High-profile critics are unwittingly driving the emergence of ESG 2.0

The recent pushback against ESG practices has encouraged much-needed reflection about the financial services industry’s imperfections. After all, the global ballooning of ESG investments has not been matched by the establishment of the infrastructure to support it.

However, a lot of the criticism overlooks emerging initiatives to address the flaws of ESG. In fact, a second wave of corporate sustainability and sustainable finance–ESG 2.0–is rising.

Yes, we have a product issue. What is an ESG fund? Nobody honestly knows–and that leads to greenwashing and impunity. But ESG critics fail to mention that regulators are moving beyond best-practice guidelines or disclosure-based standards and adopting rules-based criteria to determine what an ESG fund is.

In December 2021, Brazilian self–regulatory organization ANBIMA was the first worldwide to establish prerequisites for managers to label their funds as “sustainable” or as products “that integrate ESG factors.” In the U.K. and U.A.E, similar measures are on the way. In the European space, the Sustainable Finance Disclosures Regulation (SFDR) is also a step in the right direction towards uniformization and law-setting. When ESG fund standards are properly adopted and market players show a deeper level of ESG expertise, regulators shall find a suitable context to tackle greenwashing.

As we move forward, ESG is gradually being split in two: On one hand, financial products that integrate ESG policies, data, and practices, with the aim of identifying new financial risks and unlocking opportunities for value creation; and on the other hand, funds that intentionally generate positive social or environmental impact and are therefore aligned with moral values.

While the first type could potentially invest in oil and gas companies (assuming that ESG risks are properly integrated into valuation methodologies), the second is only meant to advance the Sustainable Development Goals. Hence, ESG may relate both to “the effect of internal and external ESG issues on an asset or portfolio” and/or “the effect of an asset or portfolio on the outside world”–the so-called double materiality.

We also have a data issue. The ESG market is largely based on the ability of fund managers and banks to integrate data to either try to measure the risks their portfolios and loan books are exposed to or to measure the impact (positive or negative) of their investments. Qualitative and quantitative data are the lifeblood of sustainability practices.

But who provides this data? More than 100 rating agencies that operate in an unregulated and non-transparent regime. Some of them even offer concomitant consulting and data services with no legal guardrails in place–a practice that has long been banned in the traditional auditing market. IOSCO and European regulators have criticized the methodology of these agencies and their undisclosed materiality analyses, reflected in the low correlation between their respective scores.

However, we are rapidly heading towards market consolidation with several larger companies buying out smaller ones. Soon, S&P, Moody’s, and Fitch will likely dominate the market and incorporate data, which is currently in the hands of ESG risk rating agencies, into their own credit ratings. At the same time, a handful of independent agencies that measure the impact of companies’ products and services will likely survive. For both, a focus on the most material ESG issues according to industry, geography, or company size is fundamental. Academic research is also working hand in hand with the industry to perfect existing materiality frameworks.

Finally, we must standardize companies’ sustainability reporting. When a German or Brazilian corporation (or one from more than 140 countries) reports its financial data, it uses the fairly universal IFRS model. But the same company’s ESG reporting can be based on more than 30 different standards. This multiplicity adulterates data quality and hampers comparability between companies. Additionally, not all sustainability reports are yet properly audited, providing a fertile ground for greenwashing.

Fortunately, many of these reporting standards are in an accelerated process of merging. And in the coming years, companies will be expected to use the global disclosure standard under development by the ISSB (International Sustainability Standards Board), announced at COP26 in 2021. In Europe, a new reporting standard will be enacted into law by the end of the year.

The inability to understand the double nature of ESG pushes the debate into ideological or conceptual traps. Climate-halfhearted American politicians behind anti-ESG bills, Elon Musk’s claim that ESG has been weaponized by phony social justice warriors, or a recent Economist report all reveal a lack of knowledge of ESG concepts and practices. By criticizing the morality behind ESG, they moralize a debate that does not need to be guided by morals.

The emergence of ESG in 2004 (coined in a UN report) was exactly meant to empty out the morality of socially responsible or ethical investments, a practice that emerged in the 19th century. ESG is profit-based and covers all industries.

It is true that we need to settle the issue of ESG terminology. We may soon come up with a less compartmentalized and more intelligible phraseology. But ESG, when done right, is mathematical (not moral), legal (not subjective), and data-led (not agenda-driven). It is more about doing well than doing good.

ESG Pyrrhonism will likely accelerate standardization, regulation, and science around ESG issues. It will instigate the emergence of ESG 2.0, a new phase of ESG development marked by lucidity, consistency, and simplicity.

Recent critics–mainly politicians, regulators, and capital markets associations–should in fact be criticized for being too slow in contributing to the much-needed structuring of an emerging (and rewarding) field.

Attempting to rugby-tackle the entire concept of ESG when the industry is still in formation prevents us from looking at ESG, in its essence, as a potential instrument for generating financial, social, and environmental value.

 

The article was originally published in Fortune. Available online here.