ESG is having a moment — one of transition and transformation under heightened scrutiny. As investors look to hold businesses accountable for their environmental and social impacts, corporations and ESG insiders are shifting resources and looking for insights on how to meet the moment, or potentially be left behind.
The acronym was first linked to the three terms — environmental, social and governance — in a 2004 report from the United Nations’ Global Compact, “Who Cares Wins.” The concept: In an increasingly globalized and interlinked society, companies will need to consider these factors to accurately manage risk. The organization recommended analysts, investors and consultants increase their research efforts in the area and for businesses and financial institutions to begin incorporating the concepts into their management practices.
From 2004 until 2020, interest in ESG remained relatively low, according to a Google Trends search. Then a slight uptick heading into April 2020 quickly pivoted into a sharp spike in interest in how companies performed on ESG metrics, slated against a backdrop that included a pandemic, widespread social unrest, an increase in severe weather events, a war in Ukraine and multiple contentious state and federal elections.
What began as a concept for academics, financial institutions and asset managers had officially entered the lexicon.
What does ESG entail? How do you measure something that’s never been quantified before? What does it mean to be sustainable, and can you regulate it? Once data is collected, what’s next? What if a metric, like social data or fair pay, means something different depending on who you ask?
With such an evolving concept, here are the biggest trends impacting how companies enact ESG strategies.
Global reporting frameworks begin to coalesce
Companies navigating the ESG environment have reported a lack of clarity on what to report and to whom. When investors began to look for information on companies’ ESG practices, various voluntary reporting frameworks popped up to fill the void. However, the attempt to solve the problem created a landscape of competing frameworks with varying degrees of overlap.
The issue is starting to resolve with multiple frameworks coalescing under the International Financial Reporting Standards Foundation’s International Sustainability Standards Board created in 2021. ISSB consolidated the work of four reporting bodies — the U.S.-based Value Reporting Foundation’s Sustainability Accounting Standards Board, the Task Force for Climate Related Disclosures, the Climate Disclosure Standards Board and the International Integrated Reporting Framework — under one roof.
ISSB’s inaugural reporting framework was released in July, focused on providing information to investors. An IFRS spokesperson said the group is aiming to get businesses to voluntarily adopt the standards, while simultaneously pushing for governments to require companies to adopt the standards. ISSB also has a collaboration agreement with the Global Reporting Initiative, whose standards allow businesses to provide additional information to stakeholders, consumers or the general public.
How widely the frameworks will be adopted is unknown, but the clutter of reporting entities is beginning to clear.
Without common metrics, companies are creating their own
Currently, there are no universal metrics to measure businesses’ performance in addressing risks and concerns related to ESG within their structure, be it evaluating carbon footprint or labor practices.
While there has been an uptick in companies publishing ESG and sustainability reports, the vast majority of ESG scores come from third-party rating agencies — such as Sustainalytics, Refinitiv, MSCI, among others — that have their own methodologies and evaluation metrics. A recent study on corporate governance by Stanford University found that 88% of investment professionals use third-party ESG ratings, a figure that is expected to increase to 92% in the future.
However, according to some experts, this lack of uniformity in reporting metrics is not an issue as long as firms are willing to collect and disclose their ESG data. Different companies look at different factors when evaluating risks, according to Andrew Behar, CEO of As You Sow, a nonprofit that promotes corporate social responsibility through shareholder advocacy.
“Rating frameworks are kind of an amorphous thing. There’s not really a consistent way of measuring apples to apples.”
Chief services officer at Sphera
“ESG is ultimately a framework about assessing risk … you need to look at the nuance when it comes to assessing and addressing risk,” Behar said. “Having one score standard doesn’t really make sense because you might have a company that is great on their supply chain emissions, but terrible to their employees and has bad governance. What will the score say?”
Mark Stach, the chief services officer at Sphera — a tech consulting firm that provides companies with ESG performance and risk management software — echoed this sentiment: “Rating frameworks are kind of an amorphous thing. There’s not really a consistent way of measuring apples to apples.”
The absence of a homogenous reporting standard has not affected companies’ efforts to disclose their ESG performance though. An annual report from the Governance & Accountability Institute states that 96% of S&P 500 companies and 81% of Russell 1000 companies published sustainability reports in 2021, reaching a record high in sustainability reports among publicly traded companies in the U.S.
‘S’ in ESG continues to lag, but not for lack of trying
Compiling ESG data relies on extracting information from public, quasi-public and private data sources, according to Stanford’s 2022 study. The social or ‘S’ component of ESG is particularly difficult to collect because it’s a predominantly qualitative metric that needs to be accounted for in a quantitative way to generate a holistic score. It does not help that companies measure “social” in different ways.
