# Is it game over for ESG? Author: Pal Sinha, Barnali Author URL: https://financedigest.com/author/pal-sinha-barnali Published: 2023-06-14 Category: FINANCE Category URL: https://financedigest.com/category/finance Meta Title: Is it game over for ESG? Challenges to current Meta Description: Explore the controversies surrounding ESG ratings and the challenges faced by companies in upholding environmental, social, and governance principles. Is it URL: https://financedigest.com/is-it-game-over-for-esghtml ![undefined](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/istock-1359584143-1736813884309-compressed.jpg) # **Is it game over for ESG?** ![](https://prod.superblogcdn.com/site_cuid_cm5qst7v3003gwirgwqtxn8i8/images/ian-nolan-1736813884162-compressed.jpg) _By_ **_Ian Nolan,_** _founding partner of Circularity Capital_ That would seem to be the allegation made by some commentators and politicians, notably in the USA.  Indeed, some of the biggest names in asset management, including BlackRock, are facing legal challenges as to whether their espoused commitment to [ESG principles is in breach of their fiduciary duties to maximize investment](https://www.financedigest.com/the-impact-of-environmental-social-and-governance-esg-investing.html "The Impact of Environmental, Social, and Governance (ESG) Investing") returns. One common response to this challenge, albeit a somewhat defensive one, is to argue that applying an [ESG screen to investment](https://www.financedigest.com/esg-investing-what-is-the-regulatory-position-in-2022.html "ESG investing – what is the regulatory position in 2022?") opportunities is just good risk management practice. Even the most focused and financial returns-driven investor doesn’t want to find themselves holding a stranded [fossil fuel](https://www.financedigest.com/stellantis-wont-race-to-split-electric-vehicles-from-fossil-fuel-cars.html "Stellantis won’t race to split electric vehicles from fossil fuel cars") asset or one whose value is diminished by fines or reputational damage from environmental, human rights, or behavioral lapses. However, even tested against this low bar, current ESG claims are [open](https://www.financedigest.com/volvo-car-considers-opening-third-plant-in-europe.html "Volvo Car considers opening third plant in Europe") to very considerable challenge. Some of the most notable cases of corporate fraud and reckless bankruptcy seemed to have come (FTX recently, Lehman Brothers, and Enron previously) from companies that had carefully cultivated their top-tier [ESG ratings](https://www.financedigest.com/financial-think-tank-calls-for-regulated-esg-ratings-in-britain.html "Financial think-tank calls for regulated ESG ratings in Britain").  As a minimum, this shows that the [current ESG system](https://www.financedigest.com/ventricular-restoration-systems-market-development-history-current-scenario-industry-insights-2030.html "Ventricular Restoration Systems Market Development History, Current Scenario & Industry Insights 2030") can certainly be gamed by cynical participants. Further fuelling the fire, the various rating agencies, unlike [credit rating](https://www.financedigest.com/credit-suisse-group-rating-downgraded-by-sp.html "Credit Suisse Group rating downgraded by S&P") agencies, give very different scores to the same company.  Should Tesla’s ESG ranking really be (because of Musk’s foibles) lower than that of Exxon Mobil? Maybe that’s an easy one, but when looking at Tesla how should we think about the enormous [benefit of having forced a whole industry](https://www.financedigest.com/the-four-benefits-of-digital-transformation-in-the-finance-industry.html "The Four Benefits of Digital Transformation in the Finance Industry") onto an electrification path, against the environmental and labor standards issues of rare earth metal extraction in less developed countries? There most obvious challenge to the [current rating systems](https://www.financedigest.com/automotive-active-safety-system-market-2015-scope-of-current-and-future-industry-2025.html "Automotive Active Safety System Market 2015 | Scope of Current and Future Industry 2025") is that ‘ESG’ is a broad concept covering three very different topics, and that there is no conceivable ‘unit of account’ which would allow us to aggregate the scores in these very different categories. In a world where everything has a monetary value, we can add two different categories together.  An apple costs 25p and an orange 20p – the combination is worth 45p.  But if we can’t ascribe a monetary value to the degree of compliance with Board composition rules then how can we aggregate a score on this metric with another non-monetary category such as [equality of pay across genders](https://www.financedigest.com/boosting-gender-equality-in-tech-the-importance-of-mentorship-to-enhance-diversity.html "Boosting gender equality in tech: the importance of mentorship to enhance diversity")?  Scores are by necessity qualitative, and there is no single answer as to the relative weights which should be ascribed to them.  