Environmental, Social and Governance thinks it’s an adjective but tries to be a noun. Jason Miklian and John E. Katsos explain why it means so much more. Or less.
Joe Biden issued the first veto of his presidency on March 20th. The bill wasn’t on guns, taxes, or other hot-button issues, but on Environmental, Social and Governance (ESG) investing. Biden vetoed an attempt by House Republicans to restrict ESG investing, as Speaker, Kevin McCarthy, said “It is clear that President Biden wants Wall Street to use your hard-earned money not to grow your savings, but to fund a far-left political agenda.”
Why has ESG become a political lightning rod? Largely because it has become one of the most common, yet divergently defined, concepts in business and management.
Originally conceptualised in 2005 as a way for companies to improve how they account for non-traditional risks, ESG today incorporates those understandings, but it has spread into a catchall for firms to show how they are “doing good” for employees, community, and society.
Most large firms have incorporated ESG principles, and some $18tn in global assets are now ESG-aligned. Meanwhile, many retail investors consider “ESG investing” as synonymous with impact investing or sustainable finance. And investing in ESG-marked products is now shorthand for investing in a socially-responsible manner.
This change is reflected in the proliferation of ESG research that attempts to measure the impact of this expansive new business-society link. We also see it in the public attention to ESG, as epitomised by several issues of The Economist and the US political debate on whether ESG represents responsible business management or simply woke virtue-signaling that needlessly injects politics into investment.
So what does this mean for the future of responsible investing?
We learned that definitional creep of ESG risks making it less measurable, less comparable, and perhaps ultimately less beneficial for the investment community.
To make sense of this evolving platform, and align the myriad perspectives of what ESG is and represents today, we collected, analysed, and categorised 1,000 definitions of ESG across the scholarly and investment landscape that emerged over 2012-2022. We learned that definitional creep of ESG risks making it less measurable, less comparable, and perhaps ultimately less beneficial for the investment community.
ESG was typically employed as a financial-mitigation measure as a way to expand understanding of business-society interactions, reduce risks and improve sustainable relationships with stakeholders. Yet, ESG’s evolving interpretations have rendered it increasingly intertwined with related terms across the corporate social responsibility, business ethics, and responsible/impact investing spaces, while others attempt to maintain a traditional risk and materiality focus.
As ESG has grown, its expanding conceptual playing field has created confusing rifts in the investment landscape. Recent ESG definitions describe it as:
- a framework to “help stakeholders understand how an organization is managing risks and opportunities related to environmental, social, and governance criteria”;
- a means “to evaluate companies and countries on how far advanced they are with sustainability,”
- a way to“consider environmental, social and governance factors alongside financial factors in the investment decision-making process,” or
- a measure “to capture all the non-financial risks and opportunities inherent to a company’s day to day activities.”
Definition creep like this often happens when a term leaps from niche realms into the mainstream. We’ve seen it before, in everything from the “el niño” weather phenomenon to isomorphism in sociology to the definition of schizophrenia. It leaves people free to use the old, or correct definitions of ESG, but unable to control how their outputs will be understood by most readers through the new interpretations.
ESG definition creep has been inflated steadily, especially by actors seeking to attract investors or others wanting to create positive social impact from their investments. And Russia’s invasion of Ukraine in 2022 has accelerated this towards bursting point. Yet, this understanding of ESG — as defined and employed by pro- and anti-ESG factions — is mis-aligned with ESG scoring and assessment frameworks.
There is a growing disconnect between ESG’s definitional founders, retail investors, business scholars, policymakers, and the public on what ESG should represent for business and society.
So there is a growing disconnect between ESG’s definitional founders, retail investors, business scholars, policymakers, and the public on what ESG should represent for business and society. This divergence has allowed bad-faith stakeholders to shop for definitions that serve their needs best, while exploiting the generally positive understanding of ESG. The resulting lack of standardisation and consistency makes it hard to make apples-to-apples comparisons across firms.
This disconnect risks rendering ESG irrelevant, as major assessment frameworks no longer define what most people think about when they think about ESG. We see it in the statements that firms make about ethical principles, and the lack of materiality of their values in ESG-branded activities. These statements also clash on ESG’s purpose and role in the business ecosystem. For example, is it a risk-reduction mechanism? Or a value-creation framework? Perhaps it’s an information generator for comparative advantage or an input for corporate decision-making. There again, maybe it’s an output to assess the impact of a firm upon society or an issue of ethics and norms. Maybe it’s none of the above. Or all of them.
This divergence has allowed bad-faith stakeholders to shop for definitions that serve their needs best while exploiting the generally positive understanding of ESG.
ESG as commonly understood in 2023 often incorporates ethical corporate decision-making. So ESG investing is “investing for good”, and ESG as an ethical activity has been baked into our investing consciousness.
This is due to investors’ desire to have more socially-responsible investment choices and fund marketers’ recognition of this desire.
At the same time investors want to to develop pitches that fuse ESG into:
- impact investing;
- the ease in which companies take generic ESG principles on board in annual reports to show positive social impact; and
- the creation of ESG scoring and assessment consultancies that have a material interest in promoting a more expansive version of the term to make their own products more essential.
In response, foundational ESG stakeholders are exasperated by what they see as a misuse of the term. Robert Eccles, Paul Watchman, Paul Clements-Hunt and other longtime ESG scholars often argue that ESG should be considered to be no more or less than the study of materiality/risk as an apolitical framework for helping businesses understand, measure, and respond to risks in our social world to ultimately improve the bottom line. As Eccles recently stated, “ESG isn’t woke: it’s capitalism.”
This approach, while understandable, downplays a commonplace perspective that was rare in management when ESG was coined: when a firm makes decisions that impact upon a society, it injects normative choices and ethical decision-making into corporate policy.
Politics, business, and society form a tripartite mechanism that cannot be disaggregated. In an era of hyper-polarisation, even benign ESG policies, such as increasing worker wages to create a more inclusive work environment, risk political weaponisation.
To ensure that ESG can still be a useful and actionable investment mechanism, our findings suggest that we need to engage with this new definitional paradigm, even if we disagree with it. We should increase transparency about which definitions we use, and most importantly stop overselling ESG as the solution to everything in business and society. If we can manage that, then ESG’s promise can take one more step closer to reality.