ESG' is not just another arbitrary three-lettered acronym that one can forget about so easily. Each of the three letters stands for "environmental," "social" and "governance," three very different and increasingly significant aspects to consider while analyzing the DNA of a particular company. While still relatively premature in its development of definition, integration, and application, ESG criteria assess a company's performance in regard to environmental, social, and governance concerns. Environmental concerns could be something such as climate change, natural resource depletion, pollution, and waste. Social concerns consist of issues regarding human capital, social opportunities, stakeholder opposition, and product liability. Finally, governing concerns consist of questions of corporate governance and behavior, which, until more recent history, haven't been explicitly expressed and therefore monetized. This paper seeks to discuss the grammar of ESG, discover how firms are responding to the growth in its popularity, and speculate about the future endeavors and practices that will come to define more clearly what it means to perform well from an ESG standpoint. 

ESG, or at the very least the conception of it, has been around for decades. “The practice of ESG investing began in the 1960s as socially responsible investing, with investors excluding stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement in the South African apartheid regime" (The Evolution of ESG Investing 2022).  While it started as simply implementing socially responsible investment strategies, it soon metastasized, and now seems to find its way into various other sectors of a company's DNA and, consequently, its functionality. The reasoning for the growth of ESG is rather intuitive and can be explained by a change in consumer base and behavior. Simply put, the world is changing, and so is the generation of investors (ESG 101: What Is Environmental, Social and Governance? 2022). As social justice controversies are ever-prevalent, corporations too are seeking to adopt the most "politically correct" optics they deem fit. As of late, that can manifest itself as certain firms refraining from investing in certain energy sectors such as crude oil and natural gas or even abstaining from investing in tobacco companies, despite their continued success in the market. I choose to put "politically correct" in quotations because, as we may see, many companies participate in a practice called "greenwashing" that undermines the noble and genuine motivations of ESG initiatives to create a particular false image for the public and investors. Nonetheless, ESG has grown to be big business and shows no signs of slowing. “Today, ESG investing is estimated at over $20 trillion in AUM or around a quarter of all professionally managed assets around the world…” (Kell 2021). So, even if certain investors aren't totally convinced about the profitability of certain ESG initiatives, $20 trillion AUM is too large of a number to possibly ignore. Better yet, this fact may serve as a forecasting element as we see the ESG sector continue to grow. 

As I write this, it shouldn't be considered hyperbole to say that the US and world economies are in shambles. The environment, too, is deteriorating. That said, companies and investors find themselves at a bit of a crossroads: do they maximize value or welfare in the construction of their own or their client's portfolio? Investing in a company such as Exxon, for example, will yield higher returns than investing in particular renewable energy companies, but it certainly isn't helping the environment bounce back from all the horrors we've committed in the name of "progress." Wharton Finance Professor Luke Taylor says "companies should not be maximizing shareholder value. They should be maximizing shareholder welfare" (Wharton Magazine 2022).  This notion explicitly favors previous notions of ESG, but other financial moguls disagree. Tesla's Elon Musk tweeted, "ESG is a scam. It has been weaponized by phony social justice warriors" (Musk 2022).  It can be seen here that even some of the world's top professors and businessmen/women disagree on ESG, or at the very least the motivations that propel it forward. This, to me, is exciting. If ESG becomes stapled into the jargon of businessmen and women, CEOs, and regular investors, the ‘grey area’ currently embedded within these words will undoubtedly become more black-and-white. State Street, for example, the world's largest custodian bank, released a 224-page 2021 ESG report outlining how they're there "to help create better outcomes for the world's investors and the people they serve" (State Street Corporation 2022). All of the world's biggest banks are placing a growing significance on ESG as they offer customized portfolio construction, ESG investment solutions, and sustainable climate bond funds while still striving to fight against gender normativity and male dominance in the workplace, as well as achieve equitable racial representation. In 2017, State Street launched the "Fearless Girl" campaign to ignite a conversation about the importance of gender diversity in corporate leadership. “Now, every company in the S&P 500 has at least one woman on its board." (State Street Corporation 2022, 26). Additionally, they have expressed taking action against directors if they don't improve their representation of people of color on their respective boards. “In the 2022 proxy season, we will take voting action against responsible directors if, first, the boards of companies in the S&P 500 and FTSE 100 do not have a person of color, and, second, S&P 500 companies do not disclose their EE0-1 reports" (State Street Corporation 2022, 27). State Street, and many other large world banks (amongst other business sectors), are striving to define, implement, practice, and prove their ESG initiatives to boost their social capital and yield more sustainable results.

