As COVID-19 kills and sickens millions of people around the world, it is also stress testing many institutions and cultural norms, among them companies and their compact with society. It’s an extraordinary challenge joining many already connected deeply to the business world, from economic inequality to racial injustice to climate change.
When questioned about their role in responding to deep-rooted problems facing all of society, companies often indicate that they can’t afford to invest in environmental protection, strong employee compensation, or other elements of a social issue because they must return sufficient profits to shareholders.
Based on research that I and my colleagues undertook at the Center for Sustainable Business (CSB) at New York University Stern School of Business, I contend that embedding environmental, social, and governance (ESG) concerns into business strategies is not only good for making money, but also essential to customer allegiance and protecting against the rising number of major threats to social stability, vibrancy, and inclusiveness that makes a healthy business possible in the first place.
However, scholars and finance professionals need to create a much clearer understanding of the business case for ESG (also referred to as sustainability), as we at the Center for Sustainable Business have begun to do with our Return on Sustainability Investment (ROSI) methodology. Without this insight, corporations will not scale up their investments in sustainability in the face of climate change, COVID-19, inequality, and many other perceived or real challenges to their bottom lines. And investors need more and better information to feel confident that a corporation focusing on its ESG performance can also meet its fiduciary duties.
Building a clear ESG business case for corporations and investors won’t be easy. Here are some of the most pressing barriers:
- There is too much diversity in self-reporting. Corporations are self-reporting using very different ESG metrics. They generally do so without audits to determine the accuracy of the data. As a result, validating or comparing performance is difficult.
- ESG ratings done by organizations outside companies lack standardization. Third-party ESG data providers and raters, much like companies evaluating themselves, use different data and different rating systems, leading to wildly differing assessments.
- Reporting ESG metrics does not equate to using smart ESG strategies. The ESG data we do have may not be the type we want. We need to understand the results of good ESG strategies and executions, rather than any.
- Non-financial ESG metrics are reported as completely divorced from financial metrics. Very few companies are tracking the return on their ESG investments or efforts in their accounting systems. Thus, there are virtually no connections being made between accounting data and sustainability investments.
- Intangible company value isn’t properly tracked. Accounting itself is an inadequate tool for ESG measurement because it is poor at monetizing intangibles, which typically make up 84 percent of a company’s value today and include many sustainability benefits, such as brand reputation and risk mitigation.
Before exploring how we can improve business case arguments for ESG, it’s worth looking at where previous efforts to understand the relationship between financial performance and ESG have struggled.
Early corporate research often failed to distinguish traditional corporate social responsibility (CSR) efforts, such as philanthropy, from embedded sustainability, which describes ESG practices that are tightly woven into corporate strategy. The distinction is important—financial performance of embedded sustainability outperforms CSR due to its focus on material ESG factors, and more recent research has demonstrated that stock market outperformance depends on companies focusing on ESG factors that have a material impact on their business (such as waste reduction in auto manufacturing). In addition, there is insufficient research on the management strategies or practices that cause improved performance. The cumulative effect of these flawed approaches? Executive leaders find it difficult to understand the sustainable management levers that improve financial performance.
Research on the performance of sustainable investing has been complicated by different investment strategies having different performance profiles. For example, using negative screens (avoiding investment in industries, such as tobacco or weapons, that work against certain values or social goals) may depress performance because it reduces the diversity of a portfolio. On the other hand, portfolios that removed coal for ESG considerations are performing very well right now. Another strategy, ESG integration—which accounts for ESG factors along with financial ones when valuing a company—tends to have better financial performance than concessionary impact investing (in which an investor accepts lower financial returns in exchange for greater societal impact). Research has conflated these strategies, making it difficult to understand the financial impacts of ESG for the investor.