Chapter 1
What Is ESG and Why Should I Care?
What Is ESG?
Board members and c-suite executives are rapidly becoming aware of ESG as an integrated way of looking at corporate life rather than in separate streams. Many donât yet fully understand ESG, how it affects their strategy and reporting at the board level, or its comprehensiveness and impacts.
ESG refers to environment, social, and governance when measuring the sustainability and ethical impact of an investment in a business or company.
It is a generic term that is used primarily in capital markets where it originated. Investors commonly use ESG to evaluate the behavior of companies and determine an organizationâs future performance and thus their worthâtheir value. It covers the three main factors that socially responsible investors measure when deciding whether to invest in a company.
ESG makes sense because a responsible company that cares about its people, customers, and the environment is more likely to outperform its peers and be successful and resilient than one that does not. An ESG-based approach is more than just a way of attracting and retaining capital. It is much broader. At its core, embracing ESG is about doing the right thing.
ESG extends to organizations beyond those that are publicly traded. Any type of organization can benefit from an understanding and application of ESG. Donors, employees, and other stakeholders too consider ESG factors when deciding whether to donate, work for, or otherwise become engaged with an organization.
The E in ESG, or environmental criteria, includes the energy an organization takes in, the waste it discharges, the resources it needs, and the consequences for the planet and living beings as a result of an organizationâs activities. It encompasses issues such as carbon emissions and climate change. These are the best-known examples of the E of ESG. Every organization, from the sole proprietorship to the corporate giant, uses energy and resources. Every company affects, and is affected by, the environment. Consideration of ESG is not just for companies that are in oil and gas, energy, or extraction. We all have an environmental footprint, and there is something that all of us can do to improve our interactions with the environment.
The S in ESG, or social criteria, addresses the relationships an organization has and the reputation it fosters with people and institutions in the communities where it does business. Social criteria include elements like labor relations, diversity, equity, and inclusion. Every organization operates within a broader, diverse society. We call that social license or social contract. A social contract is a covenant. Without earning the social license to operate, a business will not reach its full potential. In a worst-case scenario, an organization will be prevented from moving forward if its leaders and employees abuse their relationship with a stakeholder.
The G in ESG, or governance criteria, is the system of direction and control of the organization. Governance criteria go further to include the operating system of practices, controls, policies, and procedures your company adopts to govern itselfâto make effective decisions. It includes ethics, transparency, and going beyond complying with the letter of governing laws to fulfilling the spirit of them. Governance includes what is sometimes called citizenship: meeting the needs, expectations, and aspirations of external stakeholders and the public. Every organization requires governance, and the better an operation is governed, the more investment it will attract and the higher it will perform.
That is ESG 101!
Hereâs a real-world example to illustrate:
Letâs talk about Tesla Inc. Many people, when they hear the word Tesla, think of electric cars. They think, âGood for the environment.â They think, âTesla must be a company that is an ESG company.â They think, âTesla must be a good company and therefore must be good to invest in.â But is it? How does it stack up to ESG criteria?
MSCI is a company that assesses and provides ESG ratings for companies around the world so that investors can make informed investing choices. MSCI rated the electric vehicle producer, Tesla Inc., and this is what they found:
The company earns an overall grade of âA,â putting it on the higher end of âaverageâ among the 39 companies in the car industry rated by MSCI. Digging into its rating, Tesla excels in corporate governance and environmental risks, maintaining a relatively small carbon footprint and both utilizing and investing in green technologies. The company scores an average grade for product quality and safety, with the company making headlines in the past for exploding batteries, undesirable crash test ratings, and accidents involving the carsâ self-driving âautopilotâ featureâalthough CEO Elon Musk has publicly announced a commitment to improving both driver and bystander safety. What truly drags down Teslaâs MSCI ESG rating is its below-average score for labor management practices. Tesla, for instance, has been found to be in violation of labor laws by blocking unionization, and it has violated the National Labor Relations Act multiple times. More recently, the companyâs leadership has come under fire for keeping plants open and unsafe during the COVID-19 pandemic, leading several of its workers to come down with the illness.2
So, according to this rating agency, Tesla rates well in the E and the G of ESG but loses important points in the Sâthe social criteria.