“There are so many potential topics and metrics that one could choose to measure when it comes to the ‘S’ in ESG,” Katie Rowen, chief legal and sustainability officer for industrial technology company Vontier, said. “Everything from diversity, employee safety, employee engagement, growth and development, corporate philanthropy ... the list goes on and on. I think the starting point for companies needs to be what’s most material to your company and to your stakeholders, both internal and external.”
According to Rowen, a manufacturing company might consider ‘S’ as safety and regulation-related data, whereas another might focus on diversity hiring data, making it difficult to compare the two.
Despite the rising interest in ESG, firms have struggled to grasp precisely what role the 'S' plays and how it should be integrated into investment decisions, according to a report by FTI Consulting. The research notes that while companies have made significant progress when it comes to disclosing their environmental impact and governance standards, “the same cannot be said of social impact and performance.”
However, Rowen, who is also a member of MIT’s Climate and Sustainability Consortium, disagrees that the social factors are neglected in company disclosures.
“I don’t think [S] is a topic that’s overlooked at most large, mature organizations,” she said. “It’s critical to driving employee engagement, talent, innovation. [T]he people issue for companies is really an existential issue.”
But, Rowen recognizes that compiling and streamlining social data has its hurdles, including varying data privacy laws across the U.S.
“One of the major reasons that we don’t have such good data on social aspects is just because of different privacy laws in the U.S.,” said Alyssa Stankiewicz, Morningstar’s associate director of sustainability research.
While the U.S. has passed legislation protecting children’s information online, medical and educational records, there is no overarching law that covers the privacy of all types of data. Complicating matters are the scattered data privacy and security laws across states, which prevent employers from acquiring certain employee information as it qualifies as protected data, making it more challenging to collect figures on social aspects such as diversity, according to Stankiewicz.
“These differences between ... what data can be collected are often cited by portfolio managers as one reason that it's challenging to evaluate and compare companies on diversity metrics,” she said.
Use of AI picks up to help track, collect and report data
Reporting on ESG metrics has amplified the amount of data companies are required to detect and disclose. It started with tracking carbon before its eventual expansion to the broader array of ESG concepts today like greenhouse gas emissions and workforce diversity, said Jessica Kipper, Schneider Electric’s senior director of software product management.
As companies look to integrate the systems that collect and house all of their ESG data with broader company workflows, artificial intelligence has entered the conversation. Kipper predicts AI will play an important part in the digital transformation and help businesses navigate reporting frameworks and respond to disclosures, as well as give companies the ability to quickly discern how they stack up against their peers.
In August, Schneider Electric announced its own AI tool that will allow businesses to query their company’s reporting data and learn the difference between scope 2 and scope 3 emissions. AI could also give companies the ability to monitor data in real time and utilize natural language processing to keep companies apprised of their own reputations and what stakeholders want to know, John Friedman, former managing director of Grant Thornton’s ESG and sustainability sector, wrote in a LinkedIn post.
This particular application of AI for ESG — collecting and analyzing data — provides promise for businesses but is just one way companies are already trusting algorithms to assist their work.
Companies, investors, regulators and investment firms have begun using AI to aid risk assessments, identify sustainable investments, assist in compliance and more, Gihan Hyde, CEO of ESG communications firm CommUnique, wrote in a blog for FinTech Futures.
“AI is revolutionising the way we think about ESG,” Hyde wrote. “By automating tasks, identifying patterns, and making predictions, AI is helping businesses to reduce their environmental impact, improve their social responsibility, and strengthen their governance.”
The Thomas Reuters Institute cautions companies and investors looking to use AI in their workflows to remember the importance of trust when implementing the technology, recommending companies first have clear guidelines on when and how AI is used, clear disclosures of when AI is being utilized and approach implementation from a “human-centric” perspective.
Investment firms grow more weary of ESG
While a record number of ESG proposals have come before shareholders this year, approval rates are falling, according to Diligent Market Intelligence.
By June, companies already voted on more environmental and social proposals than they had in all of 2022, but with less approvals than the year before. Vanguard and BlackRock, the nation’s two largest asset management firms recently reported similar results, attributing the dip to the overly prescriptive nature of the proposals they were presented with.
The drop in approvals comes as ESG gets pulled into the political culture war. Dubbing ESG “woke investing,” multiple Republican legislators and politicians across the country have accused companies of prioritizing climate goals over investor returns. The House Financial Services Committee organized six hearings and a markup in July, dubbing it “ESG Month,” that yielded committee approval of a slate of bills that look to limit the SEC’s power to compel climate disclosures and change the proxy process. Committee Chair Patrick McHenry, R-N.C., said at the markup the bills would “combat the influence of ESG initiatives” in financial markets.
With Democrats in control of the Senate and White House, the bills have no chance of becoming law, and House Democrats have framed the attacks as anti-capitalist. However, many Republicans continue to push against ESG initiatives. Multiple Republican-led states have boycotted BlackRock for considering ESG factors in investments. Florida pulled $2 billion in assets, while Texas banned its financial institutions from doing business with the firm. State attorneys general have also targeted firms and climate alliances for considering ESG or having allied companies commit to driving down their emissions.
