The concept of ESG has many detractors, not least among many true believers in the need for companies to act sustainably. New research now suggests flaws in the idea may run particularly deep.
A team from the London School of Economics and the Centre for Corporate Governance in Copenhagen conclude that, in ESG (environmental, social and governance), the “S”—or social measures of a company’s performance—may be failing to represent substantive qualities.
In fact, when Christina Kjaer and Tom Kirchmaier looked closely at companies embroiled in “scandals”—ethics breaches, human rights abuses, corruption or product safety issues—these events often followed a year in which their “social” score had been high.
“We show that a high ’S’ score in the year prior to the scandal is strongly correlated with the likelihood of ending up in a corporate scandal,” write Kirchmaier and Kjaer.
The pair say the result indicates that ESG ratings may need to consider “more rigorous” measures of responsible behaviour, while more research may be required to decide whether companies “intentionally” try to improve their ESG scores—in particular, the “S” score.
“Whether companies use ESG merits to deceive its (sic) audience or not, our results suggest that the ’S’ score merely functions as a ‘box ticking exercise’ with limited roots in substance,” the duo conclude.
Notes on a scandal
The conclusion was reached by searching the Dow Jones Factiva service for reports of companies caught up in scandals. A total of 113 corporates were identified but were included only if the team uncovered more than 100 mentions of scandal association with their name.
The resulting companies were then checked for ESG ratings that “decompose” into subsections, with a measure specifically for “S”, or social qualities. The team were trying to test whether a high “S” score would necessarily mean lower levels of scandals “if the measurement is rooted is substance”.
Recent years have seen ESG become a highly contested issue in some quarters, in particular the US, where right-wing politicians have included ESG—and policies designed to encourage ESG thinking among corporates—into their “anti-woke” campaign agendas.
However, the result may be beneficial to those who value the general thrust of ESG thinking, but believe the concept needs refinement and boosting with better foundations.
‘Regulate the ratings’
ESG has been criticised for providing cover for “greenwashing”. So much so that it emerged, last year, that watchdogs across the world were beginning to look at regulating ESG ratings. Sacha Sadan, head of ESG at the UK’s Financial Conduct Authority, said recently that: “The whole investment chain has to get involved and ratings have to be regulated too.”
A report published in December, by professional services firm PwC, found that most investors believe annual reports contain greenwashing.
Some have argued that the only way for companies to perform well on environment and social matters in ESG is to ensure they have rock-solid governance. Paul Barnett of the Enlightened Enterprise Academy, writes for Board Agenda: “Only if we address G will trust and confidence in business and capitalism be restored. Tinkering and, worse still, greenwashing make matters worse. They fuel cynicism, destroy trust, and undermine faith in capitalism.”
It has become clear that ESG is a long way from a finished project. Indeed, asset owners, investment managers, ratings agencies and boards may only be at the beginning of understanding measurements and reviews of the component issues. Research like that from Kjaer and Kirchmaier is a helpful step along the way.