In a world of non-monetary measures, we can’t say much more than that an apple and an orange together constitute two pieces of fruit. More importantly still, whilst the ‘S’ and the ‘G’ categories do seem to be capable of being subject to some degree of their own (non-comparable) qualitative evaluation, the same could certainly not be said of the ‘E’ in ESG.  The qualitative evaluation of ‘S’ and ‘G’ largely focuses on inputs, rather than outputs. That approach makes little sense in relation to understanding the environmental footprint of a business, where it is certainly output that we need to measure. It is therefore easy to argue that a whole ESG edifice has been at best hugely oversold, or at worst built on the shakiest of foundations, testimony mainly to the asset management [world’s short attention span and cynical opportunism](https://www.financedigest.com/imf-amf-afesd-and-government-of-morocco-to-host-regional-conference-opportunity-for-all-promoting-growth-jobs-and-inclusiveness-in-the-arab-world.html "IMF, AMF, AFESD and Government of Morocco To Host Regional Conference: “Opportunity for All—Promoting Growth, Jobs, and Inclusiveness in the Arab World”"). That would certainly seem to be the conclusion of Stuart Kirk, infamously ousted as Head of Responsible Investment at HSBC [Asset Management](https://www.financedigest.com/iot-platform-wells-up-south-africas-silulumanzi-water-utility-power-asset-management-savings-and-monitoring.html "IoT Platform Wells Up South Africa’s Silulumanzi Water Utility Power Asset Management Savings and Monitoring") (“The banking approach to next zero is just claptrap” FT November 11th, 2022.) So where do we go from here? Notwithstanding its many flaws and its attraction as a target to anti-woke culture warriors, ESG isn’t going to go away. Indeed, the $1.2tn Norwegian sovereign [wealth fund](https://www.financedigest.com/norway-wealth-fund-to-vote-for-labour-rights-motion-at-starbucks-agm.html "Norway wealth fund to vote for labour rights motion at Starbucks AGM") recently sent a warning shot to the world’s so-called ESG laggards (FT, January 19th, 2023). We should, however, recognize that what we can get from a conventional ESG approach is much more limited than is claimed by many of its more cynical proponents. What’s more, if we want to think harder and differently about the challenge, maybe we should go back to the beginning and see if we can build back up from the first principles. The foundational issue, surely, is whether the fiduciary duties of investment [managers and company directors should extend beyond financial returns and give consideration to externalized costs or benefits](https://www.financedigest.com/synapse-makes-it-even-easier-for-time-poor-fds-to-benefit-from-cloud-cfo-with-new-managed-service.html "Synapse makes it even easier for time-poor FDs to benefit from Cloud CFO with new managed service"). Milton Friedman is often quoted in this regard – “the one and only social responsibility of businesses is…to increase its profits.” Others reference Adam [Smith](https://www.financedigest.com/wh-smith-warns-on-2022-profit-due-to-slow-travel-recovery.html "WH Smith warns on 2022 profit due to slow travel recovery") and his concept of ‘the invisible hand’. But how many of those advocates know that Adam Smith also wrote in their earlier work – “The Theory of Moral Sentiments”? Taken together, the two books offer an integration of economics and morals, developing a philosophy that would harness the force of self-love without being dominated by it. In more modern economic terms, the theoretical case for a laissez-faire, market [solution](https://www.financedigest.com/the-patient-monitoring-handheld-solutions-market-to-be-constructively-capsized-by-the-digitization.html "The Patient Monitoring Handheld Solutions Market to be constructively capsized by the digitization") derives from an economic model which assumes complete markets and doesn’t deal with the market failure of externalized costs.  If polluting the atmosphere with CO2 is to private advantage, its [profits privatized and its costs](https://www.financedigest.com/harley-davidson-profit-drops-on-rising-costs-and-chip-shortages.html "Harley-Davidson profit drops on rising costs and chip shortages") socialized, then of course we will have too much pollution. It seems therefore to be entirely legitimate for [businesses to tell the government](https://www.financedigest.com/uk-government-to-cap-energy-bills-for-businesses-bloomberg.html "UK government to cap energy bills for businesses – Bloomberg") that it needs to level the playing field, by taxing the externalities – a carbon tax. [Government shouldn’t try](https://www.financedigest.com/factbox-how-governments-are-trying-to-ease-inflation-pain.html "Factbox-How governments are trying to ease inflation pain") to excuse itself from responsibility by blaming businesses for the problem and implying that better ESG behavior would be sufficient to solve it. No doubt – given the right incentives – the creative genius and naked self-interest of market