Why we have no choice but to measure ESG

By Dr Rebecca Harding

At the beginning of 2022, Environment, Social and Governance (ESG) funds were hot. Money and investment were pouring in. Against a backdrop of Covid, inflationary pressures and uncertainty around global (especially the US) interest rates, investing in ESG looked good – “far more than a short-term fad”. However, regulatory raids on Deutsche Bank’s investment arm, DWS, for greenwashing, a contrarian speech by Stuart Kirk questioning ESG as a valuable investment tool, and some critical press on the subject later, is now the moment to call time on ESG?

The shortest and most polite answer to this question is a resolute ‘no’. We have no option but to transition away from where we are now to include the ESG that the investment community seems to reject.

But the key to this will be an effective and appropriate measuring tool to avoid the greenwash emerging regulatory frameworks are seeking to clamp down. Suppose we are to transition to a model where business, finance and economic activity is sustainable in every sense. In that case, we need to be able to set a baseline and measure our progress against it without imposing developed world imperatives on an emerging world that has, almost by definition, a quite different starting point and perspective on the challenges ahead.

And to do this, the advocates of ESG need to take on board the criticisms of the whole movement. These are best summarised by The Economist in its Special Report on ESG Investing as follows:

  1. There is a lot of “sanctimoniousness” in the ESG debate, and people cannot be held to account for well-meaning intentions that are ultimately unmeasurable.
  2. The wake-up call of heatwaves this summer have provided an imperative to act on climate change by “addressing the problem at source” through market mechanisms that encourage “green” innovations.
  3. Regulation helps, but the regulators have not defined what is to be measured, especially in the “S” and the “G” space tightly and this leaves huge challenges both for implementation and enforcement, inevitably increasing the risk of greenwash.
  4. The concept of ESG in investment is “deeply flawed from a regulatory and a measurement point of view. Regulatory pressures are spawning a ratings industry with divergent, “subjective” and “confusing” measurements, which mean that the industry “over-promises and under-delivers…the ESG rating agencies are the veritable acme of inconsistency,” argues the article.
  5. All of this, concludes the Special Report, is that “ESG has too often been neither a good measurement tool nor an effective risk-management one.” The answer is to measure less, particularly excluding the “S” and the “G” and “do it better”.

On this reckoning, the sector is full of fluffy aspirations and good intentions that cannot be measured sufficiently well for investment or taxation purposes to be meaningful. So the Economist advocates that we stop trying to measure the impossible and just measure what we can. The regulatory framework for this more limited scope is achievable, and the market can do the rest.

The only way to argue with this type of economic reductionism is to address it head-on. The Economist is right – measurement is difficult, and at present, many things cannot be measured consistently or meaningfully. This makes the industry reliant on the self-reporting of businesses who will always be interested in “gaming” (or artificially improving) their responses because they will potentially get preferential terms on finance or investment. The rating agencies diverge in their scoring mechanisms so they can arbitrage the imperfect information out there. The Economist, of all publications, should be aware of how this creates market advantage.

But just because something is ripe for the “too difficult” box doesn’t mean it shouldn’t be done. The Economist rightly identifies that there are weaknesses in how we define and measure the separate components of ESG and is absolutely correct to suggest that the UN’s Sustainable Development Goals (SDGs) are at best vague and at worst contributing to a sense that we are doing something when in actual fact, we are simply restating the problem, but with the appearance of action.

So, rather than starting with what we can’t measure and cannot define, let’s start with what we can. Every business buys or sells a product or service somewhere in the world. The UN has used the non-tariff barrier framework internationally to map these products to SDGs. This same exercise, conducted by Coriolis Technologies, can be applied to services using their HS code categorization within international trade according to their negative or positive contribution. By breaking this into the separate ‘E’, ‘S’, and ‘G’ components of each SDG, 85% of all products and 100% of all services can be allocated and measured.

Similarly, because the emerging sustainability taxonomies, such as the EU Taxonomy, use sectors and activities, the products or services can be aggregated into sectors that match these emerging regulations. The OECD provides a product category-based framework for Greenhouse Gas (GHG) emissions that begins the process of measuring GHG within value chains.

The Economist points to emerging satellite data and argues that it is potentially a way to create better measurements for environmental progress but less so for the ‘S’ and the ‘G’. But other data sources exist, and by integrating company asset data globally with reliable and consistent news feed data, Coriolis Technologies can geolocate and measure adverse news stories over all aspects of E, S and G. This reduces the reliance on self-reporting as satellite data becomes more comprehensive in its capacity to measure, for example, human rights violations on a geospatial basis.

This is only the beginning of the process of measuring ESG, and there is a lot of work to do. There are few ways to over-state the problem: it is a little short of an attempt to measure economic, trade and financial activity in terms of its contribution to planetary welfare – which arguably includes economic growth and development in an effort to make that activity sustainable.

Simon Kuznets, the Chief Statistician of the US War Production Board, is credited with creating the mechanisms to measure national income quantitatively. He started work to develop the measure of national income, or GDP, to explain how long-term economic trends developed over time and how wartime economies differ in terms of planning and structure from peacetime ones in the 1920s. He had his sceptics at the time, and to this day, economists argue about whether or not GDP is the appropriate metric for economic growth given the other challenges that the world faces. However, the need to measure economic activity quantitatively is not disputed; it is the principle way of explaining, comparing and creating policy tools to improve economic activity.

Now, our challenge is to make that economic activity sustainable – for people, the planet, and our long-term security. There is nothing idealistic about this – it is pure pragmatism based on necessity – for regulatory reasons in the first instance, but also because it is the right thing to do if we want to understand how economic activity needs to change. In a world of Big Data and technology, saying something cannot, or should not, be measured is complacent, inexcusable and irresponsible, even if the journey is long.

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