The Growth of ESG – Lexology
A few years ago, I suspect that very few people would have understood what ESG meant and those who probably saw it as an esoteric sub-group of fringe interest. Recently there has been an explosion of awareness and this has moved into mainstream consciousness but there is still a lack of understanding and a long way to go before there is a universally accepted frame of reference .
Even for those who know that ESG is an acronym for Environment, Social and Governance, there is a lot of subjectivity in how the term is understood. It works as an umbrella term for many close relatives, including sustainable investing, socially responsible investing, impact investing, social impact investing, ethical investing, and even conscious capital, which each have their own nuances but are united by the common thread of embracing an approach that goes beyond the traditional “bottom line” of shareholder returns.
Steve Denning, writing for Forbes notes that Milton Friedman, the darling of late 20th century capitalism and winner of the 1976 Nobel Prize in economics, is widely credited with cementing the idea that the sole purpose of business is to make money for its shareholders. For him, the free market would be self-regulating, and bureaucracy, red tape, or factoring anything other than price into the business process would simply render the process inefficient and reduce the pot of money available to shareholders. As Denning notes, the views expressed by Friedman in the early 1970s paved the way for the era of Reagan, Thatcher and free-market opportunism, and a depiction of Wall Street in the 1980s as a world where greed was praised. 
It was in this world of extreme capitalism that Jack Welch, who had become General Electric‘s (GE) youngest president and CEO in 1981, led the organization (according to its website) from a market capitalization of approximately US$12 billion to over US$400 billion in when he retired in 2001. Yet in a 2009 interview with the FinancialTimesJack Welch said, “On the face of it, shareholder value is the dumbest idea in the world.”
This is in line with a broader realization that the way this “shareholder value” mentality was implemented was not sustainable beyond a short investment horizon.
At the risk of oversimplifying, if you think of a bay where a hundred fish are caught every day, many years ago there would have been no way of knowing when there would start to be a decline in fish populations. And often that wouldn’t have mattered because the bounty of the sea was enough to provide everything mankind needed. But as the human population has grown and fishing methods have become brutally efficient, it has become increasingly clear that fishing companies need to consider the natural capital aspects of their operations. The fishing industry in the bay needs to understand what is sustainable and may have to choose between 100 fish a day for three years followed by nothing when stocks are depleted or 25 fish a day for an indefinite period.
In the Channel Islands, the work of the Pensions Sub-Committee of the Guernsey Green Forum – an informal association of Bailliage employers – recently identified that there are billions of pounds in Guernsey’s pension pots that could be pushed into more ESG-focused investments simply by offering contributors the opportunity to choose their own investment plans. How many people reading this article will know where their retirement contributions are invested? How many would be comfortable knowing that their funds are invested in tobacco companies? How many readers will make a note to go check their personal pensions after reading this article?
Pension plan trustees need to keep their finger on the pulse, to feel the mood of contributors who are increasingly interested in understanding where their pension funds are invested and who, anecdotally, seem increasingly willing to accept lower returns in exchange for a higher threshold in ESG issues.
What is ESG?
As already noted, there are many theories around the meaning of ESG, but what unites them is that they can all be placed as a counterpoint to capitalist theory in its purest form. It may be helpful to think of the different subgroup terms as part of a spectrum. At one end is impact investing, which because it focuses on an altruistic outcome (e.g. improving living standards or improving gender equality) rather than research maximum financial return, may look more like a charitable gift than an investment in the conventional sense. word. At the other end of the spectrum, there are categories like sustainable investing, which might still have financial returns as a guiding principle, but leave more room for negotiation in implementation. Investors might be willing to limit the investment opportunities available to them by restricting the investments they are willing to select. It may also involve being happy to accept less performance in exchange for greater ethical responsibility.
In a world where options are growing exponentially, blended solutions can also be appealing to those who want to grow their money without necessarily just wanting to give it to charity. This is especially the case for those who can sit in the patient capital category. A tobacco farmer may wish to stop growing tobacco for ethical reasons, but may be prevented from taking risks with their business model by being tied down by long-term contracts or having families dependent on their existing farming operations. It also might not be able to persuade a traditional lending bank to fund a transition to an alternative business culture that could take a decade to implement and have no guarantee of success.
This might suit a private wealth investor who wants to contribute to such a transition and who can take a long-term view. A few years of impact investing (which seems very close to outright giving) could be followed by a few years of low returns, followed by arm’s length investing.
Such a high-risk approach might not work for a pension trustee unless the trustees were given a specific mandate to do so by contributors, but it might work if the pension fund owned a tobacco farm that he wanted to pass.
Ultimately, it depends on the circumstances, but ESG can align well with pension funds and family offices, both of which have long-term investment horizons.
You may have noticed that in the title I only referred to ‘ESG’ and not ‘investing’ – although the two are often linked. I think it’s important to note that this is not just a business undertaken on behalf of customers, but a way of life, a system and an approach. Trustees will want to demonstrate that they lead by example if they are to attract the growing number of clients with ESG objectives. They will also need to do so to attract new talent in a world where employees are increasingly informed and selective about which employers they are willing to work for.
Why is the ESG increasing?
There is a real convergence of influences behind the rise of ESG.
Technology is improving all the time. This increases the possibilities in almost every aspect. This means transaction costs can be reduced, crowdfunding and the like become possible without the need for high entry thresholds, reporting and monitoring become more sophisticated, cheaper and easier to deploy; and blockchain can be used to monitor the integrity of supply chains.
The demand is increasing. As the public becomes more aware of the magnitude of the negative impact of human behavior on the environment and the impending point of no return increases, more and more people are thinking carefully about how how their life contributes to the overall picture and how small changes can bring about incremental changes. And while the environmental ‘E’ tends to overshadow the ‘S’ and the ‘G’, we should not forget the importance of the other two strands and that there are often unexpected crossovers; the education of women, for example, is one of the greatest contributions that can be made in the fight against climate change.
However, the deciding factor – and the main reason why ESG will eventually continue to grow exponentially – is the growing body of evidence that investments with good ESG credentials tend to outperform those with less impressive ESG credentials when challenged. measured over a longer-term investment horizon. If it makes business sense, it will be here to stay, and the biggest mid-term challenge will be sorting out the real ESG credentials from the bluster and misrepresentation.
When Jack Welch said, “At first glance, shareholder value is the dumbest idea in the world,” he went on to say, “Shareholder value is an outcome, not a strategy…your key constituencies are your employees, your customers and your products .”
When you take care of all these components, the ESG business case is written. And when there’s a business case, you cook with (insert non-fossil fuel solution of your choice).
An original version of this article was first published by IFC reviewApril 2022.