participants could find the most cost-effective solutions to [climate change](https://www.financedigest.com/exclusive-hsbc-fund-arm-toughens-thermal-coal-policy-to-curb-climate-change.html "Exclusive-HSBC fund arm toughens thermal coal policy to curb climate change"). Certainly, the oddly-named [Inflation Reduction Act](https://www.financedigest.com/factbox-governments-act-to-ease-inflation-pain.html "Factbox-Governments act to ease inflation pain") in the USA seems likely to incentivize a major shift towards a more environmentally sustainable economy. But business can do much better than being a passive bystander, awaiting the government to [lead the way](https://www.financedigest.com/leading-the-way-in-esg-the-transition-to-a-cardless-ecosystem.html "Leading the way in ESG: the transition to a cardless ecosystem"). At Circularity Capital, we [believe that the right place for businesses](https://www.financedigest.com/six-in-10-business-believe-automation-will-drive-productivity-reveals-robert-half.html "Six in 10 business believe automation will drive productivity, reveals Robert Half") to start is by properly understanding their own environmental footprint and then focusing on those actions which reduce it whilst simultaneously increasing their financial profits. Our experience has shown us that properly evaluating a [company’s](https://www.financedigest.com/eu-plans-for-company-human-rights-environment-checks-face-new-hurdle.html "EU plans for company human rights, environment checks face new hurdle") environmental footprint is a complex and painstaking exercise.  It is often helpful to undertake a lifecycle [cost analysis](https://www.financedigest.com/modified-flour-market-overview-cost-structure-analysis-growth-opportunities-and-forecast-to-2032.html "Modified Flour Market Overview, Cost Structure Analysis, Growth Opportunities And Forecast To 2032") (LCA), but use of this tool requires numerous assumptions to be made. Objectivity and data gathering are necessary to ensure that the inputs to the model are justified. The good news is that, once the exercise has been well done, you have a robust understanding and articulation of a company’s environmental footprint, which can be validated to prove its provenance. We invest in companies whose environmental footprints are “better” than their competitors, who are often [operating wasteful](https://www.financedigest.com/just-in-time-jit-and-lean-accounting-streamlining-operations-and-reducing-waste.html "Just-in-time (JIT) and lean accounting: streamlining operations and reducing waste") ‘take-make-dispose’ linear economy business models. But the real magic happens where the environmental advantage is accompanied by advantages on cost and quality, such that the company’s proposition is faster and cheaper, as well as better – in an environmental sense. We find this combination in the business models that underpin a [circular economy](https://www.financedigest.com/why-building-new-products-for-a-circular-economy-is-essential-if-we-are-to-preserve-the-earths-finite-resources.html "Why building new products for a circular economy is essential if we are to preserve the Earth’s finite resources").  These offer faster, cheaper, better solutions and will allow us to de-couple [economic growth](https://www.financedigest.com/german-economic-growth-to-remain-muted-in-near-term-imf.html "German economic growth to remain muted in near term – IMF") from both ever-increasing natural resource consumption, as well as natural capital degradation. Properly understanding the business models that can deliver those twin objectives isn’t straightforward, and the effort to do so couldn’t be more different from the approach of sub-contracting judgment to an external agency’s unexplained ‘black box’ model of ESG evaluation. Companies with authentically lower material resource intensity than those in the wasteful take-make-dispose linear economy have both a cost advantage and a superior customer proposition, [leading to faster growth](https://www.financedigest.com/chromatography-accessories-and-consumables-market-booming-demand-leading-to-exponential-cagr-growth-by-2023.html "Chromatography Accessories and Consumables Market Booming Demand Leading to Exponential CAGR Growth by 2023").  Both of these are likely to be recognized and monetized in financial [markets through a ‘sustainability premium’ added to the earnings multiple used in their valuation](https://www.financedigest.com/u-s-automotive-and-aircraft-interior-genuine-leather-aftermarket-is-expected-to-push-sales-at-3-6-cagr-with-the-market-valuation-reaching-us-11-1-bn-in-2031.html "U.S. Automotive and Aircraft Interior Genuine Leather Aftermarket is expected to push sales at 3.6% CAGR, with the market valuation reaching US$ 11.1 Bn in 2031"). By digging deep into the ‘E’ in ESG, investors can therefore deliver premium financial returns _and_ contribute to a healthier planet in a combination of which Adam Smith would surely be proud. --- This blog is powered by Superblog. Visit https://superblog.ai to know more. ---