ESG, the portmanteau term for the assessment and management of Environmental, Social and Governance issues, has become the latest corporate ‘must-have’. Rating agencies and consultancies are developing ESG scores for clients, using a variety of algorithms. But as the MIT ‘Aggregate Confusion’ project found, companies could be in the top 5% on one ESG rating algorithm and the bottom 20% on another. And reputable firms like Shell find their ratings to be A from one rating agency and C+ from another. A recent issue of the Financial Times’s Responsible Investing supplement, FTfm, notes that “a lack of definitions and data is a sizeable obstacle to sustainable (ESG) investing”.
Many more organisations – from the EU to the World Economic Forum and others - are trying to provide a converged set of definitions and algorithms for ESG scores.
Our question is what are the resulting ESG scores useful for? Even if a definition is agreed upon and the push to provide ESG data is achieved, does a focus on improving ESG factors create value? Are there other tools that increase value better?
We start with clear and causal evidence from analysis of US firms that imposing long-term incentives on executives — in the form of long-term executive compensation — improves business performance. Long-term executive compensation includes restricted stocks, restricted stock options, and long-term incentive plans. Firms that adopted long-term compensation experienced a significant increase in their stock price. This stock price increase foreshadowed an increase in operating profits that materialised after two years. The reasons for these performance improvements were that firms made more investments in R&D and stakeholder engagement, particularly in employees and the natural environment.
It is not clear whether adding explicit long term incentives for executives would have such a significant effect in cultures outside the USA.
The same authors looked at the implications of integrating environmental and social performance criteria in executive compensation, again in US firms. They found that this does mitigate corporate short-termism and improves business performance: firms experience a significant increase in firm value, which foreshadows an increase in long-term operating profits. The findings suggest that the integration of environmental and social criteria directs management's attention to stakeholders that are less immediately salient but financially material to the firm in the long run.
From another direction: in 2007 Ethisphere started gathering and collating non-financial data alongside the financial results of those it judged most ethical. The 2021 Ethics Index was a list of 135 publicly traded companies, the ‘World’s Most Ethical Companies’. Scoring of companies is based on the Ethics and Compliance Program, which explores the culture of ethics, Corporate Citizenship and Responsibility, Governance, and Leadership, and Reputation. Ethisphere looks for companies to integrate ethics and values with corporate strategy; for organisations that encourage employees to speak up; for decisions to be transparent; to exercise social responsibility by looking for innovative ways to make a difference; and includes the safety of employees, equity, inclusion and social justice. It finds that the companies in their Index outperformed a comparable index of large-cap companies over the past five calendar years.
The research discussed above suggests that:
These three conclusions seem to span all private sector firms. They could also apply to the public sector, though they are not designed for that.
We then started to think specifically about the Environmental Impact factors of ESG. The focus on carbon zero and reduction in fossil fuel usage has moved to centre stage. Many new measures of environmental impact have been introduced, often sector-specific. So, for instance:
So firms’ Environmental Impact factors are dependent on sector specifics and would seem to be measurable separately from SG scores.
Bringing these trains of thought together to answer the question – if (when) ESG definitions and data collection were in place, would the resulting ESG scores help firms to create value?
The above analysis suggests that an organisational focus on improving ESG scores could lead to longer-term executive orientation, and hence to some of the benefits highlighted above. It also suggests that the environmental aspect of ESG is usefully separated from the social and governance factors. A focus on SG plus ethics, employee culture and social behaviour through long term executive orientation could have a more direct effect on value creation.
Maybe the famous quotation from General Eisenhower “plans are useless, but planning is essential” helps to explain what we seem to be observing with ESG. So, ESG scores are a fad, the value creation comes from the process of creating them.
Gill Ringland and Patricia Lustig