Sustainalytics, another influential rating organization, places Tesla in the high-risk category for investing in based on its ESG rating.
Compared to Fiat Chrysler, Honda, and Toyota, Tesla is a higher-risk investment based on its ESG ratings. In fact, Tesla ties with Ford as the riskiest ESG-based investments in the auto sector.
As we know, ESG has three streams; environment, social, and governance flow together when people decide whether to invest in a company or not. The view of several investor voices is that if a company fails the test on any of the three streams, it would not be considered an ESG investment. Therefore, some say3 that Tesla is not an ESG investment because it does not pass on all three ESG streams.
One financial commentator echoes the thoughts of other internet bloggers that Tesla doesnât actually pass on the governance pillar either, based on independenceâor lack thereofâof board members and on Elon Muskâs compensation arrangements, which are not only significant but also not aligned with corporate results.
Companies cannot ignore the bloggers! Some rating organizations like Bloomberg and MSCI include metrics for social news sentiment scores. These organizations track news feeds daily for stories on companiesâ environmental and social behavior.
Tesla has skated along for some time on its reputation for putting the environment first, but its weak governance and what some call âhorrid treatment of workersâ4 keeps it in the news for all the wrong reasons.
The point is this: when investors must make a choice between a leading, average, or lagging ESG-rated company, they will choose the leader every time.
Hereâs another illustration. When many people hear âBP Oil,â they think of oil. They think, âBad for the environment.â They remember the Deepwater Horizon oil spill in the Gulf of Mexico, which began in April of 2010. They think, âBP Oil must be a company that is not an ESG company.â They think, âBP Oil must be a bad company and therefore not good to invest in.â But is it? How does BP Oil stack up to ESG criteria?
Turns out BP Oil is an ESG company. In fact, it rates strongly in all three categories: environment, social, and governance.
BP Oilâs 2009 sustainability report was a typical communications piece. It is well-written. It positions the company as operating at the edge of the energy frontier and talks about how a revitalized BP is âdriving innovative, efficient and responsible operations.â5 The report was barely posted on their website when the Deepwater Horizon disaster happened.
Fast forward to 2021. BPâs 2021 sustainability report is night-and-day different from the 2009 report. The 2021 report is one hundred pages of full disclosure. It tells the reader not only what BP Oil wants people to know but also exactly how the company rates in multiple areas. The report is accompanied by a comprehensive datasheet of all their environmental metrics, and their website allows the public to drill into excel sheets to see what underlies the rolled-up information. Regardless of your thoughts on fossil fuels, there is no doubt that there has been a sea change at BP Oil, and it is serious about ESG.
The bottom line of these two stories is that Tesla is not considered an ESG company, but BP Oil is!
What Are the Drivers of ESG? Why Are We in the ESG Era?
Letâs talk history. Over the last two decades, the following three streams have converged:
The first stream is the onset of environmentalism driven by both the science (for example, the impacts of climate change itself) and the voices of corporate and individual activists. Organizations (e.g., the United Nations and Greenpeace), political parties, individuals such as Al Gore, a plethora of celebrities, and of course the latest and perhaps loudest voice, Greta Thunberg, leading a force of student activities, have all worked to increase awareness of environmental issues. These examples barely scratch the surface of the voices calling out to protect our planet. Climate change protests have become a common occurrence and a driving force for action. The driver is of course the planet and human life itself. Collectively we only have one planet. Individually we only have one life. These facts are the true drivers of the environmentalist movementâthe groans of the planet and the realization of individuals that if we donât act, who will?
The second stream began with socially responsible investing (SRI) and was set off by a few niche players in the investment world, including union activists lobbying investors to do SRI. Faith-based organizations began calling for ethical and altruistic investment options. For example, SRI might mean not investing in companies that produce alcohol or tobacco or companies that produce morally questionable products. Or it could mean only investing in companies that have a proven track record of social responsibility and community investment.
Individual investors became increasingly frustrated at low returns on their retirement funds while a few individuals at the top were reaping...