Tompkins Weekly     9-13-23

By Betsy Keokosky

There is a sustainable investment development gaining momentum recently that is worth keeping an eye on.  It is the practice of analyzing a company’s environmental, social and governance (ESG) risks, and assessing opportunities for improving them.  Here, Governance means the internal governance of the company itself in areas such as diversity, transparency, accurate disclosure, and ethical decision making.  It is driven by investors and increasing recognition from the financial community that climate change, disruptive technology, supply chains, and the social and environmental health of the planet are all related economic risk factors.  Good governance is recognized as the best way to navigate these changes.

How does this new investing development affect the current business model –  the prioritization of short-term shareholder profits?  This model has been dominant since the 1970s and the late 1980s shift to the current global economy.  Under its influence, CEO pay has skyrocketed, and income and wealth disparities have deepened and contributed to the polarization of our country.  Our dependence on cheap fossil fuels has extracted a terrible toll on the health of the planet, and all its inhabitants.

Elizabeth Keokosky. Photo provided.

There has been pushback against these economic imperatives. Both the B Corp certification and the corporate social responsibility (CSR) initiatives have recognized high standards of social and environmental business performance.  But overall, neither investors, nor the investment companies they trade with, have paid much attention to the environmental and social effects of the companies, whose stocks they exchange.  The main decision factors have been economic performance and risk.  That has been changing.  Or rather, what is regarded as risk has been changing.

This is evidenced in the roots of the term ESG in the sustainable development goals promoted by the UN.  It was first used in a 2004 report entitled “Who Cares Wins: Connecting Financial Markets to a Changing World.” Professor Elizabeth Pollman, who writes about corporate law, traces it back to the formation of the UN Global Compact.  She writes ““This report is the result of a joint effort of financial institutions which were invited by United Nations Secretary-General Kofi Annan to develop guidelines and recommendations on how to better integrate environmental, social and governance issues in asset management, securities brokerage services and associated research functions.”

Again, in 2005, at the behest of the UN, two groups enlarged these ideas.  One, the UN-PRI,  which consisted of investment and environmental experts, encouraged investors to be responsible and proactive in enhancing the effectiveness of ESG progress. Another group from Freshfields, a leading global law firm, suggested that financial trustees should include environmental and social consideration in their analysis of companies.

New disclosure standards and principles articulated in the next decades kept increasing momentum.  In 2000 Paul Dickinson, a Trustee of the Scottish Findhorn Foundation, co-founded The Carbon Disclosure Project (CDP).  Beginning with 35 investors, 23 years later it included investors with more than $136 trillion in assets.  In 2009 CDP started reporting the company’s efforts not only with carbon, water security, later adding water security, deforestation and some other agricultural products.  It has since become the global, gold standard disclosure system for investors, companies, cities, states, and regions to manage their environmental impacts

In 2020 The World Economic Forum published the Davos Manifesto as a set of ethical principles to guide companies through the Fourth Industrial Revolution. The document expressed the need for companies to serve all stakeholders, with an emphasis on companies treating people with dignity and respect, integrating human rights into the supply chain, paying their fair share of taxes and achieving ESG objectives.

Growth and Contributions of Pension Funds

P. Brett Hammond, a member of the Pension Research Council’s advisory board, noted the contribution of pension funds to ESG principles. Large shifts in ESG investing occurred only after institutions with substantial asset pools exerted their influence, Hammond pointed out. As of 2020, U.S. pension funds managed $6.2 trillion of total assets incorporating ESG principles.

Fiona Reynolds, former CEO of AIST (Australian Institute of Superannuation Trustees) and long time CEO of the UN-PRI, explained the relationship of pensions to sustainable investing this way (edited for clarity): “Asset owners around the world were getting bigger and stronger because people poured money every month into their pension funds assets under their management.  With this growth asset managers became more influential and had different expectations because they’re not just managing money for day trading. Their management had a long-time horizon.  This meant they started asking more questions of businesses, started becoming more sophisticated, and began demanding more answers.”

Now the New York State Common Retirement Fund, one of the largest public pension plans in the United States, has set 2040 as its goal to transition its portfolio to a net zero greenhouse gas emissions. “With $226 billion in assets, New York’s fund wields clout with other retirement funds and its decision to divest from fossil fuels could accelerate a broader shift in global markets away from oil and gas companies,” a New York Times report said.

Data Collection, Scoring, and Standardization

If you are a business, putting an ESG report together is not trivial.  It depends on choosing an ESG framework which requires a thorough analysis of your business, your supply chains, and your pertinent sustainability goals and how you can use the scores to improve your business – and, hopefully, hiring or contracting with someone who understands ESG frameworks. The framework determines what data is collected, how it’s analyzed, how scores are created and a multitude of other things.

ESG is becoming mainstream, but it is not mature. There is disagreement on standardization. Some would just like to throw ESG out.  Yet a team of researchers at the MIT Sloan Sustainability Initiative  argue that too much good would be lost and that ESG, however flawed, is currently the best way to measure the ethical behavior of companies, especially with greater transparency.  Standardization at this point “would set in stone an imperfect measure, prone to be manipulated by firms and disincentivizing all research for further improvements,” they write.   Instead, they advocate for an approach that holds ESG ratings to a higher standard.

Potential limitations and issues with ESG scores

As reported by TechTarget, there are a series of potential limitations and issues with ESG scores that individuals, organizations and investors should be aware of.

• Lack of standardization makes comparisons across different scoring methodologies difficult and can potentially lead to an organization getting a higher score on one vendor scoring mechanism than another.
• Self-reported data.  Without the validation of a third-party auditor, there’s a risk the data can be subjective, skewed in some way and potentially inaccurate.
• Greenwashing.  Organizations make green claims that can potentially influence a score without making a material impact on the environment.
• Transparency.  While there’s a general understanding of how the scores are calculated, few if any firms provide full transparency into the calculations.
• Scope.  An ESG score might not reflect the scope or comprehensiveness to cover everything that might be applicable to a complete ESG picture.

Compared to Europe and Asia, the US has been late catching up on ESG investing.  The disclosure rules of the US Securities and Exchange Commission, which regulates ESG rules and investing, are not stringent enough for some but are still vulnerable to legal challenges from others.  This is all still evolving.  Perhaps the MIT Sustainability people have it right – rather than reject an incredibly encouraging development because it doesn’t meet environmentalist standards of perfection, they should be doing everything they can to encourage it, shape it, regulate it, and shepherd it into the model they envision.   This could be a game changer, and a win-win situation for businesses, consumers, and the planet.

Elizabeth Keokosky is a long-time gardener who lives in Danby in a stone house built by her husband. She worked in computing at Cornell University and started a nonprofit cooperative utilizing biomass for energy after a late-in-life degree in Regional Economics at Cornell’s City and Regional Planning. She is now secretary to the Conservation Advisory Council in Danby, has two grown-up children, attends Quaker meetings and tries to make her way through the various contradictory perspectives of modern life.