The question then becomes, how will companies be entering this ESG space? 

Gathering data presents one of the largest challenges when it comes to the analysis of ESG. How do data scientists know what is to be considered "ESG-related or not?". The definition is, to some extent, new and ever-changing. Something one person considers related to ESG may not be in the definition of ESG for another, and therefore a conflict arises. What we see is not a conflict between two people disagreeing on definitions, but incongruence on what to quantify and how to do it. More specifically, one reason why a particular company's performance in ESG is hard to quantify is due to the lack of data analytics that currently exists. As previously mentioned, because this area is relatively underdeveloped, there exists little data from which meaningful conclusions can be derived. As a result, industry and investor sentiment is often both confused and skeptical as to what ESG actually means. In this sense, there is a negative feedback loop in regard to the growth of ESG: there exists little data, so ideological and financial backing reflects this void. But because of this diminished amount of ideological and financial support, there isn't the amount of growth in the data analytics of ESG-related decisions that would make this sector flourish, or at the very least be considered more deeply. The next five to ten years will be years of immense growth for ESG. Jobs that don't yet exist will be some of the most important roles for companies, and unheard-of amounts of capital will be allocated to ESG initiatives. In simpler terms, people can define ESG in slightly different ways, but improving methods in data analysis will allow people to see which ESG measures are affected most. Bell and Nelson write, "Building data analytics capabilities could be key to helping corporates produce trusted ESG performance reporting and investors incorporate that insight into their investment decision-making process” (2021). Technology and data innovation aren't only important to the companies issuing ESG performance data, but also to the investors consuming that insight. “As demand for deeper and more credible ESG performance data and insight grows, corporates should improve the way they collect, aggregate, and take management responsibility for their own data...For investors, innovation in areas ranging from cloud computing to Al can help integrate ESG data into investment analysis. For example, Al can allow investors to uncover material data that may exist outside a company's formal ESG disclosures." As with anything new, there are bound to be kinks that hinder consumer sentiment and sector growth. Companies and investors alike are learning how to maneuver in the murky ESG waters that the entire market floats in, all while trying to clarify our surroundings. Technological advancements in data science will pave the way for more efficient, calculated, and intentional decision-making as ESG is considered more seriously. 

However, where there exists a certain framework for creating a particular image derived from ESG strength, there too exists loopholes to take advantage of the favorable optics of being aligned with ESG. DWS, a German asset management company previously a part of Deutsche Bank, was under recent scrutiny for greenwashing, which is when firms make misleading ESG disclosures and give asset owners and investors a positive impression where none is warranted. Desiree Fixler, a former executive at DWS “has said that DWS's claims that hundreds of billions of its assets under management were 'ESG integrated' were misleading because the label didn't translate into meaningful action by relevant fund managers. DWS has since stopped using the label" (Arons et al. 2022).  In other words, DWS was framing certain investments as ESG integrated – presumably for social clout - when that certainly wasn't the case. Other firms also provide unclear, perhaps misleading claims when talking about ESG. The ESG data provided in the firm's quarterly or yearly reports have been, historically, unaudited, but this appears to be changing (Yu, Van Luu, and Chen 2020).  An increased level of precision and conscientiousness by auditors will keep firms honest in their reports and prevent profiting from greenwashing. Ellen Pei-yi Yu, Catherine Huiriong Chen, and Bac Van Luu, professors at the School of Business, Economics and Informatics at Birkbeck University and King's College Business School and Global Head of Currency at Russell Investments respectively, found that "firms exposed to greater scrutiny, i.e. effective supervision under institutional investors, are less likely to engage in ESG greenwashing." So, while auditors have to be increasingly tedious in their reviews of a firm's annual reports, firms are, too, becoming increasingly honest and diligent with their reporting - they have no choice (Yu, Van Luu, and Chen 2020). 

