ESG is past its peak. But it is more important than ever before
The hype is dying down, but ESG-related issues remain urgent
TLDR: Environmental, social and governance- related (ESG) issues have been on the upswing for almost 20 years, but public sentiment towards them seems to be cooling now. Many industries are already playing catch-up with new ESG regulation. As a result, some of them are rushing to tick all the boxes on paper, without doing real in-depth work on sustainability. Some renowned ESG researchers are turning away from ESG in favor of other concepts like “intangible assets” or “long-term value.” These trends are worrisome because climate change, nature degradation and social issues do not stop by looking away. On the other hand, such dissenting voices do offer a valuable opportunity to reflect on one’s own approaches to ESG, and to improve them where appropriate. This post was originally published in February 2024.
When interest rates rise, long-term aspirations fade into the background. This is natural: As financial institutions pass on the higher cost of borrowing, their customers become less keen to embark on projects with high upfront costs and uncertain outcomes.
ESG-related topics have been influenced by this backdrop. Many sustainable projects come with large upfront cash needs and decades of low or uncertain return on investment. In an environment with low interest rates, this can be feasible as long as the expected returns are sizable enough in a few years or decades. With higher rates, however, financing costs become too high and future returns get discounted to the point of irrelevancy.
The result is, at the time of writing this piece, a difficult environment for ESG-related topics. Given the necessity of solving problems like climate change, nature degradation, and social issues, such topics do not merit being pushed aside. To illustrate, consider the fact that 2023 was another year of peak oil — and the absolute peak will likely not be reached until about 2028, according to the International Energy Agency. Even adjusted for multi-annual climate phenomena like El Niño, climate change seems to be accelerating:
Unfortunately, other factors are further complicating the journey to a greener and more equitable future. Many industries cannot keep up with the pace of ESG regulation, despite the fact that regulation is likely not moving fast enough. Some companies treat ESG as a compliance exercise without truly committing to important causes, which makes analyzing them more challenging. Leading voices on ESG are turning their attention elsewhere. All this is happening against the backdrop of an increasingly conservative political landscape and a looming U.S. election.
These are challenging times for sustainability. But in all challenges lie opportunities. It is upon us to embrace these challenges to make sustainability better, quicker, faster.
ESG regulation is already moving too fast for many industries
“The new ESG regulation will hit us worse than whatever came out post-2008,” one investment fund manager in Europe told Wangari. “It is so complicated that even consultants admit that they don’t understand it.”
This fund manager really cares about climate and the environment, and his fund is in fact an ESG-led fund. They have developed their own ESG scoring system based on taxonomy alignment. He and his team clearly know their subject, and they know it well. Nevertheless, they are not happy with the new European regulations, notably CSRD, which are coming into effect this year.
“We are just scared of lawsuits. If a customer claims that the portfolio we assembled for them isn’t as green as their contract stipulated, we don’t have the technical means to prove them to the contrary, and we don’t have the financial means to defend ourselves with a good specialized attorney,” another fund manager told us. His fund has close to 300 million euros in assets under management and has performed well for over 20 years. Nevertheless, the European laws against greenwashing are causing headaches for him and his team.
Even a C-suite executive from a major European bank admitted needing to deploy significant resources in order to comply to these new laws. They had faced major legal troubles with regards to their claims about sustainability some years prior.
With the U.S. issuing new legislation around sustainability reporting this year, it will only be a matter of time before financial institutions and corporates in countries around the world face similar struggles. Overall, ambitious policies seem to be rolled out without the necessary support to aid in compliance. Even in the fast-paced financial industry, this is making waves at players of all sizes.
ESG cannot be left to policymakers alone
When we explain what Wangari is setting out to accomplish — encouraging more sustainable investment by building software that incorporates sustainability performance data into financial projections — one common reaction is “regulators should be doing this.”
And indeed the necessity for good regulation cannot be overstated. Wangari is not a compliance tool, either: Rather, it seeks to take advantage of the wave of data that is rolling out following such regulation, and passes that advantage on to financial institutions.
In a democratic society, however, sustainability cannot be left to policymakers alone. Parliaments are elected every few years, and politicians must show that they have made real progress in that timespan if they want to be re-elected. This is rarely the case, however, with sustainability-related projects. By definition, sustainability is a long-term ambition. Sustainable projects only carry fruit years, if not decades, after they started. Without meaningful progress to show in the next election, politicians who start sustainable projects or policies risk losing their seats.
Incidentally, this might explain why politicians in the West are relying on unrealistic doomsday scenarios to inform their decisions. After decades of complaints by voters that politicians are not taking action against climate, they have found a defendable strategy: If they can justify that their longtermist project might prevent impending doom, they stand a chance to be re-elected.
In autocracies, sustainability-related policies might seem easier to implement given the absence of fair elections. Given the prevalence of corruption in such regimes, however, many potential projects never get started or get stopped before they can generate meaningful returns anyway.
One notable outlier is China, which has a very stable state and some of the biggest sustainability-related projects in the world. That being said, China is grappling with many other problems, which might dampen hopes for even more sustainable mega-projects.
People living outside of China cannot rely on their government to tackle sustainability — and given most governments’ track records over the past decades, it does not seem wise to do so either. Aside from blaming individual consumers for their eating habits or modes of transport, the other meaningful levers for sustainability are businesses. Without financial backing, many businesses cannot flourish — hence Wangari’s rationale of helping the financial sector encourage and profit from sustainability.
ESG is more than compliance
As many new sustainability-related regulations are being rolled out, businesses are starting to feel the pressure. Many are turning to predefined frameworks or even checklists to make sure that their ESG performance is satisfactory.
