental, social, and corporate governance, which is what they stand for, “won’t save the planet,” the caption to the cover of this edition of the UK magazine said.
“Environmental” comprises, among other things, climate change, greenhouse-gas emissions, water and air pollution, environmental diversity, and efficient waste management. “Social” includes things like working conditions, gender integration and diversity in staffing policies and practices, labour rights, equal opportunities, employee satisfaction, and the respect for privacy. “Governance” in this context refers to how representative and effective a company’s board is, the composition and efficacy of internal and external auditing and review boards, the criteria used to calculate the salaries and benefits of senior staff, and how companies behave in terms of lobbying and electoral campaign donations.
There is also its compliance with transparency rules and with rules on conflicts of interest and the prevention of bribery and other forms of corruption.
Inside, the magazine’s lead article said that ESG-based investment suffered from three fundamental problems. First, its aims are conflicting in practice, as a company might score highly on governance but poorly on environmental and climate protection. Which set of criteria should an investor prioritise?
Second, the concept is founded on a premise that has no empirical foundation. It merely assumes that ESG investment is inherently profitable and also that companies will not pass off the costs of negative externalities onto society rather than bearing them themselves. How many companies have burdened society with harmful pollutants and other waste products and environmentally harmful packaging materials?
Third, the ESG system is awash with inconsistencies and can be easily “gamed.” It facilitates greenwashing and can be used to mislead the public and investors and make them think that a company is compliant with ESG standards.
The article points out that while credit ratings correlate by 99 per cent across ratings agencies, “ESG ratings tally little more than half the time.”
It concludes by saying that it would be better to delink the three components of ESG and focus on only the first one, the E. In other words, it advises setting aside criteria related to societal concerns and governance and concentrating instead on environmental criteria. Moreover, it maintains that “the E should stand not for environmental factors, but for emissions alone.”
However, such reductionism is potentially extremely harmful. Let me remind the readers of what I wrote in Ashraq Al-Awsat newspaper in November 2018 about “corporate responsibility.” Is it a company’s job just to make profits, or does it have societal obligations as well.
I cited a 1970 article by the US economist Milton Friedman, a recipient of the Nobel Prize for Economics, saying that companies had a single aim, which was to make a profit, and that shareholders did not give company managers the authority to spend company assets on social services. Such spending was the job of governments, Friedman said, which levied taxes on companies precisely for that purpose.
Proponents of this view assume that the economy is operating in accordance with the rules of the free market and with regulations in place to ensure integrity and fair competition. In such an economy, companies tend to their own affairs, and governments are left to perform their responsibilities.
As Michael Porter, a professor of business at Harvard University in the US, has noted, the relationship between companies and the societies they operate in has passed through three stages: voluntary donations for philanthropic activities; the introduction of governmentally imposed financial obligations on top of income taxes for specifically designated societal ends; and, lastly, corporate social responsibility, which coincided with the announcement of the UN Millennium Development Goals (MDGs) that were supposed to be achieved by 2015. The MDGs have since been superseded by the Sustainable Development Goals (SDGs), which have set 2030 as the target.
There is a consensus today that the private sector has an important part to play in achieving the SDGs, the key concept of which is sustainability. This entails making the achievement of comprehensive growth, societal development, environmental and climate protection, and governance part and parcel of a corporation’s activities and not just a facade or a gesture of goodwill directed at society.
This is not to suggest that Friedman’s view that companies are only there to make profits no longer applies. After all, if they do not make money they will eventually go out of business due to bankruptcy or takeovers. The significance of the new criteria related to sustainability is that they help to establish how companies should earn their profits.
Company managers often claim that one of their aims is to achieve the SDGs. To me, this seems excessive because the SDGs were originally formulated as indicating the responsibilities that governments should shoulder while companies and others would merely help to attain them depending on their fields of activity. Companies would find it necessary to conform with environmental, social, and governance criteria not because they wanted to, but because the goals behind them now shaped the environment of an effectively regulated market and its incentives.
In a framework of this sort, binding regulations extend beyond such obvious obligations as paying taxes and customs duties, complying with quality standards, and behaving in ways consistent with antitrust laws and also include observing appropriate workplace conditions as defined by the International Labour Organisation (ILO), environmental considerations, and labour laws.
Moreover, the rules of non-price-related competition require companies to market themselves as the supporters of society and its values. A company’s reputation is no longer contingent just on the quality of its products and its competitive pricing, but also on how it helps society or the community attain their aspirations.
Some companies were established by founders who were convinced that making a profit need not conflict with doing good for their communities. Some also adopt a cooperative model that instead of distributing profits among shareholders invests a portion of their revenues to expanding their activities and another portion to charitable trusts dedicated to education, healthcare, or other social services.
Some of these work like some sovereign wealth funds in that they cap spending on current social services to a certain percentage so that most of their assets are reserved for the benefit of future generations. In terms of their environmental commitments, prudent company managers will also often make provisions for the future in anticipation of changes in the laws and regulations governing transparency and disclosure and in response to public pressure to preserve the climate even, according to scientific reports, as it continues to deteriorate further.
Companies in Japan offer a model that is worth studying. Business federations in that country sponsor competitions in which companies vie with one another in terms of their commitment to sets of agreed principles, not just with regard to the work environment and competition, but also in terms of behaviour that defines a new approach to management consistent with the drive to sustainability.
This includes the production of high-quality products and services that are useful to society, the disclosure of activities to ensure they meet binding criteria, business operations at home and abroad that respect human rights and international human-rights instruments, the provision of clear and detailed information to consumers to enable them to make informed choices, and the guarantee of a healthy work environment for all employees in keeping with equal-opportunity principles and fair pay.
It also includes the implementation of environmental-protection and carbon-emissions reduction measures, recycling waste in collaboration with the relevant authorities and civil-society organisations, and contributing to a comprehensive crisis-management system in collaboration with agencies responsible for fighting terrorism and organised crime or for responding to earthquakes and other natural disasters.
Company managements pledge to implement measures intended to achieve such aims. Not only do they regard this as an essential commitment on the part of senior management, but they also believe that being remiss in these areas would harm the company and its reputation. This means that if lapses occur, the management must acknowledge them immediately and take steps to address the problem and prevent it from reoccurring.
Business ethics of this sort represent the translation of ESG into practice. Compared to them, what sort of advice is the Economist offering? What good can come from reducing the non-financial rules that companies should follow to the E for emissions and then discarding the rest of what may be environmentally harmful byproducts and behaviour, let alone not paying attention to societal impacts and governance?
All this approach does, is give prevalence to a single factor, namely carbon pricing. Yet, not only are pricing systems still confused, but they generally cover only 23 per cent of the world’s harmful emissions as mentioned by the Economist article itself.
Indeed, the world does not need more greenwashing and other such behaviour. But nor does it need the kind of reductionism that tunnels in on a single criterion, regardless of how crucial it is.
The best solution would be for all concerned to come to a consensus on the critical criteria that should be used for the environmental/climate, societal, and governance components of ESG. Then they should commit on implementing these standards and reporting on progress using a methodology similar to that used for financial reporting and the calculation of credit ratings, these themselves being subject to continual evaluation and refinement.
*An Arabic version of this article appeared on Wednesday in Asharq Al-Awsat.
*A version of this article appears in print in the 28 July, 2022 edition of Al-Ahram Weekly.