Environmental, social, and governance criteria in business are becoming a major topic in the corporate world. However, the rapid transition in time, when we do not have it in abundance, leads many companies into the traps of (un)intentional misrepresentation of environmental and social performance. How is the concept of corporate social responsibility changing, what are the ESG criteria as their massive misuse today leads to classic examples of greenwashing?
Growing pressure on companies to become sustainable
Professor Ioannis Ioannou from the London Business School points out that the pressure on companies to become sustainable has been growing in the last few years, and that this pressure is manifested on several levels. First, millennials and Gen Z are asking more and more questions about the impact of companies, products, and services on the environment and society. Secondly, science is increasingly saying that increasing environmental and climate problems are present, which forces decision-makers to adopt plans to reduce carbon dioxide, to commit to other environmental goals, as well as to adopt regulations governing this area. Finally, investors (banks, funds, etc.) are increasingly requiring companies to understand environmental, climate, and social risks and to include them in overall risk assessments.
The response of companies to these pressures is different. Ioannis points out that companies go through a rethinking process in which they try to understand what environmental and social issues are important for their business, then how to change the relationship with shareholders and other internal and external stakeholders and with the community in general.
Generally speaking, striving for companies to become sustainable is not a new idea. However, 2015 brings a significant turnaround, as the Paris Climate Agreement takes place, and the United Nations comes out with the Sustainable Development Goals (UN SDGs) as part of the 2030 Agenda. These initiatives significantly contribute to redefining the concept of environmental and social responsibility.
The following is a brief overview of the evolution of the concept of corporate social responsibility, followed by an explanation of what ESG means.
A brief overview of the evolution of the concept of corporate social responsibility
In the 1980s, the concept of sustainable development gained importance, especially after the publication of a report entitled “Our Common Future” in 1987, issued by the World Commission on Environment and Development (the report is better known as the Brundtland Report). This document defines a generally accepted definition of sustainable development: development that meets the needs of present generations without depriving future generations of the opportunity to meet their own needs.
The implementation of sustainability in the corporate world has had its development path. First, based on the definition and implementation of regulations on worker and environmental protection during the 1980s, the importance of health, protection, and safety of workers, as well as the environmental impact of business, is growing in the corporate world. Then, in the 1990s, sustainable development gained (mostly declaratively) more and more importance, now with a focus on reducing the negative impact on the environment. At the beginning of the 21st century, in further attempts to achieve sustainability, companies practice the concept of Corporate Social Responsibility (CSR). Given the accumulated environmental and climate problems, today CSR is slowly evolving into the ESG (Environment, Social, Governance) concept, to quantify the impact of companies and rank them by industry by the degree of sustainability.
What is behind the abbreviation ESG?
The abbreviation ESG comes from the words Environmental, Social, and Governance. The ESG criteria represent a set of standards that banks and other investors may consider if they tend to invest money in environmentally and socially beneficial projects. Environmental criteria (E) should show how much a company is guided by environmental principles in its business, i.e. how much they protect the environment through their activities. The social (S) criterion shows how well a company manages relationships with employees, suppliers, customers, and, in general, with the community in which it operates. The governance criterion (G) of a company deals with how it manages its processes, rewards managers, conducts internal audits and controls, and shareholders’ rights.
Overall, the ESG is used as a framework to assess how a company manages the risks and opportunities created by changing market and non-market conditions. Variability is reflected through environmental, social, and economic changes, which affect the overall environment in which companies operate.
Overview of the criteria considered in the ESG sphere:
- Environmental factors:
- Climate change and carbon dioxide emissions,
- Water and air pollution,
- Energy efficiency,
- Waste management,
- Availability of water resources
- Social factors:
- Customer / customer satisfaction,
- Data protection and privacy,
- Employee engagement,
- Community relations,
- Human rights,
- Labor rights.
- Board structure of directors,
- Structure of the audit committee,
- Bribery and corruption,
- Salary of managers,
- Contributions to policy,
- Whistblowers schemes.
