Do investors score an own goal with ESG?
16 August 2023

My question has no malicious intent. I understand why investors turn ESG risks into a set of data points to feed their algorithms. I believe many investors want to take environmental and social issues more seriously. They understand risk better than most of us. And, like me, many have kids who are holding them to account.

The world committed to sustainable development more than 50 years ago, and the trends – with very few exceptions – are still accelerating in the wrong direction. The main reason we are doing so badly is because sustainability challenges are complex. That is why they became ‘sustainability challenges’ in the first place. Investors may think that that their entry into this space is going to make all the difference. Hubris is often a component, but every own goal is achieved through a combination of factors.

Investors select ESG data points to inform their decisions. A model is a partial truth and, in this case, this partial truth is a practical necessity for harmonising investor ESG expectations that teetered on the edge of chaos a year or two ago. There will be blindspots. These don’t necessarily yield own goals if we place our defenders well. Smart investors have scouts posted to feed them more nuanced and contextual insight on:

  • Relationships between the atomised issues listed on their scorecards (this is imperative when the risk is systemic)
  • The fact that historical data and assumptions (upon which their models are based) are likely to fail when it really counts.

There are no easy ways around either of these problems, but I don’t think that many investors confuse their data set for the truth.

Nope. The thing about own goals is that it’s always the other guy.

In this case, the other guy is the executives of the companies in their investment portfolios. While financial accounting has not changed much since double-entry accounting appeared 500 years ago, ESG accounting exploded in the past few years. Executives – generally busy people – are overwhelmed despite sincere attempts of ESG investors to harmonise their expectations. Like the investors, corporate executives delegate to professional ESG disclosure teams (can you hear the money bells a-ringing?) and overlook the obvious: effective ESG disclosure requires effective consideration of material ESG aspects beforehand.

A moment of reflection confirms Exco’s worst nightmare: virtually any decision, taken by anyone anywhere in the organisation might be improved by consideration of material ESG aspects. A new smart logistics initiative? What are the implications for carbon emissions? What are the implications for employing more black women? What are the implications for engaging more small businesses in the supply chain? The implications might be positive, negative or non-existent. We are not sure at all, but investors are telling us that it matters. Worse still: progress on ESG integration is not easy to measure. Managing ESG risks better should mean fewer incidents of ESG-related failure. But the system is full of incentives to make employees better at hiding early indicators of failure and Exco is none the wiser, until they’re fighting fires on all fronts. The undoubtedly complex task of ESG integration vies for attention with many other equally complex tasks. Then the executives’ eyes land on an onerous but ultimately simple investor framework for ESG disclosure. E-S-G. They are tempted to override their executive intuition: this problem might be more straightforward after all.

It is a fatal error. In pursuit of two birds with one stone, standardised disclosure expectations double-up as a strategic decision-making framework. A standardised approach is necessary for investors who seek comparability. While it is suitable for some ESG decisions (such as complying with labour standards or emissions regulations), it may obscure opportunities for the organisation to differentiate its performance based on its ESG response. At that point, it acts as an unintended brake on innovation. Even within the same sector, different companies find different ways to innovate to address ESG challenges because they have different capabilities and operate within different contexts. The best tool in this situation, undoubtedly, is Cynefin: a decision-making framework that makes the difference between complex and complicated as simple as possible. There’s no way round complexity, and getting to grips with what it means in advance of your peers is a good idea.

The other thing about own goals is that it’s a bad metaphor when there is no opposing team.

Getting ESG right is about Team Human. If we don’t do it together, we will all lose.


Banner photo by ÁLVARO MENDOZA on Unsplash

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