Adhering to legal best practices, however, is not the most that companies can do. Every company should review its sustainability standards and make sure that they are making meaningful progress towards environmental and social goals, rather than optimizing for numbers.
As Alex Edmans, professor of finance at London Business School, points out in an essay, sustainability metrics only offer a partial information about the performance of a company. Softer, more qualitative data points are often as important as hard standardized metrics.
Imagine two children who have both aced a French vocabulary test. One of these children grew up bilingual, the other rehearsed its vocabulary the day prior to the test. Which one of these is proficient in French? The test results cannot tell you. You will have to speak to the children to find out. It is the same with companies and their sustainability-related performance.
Unfortunately, the aforementioned professor Alex Edmans is amongst the recent crop of scholars that are moving away from ESG. From a scientific point of view, it can make sense to investigate more popular concepts in order to get more citations and get papers into more prestigious journals. Although Edmans’ ambitions seem genuine and not career-driven, it does fit into the overall picture of ESG moving into the tail end of a hype cycle.
Other variables merit corporate executives’ attention — but they are less urgent than ESG
Professor Edmans calls attention to other variables such as strategy, productivity, innovation, capital allocation and brand. He argues that these variables are equally important intangibles that significantly affect financial performance.
His argument, however, carries a flaw: Variables such as strategy or productivity might benefit the planet and society. They do not, however, put it in the front and center of their focus. Given the urgency of climate-, nature-, and society-related problems and the fact that businesses have many means to make a difference here, the only ethically correct variables are therefore ESG-related.
It is good that some ESG-related variables can drive financial returns for shareholders. The whole premise of Wangari relies on this to be true; otherwise our software would benefit investors but hardly move the needle for the planet or for society. That being said, even if the core motivation of financial institutions that embrace ESG is money, it is necessary to reconcile that motivation with more ethical and sustainable goals. Otherwise the entire ESG movement can be scrapped.
Political sentiment is turning more conservative
Up to this point, have explored a number of factors that are challenging ESG: high interest rates, industries that cannot keep up with shifting ESG regulation, challenges that politicians face when reconciling their career ambitions with ESG-related causes, companies that game the system by optimizing for hollow numbers instead of real progress, and thought leaders distracting the discourse by pointing toward other financially relevant variables.
A final and rather important factor is political sentiment. ESG and other “woke” concepts reached their peak around 2021 to 2022 and have fallen ever since. Case in point: Mere days before this piece was written, Google had to apologize for making its image generation AI overly diverse. Images included a Black Nazi soldier and a supposedly medieval British king with Native American features. Less than two years prior, Netflix was lauded for the “delightful fantasy” it served by including actors of South Asian descent and of other ethnicities in its period drama Bridgerton. Although Netflix involved real actors while Google generated artificial images, the differences in public reception remain striking.
The “woke” sentiment of the past years — in this context, woke shall be defined as embracing diverse views, and caring about the future of the planet and its inhabitants — might have been fueled by major events like the pandemic and the Trump presidency in the United States. The pandemic fueled a sentiment of “we are all in this together,” and the Trump presidency spurred many citizens to take opposing views of the obviously anti-woke country leader.
The tides, however, are turning. With uncertain economic outlooks and all the factors described above, people are trying to fend for themselves. For some people, this implies hanging out with their own, and not sacrificing the little prosperity the present moment has to offer for an uncertain future. In other words, the average citizen is turning their back on ESG.
ESG can help grow the pie
It is a pity that the tides have turned this way, but it also presents an opportunity to reflect on past shortcomings of ESG. The reaction that sustainability is for policymakers makes us at Wangari reflect and reinforce our purpose of existing.
Our team is sometimes guilty of overly quantifying datapoints instead of trying to understand the bigger picture that is much more qualitative and often messy. Seeing corporations game the numbers instead of doing the real work serves us as an important reminder that we need to read the text before crunching the numbers.
When scholars try to distract from ESG-related variables, we carefully consider these new variables and determine that sustainability is the only way that we can ensure a livable future. This, in our view, is more valuable than short-term profits and generous dividends to shareholders — particularly in cases when rewards to shareholders are distributed to the detriment of a company’s long term sustainability performance.
While we are powerless against political sentiment, we are also aware that this is constantly in flux and might change again in a year or two. Thinking long-term also involves not getting to fixated on conditions that naturally fluctuate. For this, the current backdrop is a great reminder.
Last but not least, we must remember that ESG at its core is meant to grow the pie. By creating value for the greater good — for nature, wider society, the climate, the future — they actually increase their chances of prospering individually and growing more than their unsustainable peers. It is these companies that Wangari’s software aims to find, so that they get access to the appropriate amount of capital to grow the pie in the best way possible.
What we’re reading at Wangari
As
pointedly puts in Twin Peaks, sustainability is a commercial advantage. As both the ESG movement and the oil markets reach their peaks, it is worth pondering that sustainability is really about financial success. This does not just mean the climate risk posed to a company, but encompasses all the opportunities for a company to become more nimble and harm the world less.Solar and wind energy might be the cheapest sources of energy, but they make energy more expensive overall because of their volatility. In addition, policymakers and news reporters are still using a doomsday climate scenario as a baseline estimation of what the future holds. As
writes in The LCOE and RCP8.5 One-Two Punch, this leads to misguided decisions, poor capital allocations, and — in the worst case — poverty.In a long but insightful piece,
shows Why Nuclear Is the Best Energy. There are finer points worth discussing, but overall he makes a brilliant point about the upsides of nuclear. It is the safest source of energy (yes, Fukushima and Chernobyl are taken into account), emits little carbon and minimal waste, it is reliable, cheap once upfront costs are managed, and provides plenty of energy to consume and export.