How Do We Make ESG Sustainable?
It’s the acronym that has taken the business world by storm (and made its way into many teams’ Wharton Global High School Investment Competition portfolios — See Box). ESG, which refers to Environmental, Social and Governance factors, is the lens that people use to evaluate companies’ efforts to do more than make a profit – like contribute positively to the planet, practice inclusivity in the boardroom, and support social causes.
ESG considerations are reshaping corporate priorities. ESG fits into the broader landscape of accountable capitalism – a system in which stakeholders (people with an interest in a business, including owners, managers, board members, employees, customers and investors) hold organizations accountable for the externalities that they create (positive or negative outcomes of their business activities), and price them correctly in the market.
The ESG movement is driven in large part by investors, who are focused on opportunities to build company value and generate investment returns. In ESG investing, investors apply non-financial factors like environmental, social and governance to analyze a stock’s performance and long-term potential. By many accounts, investor demand for ESG has been growing robustly in the past 10 years.
Witold Henisz, vice dean and faculty director of the ESG Initiative at the Wharton School of the University of Pennsylvania, said, “We often hear statistics organized by institutions like the Global Sustainable Investment Alliance that tout $35 trillion or 36% of all globally professionally managed assets incorporate or demand ESG factors be included in their investment thesis… Bloomberg even reported that the expected demand for ESG investing was going to be $50 trillion as soon as 2025.”
Discussing the Possibilities
But not everyone embraces ESG – and not all data suggest that investor demand is that robust. For example, research by Wharton faculty members Luke Taylor and Bob Stambaugh concludes that the actual amount of ESG investing may be more like $2 or $3 trillion. What’s more, a countermovement challenges the efforts to value ESG factors and incorporate them into strategic initiatives, claiming that such efforts are being used to push political goals.
This friction point sparked the August 2023 LinkedIn Live conversation “ESG: Dispatch from the Front Lines of Accountable Capitalism,” organized by Wharton’s ESG Initiative and Wharton Executive Education.
Dr. Henisz moderated a virtual panel discussion with three leaders in ESG integration – across financial services, consulting and corporate – as well as a Wharton associate professor of business economics and public policy.
What’s next? asked Henisz. “Will we find better data, build better models and drive substantive change? Will we see less-lofty claims, but no changed effort in which companies avoid using the label ESG, but continue to pursue meaningful reform? Or will the current headwinds lead to delays and tactical retreats that reverse progress and taint the ESG movement as just another fad?”
The hour-long LinkedIn Live discussion is available HERE.
ESG Experts Express Policies and Purpose
Below are highlights from the panel of ESG leaders, as they pull from their professional experiences to suggest how companies, investors and policymakers can support the future strength of ESG.
How can we accelerate progress toward accountable capitalism? “We have to reshape our economy in so many ways. And we have to choose to put aside a bit of the noise, because there isn’t much space for that when data and everything is telling us the right direction,” said Viviana Alvarez, former head of sustainability and corporate strategy at Unilever North America, a consumer goods company and leader in the corporate ESG movement. “I think there’s going to be a lot of innovation and new industries, new jobs, new economies, going towards what we need to do in terms of [ESG] adaptation, and that is going to happen across all industries. So that is very exciting. How to demonstrate that to shareholders? Well, we have to stress-test a portfolio. Can you continue to produce your product or service at this pace in the next five to 10 years? We know the answer is no. A lot of procurement officers (people responsible for determining the best sources of supplies for a company) don’t really sleep at night, because they know their commodities depend on a lot of these fragilities — and we’re not talking five to 10 years from now, we’re talking three years from now. These things are going to accelerate very much-needed rapid change. And we will see which companies are reacting or being proactive.”
“It’s important for investors to look at each company and look at governance. There’s a lot of things we can observe from that.” –Jennifer Grancio, Engine No. 1
What does Effective ESG look like inside companies? “The companies that get this right do five things,” observed Monica Dimitracopoulos, corporate sustainability leader, EY Americas, a professional services organization within Ernst & Young. “They are deepening their understanding of stakeholder expectations…They are putting in place the right governance at the board and executive-leadership-team levels. They’re embedding this as a lens into how they think about their strategic priorities and growth agenda. They’re essentially moving toward operationalizing these initiatives and allocating the right amounts of capital. And they’re staying very connected to the market, to their stakeholders, transparently reporting on progress or lack thereof and generating quality data. I think that first point is the most important one, which is knowing your stakeholders, knowing their expectations, but importantly, not just those expectations, because they’re not all created equal, but those that matter the most for your organization’s future success. Thinking about how to prioritize those is what sets apart companies that are doing this well. As we look ahead, this is only going to become more important.”
How can we get asset owners to see the opportunities of ESG and accelerate change from the investor side? “When we think about the E and the S and the G, we know corporate governance always matters,” said Jennifer Grancio, CEO of Engine No. 1, a hedge fund that is part of a new breed of shareholder activists believing that social good is important to a company’s value and impacts the bottom line. Founded in 2020, Engine No. 1 is all about active ownership of the companies in which it invests. “I think we can be very disciplined, whether you’re an investor like we are, and we’re investing on behalf of others, how a company behaves. Tesla is a great example. They have built a beautiful engineering process that takes us down the [positive environmental impact] road very quickly and creates competition on battery electric vehicles. But, there are moments in time where if Elon Musk is running their company, you could give them a very negative grade on governance. And so, it’s important for investors to look at each company and look at governance. There’s a lot of things we can observe from that. And there’s a lot of research to back up what good and bad governance look like.”
What should people and policymakers understand about ESG factors? “I think it’s crucial for investors, consultants, strategists to really understand how climate risks affect prices and financial markets and might change long-term corporate strategies,” noted Arthur van Benthem, faculty co-director of the Wharton Climate Center. “I would say that climate-risk pricing is real. For example, take the housing market. There’s some really interesting research by my colleagues here at Wharton who studied the housing market in Florida. They show that houses that are in high flood risk areas transacted 19% less and sold for 5% less than very similar houses in low flood risk areas…Good strategists and leaders need to understand why and how financial markets respond and how to be prepared for that.”
When it comes to the sustainability of the ESG movement, Dr. Henisz summarized the panelists’ insights like this: “We need to experiment. We need to embed ESG into the core. We need more system-level thinking. We need people who have a sense of purpose that are willing to drive this experimentation and integration. And we all need to understand the role that externalities (side effects or consequences of commercial activities) play in this broader system that companies are embedded in.”
Grancio of Engine No. 1 echoed that ESG can’t be something we do on the side: “We need to assume that the E and S and G is data and material and push it into the core of how people think about things.”
Conversation Starters
Dr. Witold Henisz asks, “What’s next? Will we find better data, build better models and drive substantive change? Will we see less-lofty claims, but no changed effort in which companies avoid using the label ESG, but continue to pursue meaningful reform? Or will the current headwinds lead to delays and tactical retreats that reverse progress and taint the ESG movement as just another fad?” Where do you think the ESG movement is headed and why do you hold those beliefs?
Panelist Viviana Alvarez says, “I think there’s going to be a lot of innovation and new industries, new jobs, new economies, going towards what we need to do in terms of [ESG] adaptation.” As a future business leader and employee in this evolving economy, how do you hope to contribute? What new job or innovation do you hope to see?
Lots of novice investors are enamored with Tesla because its electric cars are helping to lead the world away from carbon dependence. But what is Jennifer Grancio saying about the value of corporate governance, supported by the Tesla example? Why is this critical to the perspective we have and the decisions we make as stakeholders?