McKinsey and Company, a leading global management consulting firm, outlines five ways ESG creates value for a firm. Firstly, “A strong ESG proposition helps companies tap new markets and expand into existing ones" (Henisz, Koller, and Nuttall 2021). This ties back to the idea of social optics. It has been found that "companies with social-engagement activities that were perceived to be beneficial by public and social stakeholders had an easier go at extracting those [gold] resources..." Optics or not, having positive ESG propositions can now boost your social capital amongst investors and stakeholders. Secondly, "ESG can also reduce costs substantially." Let it be known here that "costs" are both the implicit and explicit costs that go into the production of something - be it the cost of raw materials, water, or carbon. McKinsey colleagues "found a significant correlation between resource efficiency and financial performance." For example, the company 3M saved $2.2 billion USD since the rollout of its "pollution prevention pays" program more than three decades ago. So, while some consider the possibility of diminished performance in one's portfolio to be a turnoff or hindrance to success, far fewer consider how much one saves by prioritizing an ESG-friendly portfolio. Thirdly, one would experience "reduced regulatory and legal interventions." Depending on one's discipline, this has varying levels of importance. All corporate profits are at risk from state intervention. However, "In banking, where provisions on capital requirements, 'too big to fail,' and consumer protection are so critical, the value at stake is typically 50 to 60 percent." In other words, strength in ESG has granted companies more strategic freedom and government support while accounting for capital. Fourthly, strength in ESG uplifts employee productivity. At a very human level, we like to be a part of things that are greater than us, something that instills a sense of purpose. ESG does just that. By gaining not only satisfaction in one's work, but also a sense of connection, people are more apt to collaborate, work hard, and succeed. Conversely, "...a weaker ESG proposition can drag productivity down." Last but certainly not of the least importance, a strong ESG proposition can optimize asset investment. By allocating capital to sectors that promise sustainable returns, investors are opening themselves and companies alike up to returns with no expiration date. Just think about it, what provides more longevity: renewables and waste reduction initiatives or oil fracking? Surely the former. "While the investments required to update your operations may be substantial, choosing to wait it out can be the most expensive [and irreversible] option of all." The future of ESG, like anything, is unpredictable. But what is predictable and ultimately in our control as consumers and asset owners, is to consider reallocation sooner rather than later. 

Most companies, if not all, offer ESG solutions to clients keen on ESG-friendly decision-making as it relates to their respective portfolios. VwC, a leading company that offers business management and financial and accounting services, for example, is one firm that advertises its emphasis on ESG. They essentially sell how they have an advantage over their competitors, and why clients should choose them for their ESG needs. The race towards who can capitalize on this emerging market of ESG has already begun but is far from over. As with many business relationships, I reckon this too will come down to trust and performance. Greenwashing will diminish investor trust, so transparency in one's motivations grows in significance. At the end of the day though, nobody cares how ESG-friendly one's portfolio is if it exhibits diminishing or negative returns. What we are seeing is clear: the world speaks to us in one way, but money sometimes speaks in another way, and louder. We either continue to be okay with destruction if it ensures a profit, or settle for fewer returns on our assets with the knowledge that no irrevocable harm has been done.

References

Arons, Steven, Karin Matussek, and Nicholas Comfort. “Deutsche Bank's DWS Unit Raided amid Allegations of Greenwashing.” Bloomberg.com. Bloomberg, May 31, 2022. https://www.bloomberg.com/news/articles/2022-05-31/deutsche-bank-s-dws-unit-raided-amid-allegations-of-greenwashing.  

Bell, Dr. Matthew J., and Mathew Nelson. “Is ESG Data Unlocking Long-Term Value?” EY. EY, November 3, 2021. https://www.ey.com/en_us/assurance/is-your-esg-data-unlocking-long-term-value.  

“ESG 101: What Is Environmental, Social and Governance?” MSCI, 2022. https://www.msci.com/esg-101-what-is-esg.  

“The Evolution of ESG Investing.” MSCI, 2022. https://www.msci.com/esg-101-what-is-esg/evolution-of-esg-investing.  

Henisz, Witold, Tim Koller, and Robin Nuttall. “Five Ways That ESG Creates Value.” McKinsey & Company. McKinsey & Company, June 23, 2021. https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/five-ways-that-esg-creates-value.  

Kell, Georg. “The Remarkable Rise of ESG.” Forbes. Forbes Magazine, December 10, 2021. https://www.forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/?sh=3b0865091695.  

Musk, Elon. “ESG is a scam. It has been weaponized by phony social justice warriors." May 18, 2022, 12:09pm. https://twitter.com/elonmusk/status/1526958110023245829

State Street Corporation. “2021 ESG Report.” Accelerating Growth 2021 ESG Report, April 20, 2022. https://www.statestreet.com/ideas/articles/2021-esg-report.html.  

Wharton Magazine. “How Should Companies Respond to ESG Issues?” Wharton Magazine, April 15, 2022. https://magazine.wharton.upenn.edu/issues/spring-summer-2022/how-should-companies-respond-to-esg-issues/.  

Yu, Ellen Pei-yi, Bac Van Luu, and Catherine Huirong Chen. “Greenwashing in Environmental, Social and Governance Disclosures.” Research in International Business and Finance. Elsevier, January 27, 2020. https://www.sciencedirect.com/science/article/pii/S0275531919309523.