The pitfalls of greenwashing in ESG
It is noticeable that the demand for investors whose investments can positively impact society and the environment is growing. It is therefore logical for banks and other investors to adapt to these trends. However, due to the aforementioned great pressure from the public and the market, many market players are subject to the pressure of speed and complexity of the problem, try to implement the given market requirements by the use of shortcuts. Thus, today greenwashing threatens to neutralize all the progress that has been made so far in this sphere.
One survey shows that as many as 44% of investors are concerned that ESG investments do not reflect what they should. As concerns about climate change grow, so do some companies overemphasize the green characteristics of their products and services, making them want to profit from a wave of new trends.
Another study supports the above. Namely, the company Morningstar inc. has identified 253 funds in the US that in 2020 focused their business on ESG. Of the total number of funds, as many as 87% of them conducted rebranding, by only adding words to their missions, such as “sustainable”, “ESG”, “green”, “climate”, etc. However, if you look at the structure of their portfolios, it can be concluded that none of the mentioned funds has changed the way of doing business to be realistically sustainable.
Three roads to greenwashing
In my opinion, three challenges easily lead companies to practice greenwashing in the ESG sphere:
I Inconsistency of standards governing ESG
ESG has become a great business opportunity and a massive investment trend. In the USA, every third dollar invested has an ESG label, while in Europe this is even a more common case. However, as we have seen, fund managers can put any label on the funds being invested.
The misuse of the ESG occurs mostly as a result of the lack of a single global definition and measurement standard that would be applicable and comparable worldwide. Additionally, the terminology is confusing, unclear, and complicated. All this allows for a high probability of disorder in this area.
Positive developments in this area are reflected in the cooperation of leading organizations that define the reporting framework (CDP, Climate Disclosure Standards Board, Global Reporting Initiatives, International Integrated Reporting Council, Sustainability Accounting Standards Board), which seek to define a common framework. Also, the Big Four (PwC, EY, KPMG, Deloitte) in cooperation with the World Economic Forum last year announced a set of measures for ESG reporting called “Stakeholder Capitalism Metrics”, which currently, in the absence of a globally accepted comprehensive framework, represents the greatest progress towards ESG standardization.
II Inadequate human capacity
Dr. Kim Schumacher, an expert in sustainable financing and ESG from the Tokyo Institute of Technology, coined the term “ESG competence greenwashing”. Dr. Kim points out that under the pressure of environmental activists, the companies began to rapidly develop environmental awareness. As a result, some companies that have been slower to embrace this trend are now trying to take shortcuts to become sustainable. They quickly hire internal staff who have so far dealt with some kind of social responsibility in the company (most often the company’s PRs) or are only now training someone from the organization for that position.
Thus, today, financial analysts are rapidly attending courses and obtaining certificates, but it is questionable whether there is adequate expertise behind these certificates. Dr. Kim states that ESG expertise requires specialist knowledge. Therefore, he suggests that to avoid ESG greenwashing, ESG teams in companies must be composed equally of financial and non-financial experts (unlike the current situation where 80% of team members are purely financial experts, which shows that it is still focused on traditional financial analysis rather than good ESG integration). Finally, it is necessary to define clear criteria for how to become an ESG expert or an expert in sustainable development.
III The ESG is not a legal obligation, but a voluntarily accepted standard
Recently, the former head of sustainable investment in the largest global investment fund BlackRock, Tariq Fancy, raised dust when he said in an interview that ESG “creates a giant societal placebo where we think that we’re making progress even though we’re not“.
Fancy points out that investment strategies are mostly short-term and do not take into account long-term challenges. What is paradoxical is that the irresponsible behavior of investment funds is often profitable. The so-called stakeholder capitalism is, according to Fancy, pure marketing that was created to convince the public that governments don’t need to interfere with their measures, but that the market can cope alone with the climate crisis.
As he points out, market failures are the main causes of the climate crisis that need to be addressed through a systemic solution that can only come from governments. If we do not want a bank to finance something, then it should be defined as an illegal activity. We cannot rely on someone to become ethical overnight without pressure. The expectation that big business will self-regulate is a recipe for disaster, Fancy concludes.
Podcast The Sustainability Agenda, Episode 91: Interview with Professor Ioannis Ioannou, leading sustainability researcher at London Business School, Google podcast
Podcast The Angry Clean Energy Guy, episode 49, Google podcast