Several investment firms have shuttered their ESG funds this year amid heightened scrutiny in a highly politicized environment. BlackRock became the latest, when it closed a pair of ESG mutual funds in late September. The firm later opened two climate-specific funds — one focused on companies at varied stages of the net-zero transition and another tabbed to an index of companies aligned with Paris Climate Accords goals — but more ESG funds have closed this year than in the last three combined, according to ETF.com.
SEC broadens imprint over ESG
To streamline disclosure reporting and improve consistency, the Securities and Exchange Commission released a proposal in March 2022 mandating that companies describe on Form 10-K their levels of greenhouse gas emissions and strategy toward reducing climate risk, a move that was met with much criticism from some Republican lawmakers, industry organizations and dozens of state attorneys general.
The agency has twice postponed a final rule as it seeks to evaluate a record number of public comments. Though the SEC previously indicated its plans to release the climate risk disclosure rule in October, senior agency chairs have declined to set a formal completion date.
However, according to Rowen, the disclosure rule should not come as a shock to companies — especially those operating on a global level — as corporate sustainability reporting standards already exist in countries outside the U.S. The international standards could serve as a template. For example, the European Union’s Corporate Sustainability Reporting Directive, which went into effect in January, requires comprehensive and detailed disclosures from companies regarding their sustainability efforts. The rule also impacts U.S. companies with EU subsidiaries.
“The concern about greenwashing is real. I think that's just led to a lot of firms reviewing their own internal processes, making sure everything is buttoned up and ready for the utmost regulatory scrutiny.”
Associate director of sustainability research at Morningstar
“I think for a lot of us, we’ve been prepping for this for years and, candidly, feel pretty ready from a data disclosure standpoint,” Rowen said.
Separate from the disclosure rule, the SEC has initiated a crackdown on greenwashing to curb misleading ESG claims made by investment funds. The country’s leading financial regulator updated its 20-year-old “Names Rule” in September and will now require funds that use terms such as “growth,” “value” or refer to the incorporation of ESG factors to adopt 80% of its proposed investment policy, ensuring a fund’s portfolio matches the asset being advertised in its name.
“Such truth in advertising promotes fund integrity on behalf of fund advertisers,” SEC Chair Gary Gensler said in a statement.
The announcement was shortly followed by another move made by the SEC to curtail greenwashing claims: The agency collectively fined Deutsche Bank’s subsidiary DWS $25 million for “misstatements regarding its Environmental, Social and Governance (ESG) investment process” and anti-money laundering violations.
“The concern about greenwashing is real,” Stankiewicz said. “I think that's just led to a lot of firms reviewing their own internal processes, making sure everything is buttoned up and ready for the utmost regulatory scrutiny.”
Despite some pushback, there’s a broad move toward more ESG initiatives
Even with the politicization, SEC disclosure rules looming and a need for reporting clarity, businesses are still forging ahead with their ESG plans. According to a 2022 report by McKinsey & Company, organizations “across industries, geographies, and company sizes” have been allocating more resources toward improving their ESG performance.
Companies continued to invest in ESG last year in spite of recession fears, according to a September KPMG survey of 201 business executives at companies with over $1 billion in revenue which found 55% of respondents scaled up ESG practices. Twenty-six percent of respondents reported scaling back operations due to economic fears.
Companies reported a mixed financial impact of those investments, with a plurality — 32% — reporting ESG programs have a “negligible” impact, according to the KPMG survey. Larger companies are reporting greater benefits from implementing the practice, as 43% of respondents from businesses with more than 10,000 employees said that their company’s ESG program improves their financial performance.
“To truly be sustainable, ESG programs must be aligned with the business strategy, well-executed, and measured,” Rob Fisher, ESG head for KPMG’s U.S. operations, said in the report. “The fact is there are many levers by which ESG can add financial value, but that also requires deep enterprise-wide engagement to maximize the potential and gain a competitive edge.”
While companies work to integrate ESG into their operations, demand for ESG funds continues to rise. Sustainable investment funds yielded greater returns than traditional funds over the first half of 2023, according to an August report by Morgan Stanley’s Institute for Sustainable Investing. While increased interest rates contributed to ESG funds underperforming expectations in 2022, the funds saw a median return of 6.9% over 2023’s first six months while traditional funds yielded median returns of 3.8%, per the report.
Morgan Stanley also found the volume of assets in ESG funds is rising, with the $3.1 trillion invested in sustainable funds as of June 2023, representing nearly 8% of global assets under management. Investments in ESG funds are expected to comprise more than one-fifth of globally managed assets by 2026, a figure PriceWaterhouseCoopers estimates will be more than $33.9 trillion.