Primarily owing to issues of climate change and the need for sustainability and social inclusion, ESG has become an integral part of corporate governance today. This article contextualizes the relevance, implication, and impact of such investing measures in contemporary times.
Since the start of the Industrial Revolution, human activities such as burning fossil fuels, including coal and oil, have increased greenhouse gas concentrations in our atmosphere. For instance, average atmospheric carbon dioxide levels have increased from 280 parts per million to 410 parts per million in the last 150 years. As a result, the amount of heat being lost from the Earth has slowed down, something that is called the ‘enhanced greenhouse effect’, and it is warming our planet. In fact, Earth’s average surface temperature rose about 1.18 °C from the late 1800s to 20201.
Economic Growth vs Sustainability: ESG as a corrective measure
The “Intergovernmental Panel on Climate Change (IPCC)” in its first report in 1990 called for the need for “global cooperation” to tackle climate change. And till today, 5 Assessment Reports have been published. The 6th assessment report is in its process and the synthesis report would come out at a critical moment in our lives before 2030 when the world will have to take some critical decisions in order to limit global temperature within the 1.5° cap. A failure to meet such targets would mean that we can have an upper limit of around 4° C to 5° C in the future2. And to achieve the 1.5° cap, emissions need to decrease by 43% by 2030. To put the emission records in context, our earth is already 1.1° C above pre-industrial levels, which has mostly affected around 1 Billion people (who account for less than 1% of emissions). There are three billion people (mostly from the global south) that currently reside in areas that are highly vulnerable to climate change3.
In terms of Global GDP growth and global CO2 emissions rate, there is a decoupling effect seen, where global CO2 emissions are growing at a slower and diminishing rate as compared to the growth of global GDP. In other words, the richest 10% emits 50% of all the emissions, and the bottom 50% emits only 10% of the emissions. Inequality is not just high between the global north and the global south but within these two spaces as well. Within Europe, the top 10% of income earners produce 5 times more emissions than the bottom 50%. In East Asia too, the top income earners emit more emissions. In the Netherlands, the top richest 10% own 61% of the wealth, and the top 0.001% have seen the largest and the fastest increase in their wealth in the last 25 years4. Within this model, one can find a positive correlation between wealth and global warming: with increasing wealth comes environmental destruction5. Mostly because the wealthy impact the environment through their investments: mainly in sectors such as energy and real estate.
Average Per Capita Group Emissions (Source: World Inequality Database)
The Free Market: Growth vs Equity
There is enough literature that suggests how free market capitalism has primarily based itself on efficiency while neglecting equity, ever since its inception6. It has resulted in gross inequality, enhanced social stratification, exploitation, and the creation of an extractive economy. Wealth has largely become concentrated in the hands of a few, resulting in larger disparities. According to a Global Justice Now report, out of the 100 largest economic entities in the world right now, it was found that 69 of them are companies and only 31 are actually nation-states. In fact, the top 10 companies combined in terms of their revenue are larger than the bottom 180 countries around the world7.
The Origin of ESG
It started with Kofi Annan, the former Secretary General of the UN who approached over 50 CEOs of major financial institutions to collectively deliberate the cause of sustainable businesses. Environmental Social Governance (ESG) refers to three central factors in measuring the sustainability and ethical impact of investments. Today, ESG ratings have become quite helpful for a broad range of investment and non-investment cases. What was a system which, at best allowed an observer to compare companies against each other on a curve, has morphed into a system that will enable a policymaker or a consumer to assess the actual performance of firm vis-a-vis policy goals such as the SDGs. It represents a company’s long-term sustainability in the face of issues like climate change.
In the Indian context, state capacity alone is incapable of meeting the demands of such a large workforce. Hence, the private sector has come to play a crucial role in building livelihoods and in helping people get out of poverty traps. However, beyond the private sector’s profit-maximizing preferences, it needs to cater to dynamic challenges such as structural inequality, inequality in access and opportunities, issues of displacements, and extraction economy among others. Hence the “Social” component in ESG increasingly needs to answer these structural policy problems.
ESG Funds: Impact Investing for a Sustainable Future
ESG funds are portfolios of equities and/or bonds for which environmental, social, and governance factors have been integrated into the investment process. This means the equities and bonds contained in the fund have passed stringent tests over how sustainable the company is regarding its ESG criteria. A growing number of investors rely on these factors to determine whether they ultimately want to invest, or continue to invest, in a given business. The practice places value on companies’ choices to be environmentally conscious, ethically aware, and forward-looking. While ESG investment may be characterized as ethical in its approach to capturing environmental and social impacts, at its core however, ESG investments are a window to understand a company’s long-term prospects in terms of sustainability. In terms of the environmental and social components, a growing amount of research shows how there is a positive correlation between Corporate Social Performance and corporate balance sheet performance8.
Wang and Qian (2011) researched the relationship between corporate philanthropy and financial performance. Corporate philanthropy is expected to have a positive impact on corporate financial performance because it helps companies to gain socio-political legitimacy, thereby enabling companies to receive positive stakeholder responses9. Today’s discourse on ESG glances over the nuances associated with impact investing: how the industry can mold itself to add these facets to its productivity and marketing strategies. Because at its core lies the idea that corporate responsibility is good for achieving social optimum: responsible companies are more transparent, pay attention to their stakeholders, and have stable long-term relationships, all of which result in lower informational asymmetry, lower risk of agency costs, et al10.
The Way Forward
There is a general acceptance that financial assessments cannot be accurately made without access to ESG-related information. As such, ESG has become less of a question of philanthropy or ethics and more of a practical acceptance of the underlying relationship between corporate finance and society. Beyond ethics, it posits the idea that a number of assets today are overpriced simply because they have not attuned themselves to the dynamics of climate risk, and sustainability amongst others11. The IEA estimates under its most climate-ambitious scenario (net-zero emissions) that demand for oil will drop to around 24 million barrels per day and demand for natural gas to 1,750 billion cubic meters by 2050, versus around 100 million barrels per day and 4,100 billion cubic meters respectively today. Given these dynamics and issues of depreciating natural capital, companies need to adopt sustainable mechanisms that do not hamper the abilities of future generations. As a result, there is a growing need for improved transparency and accountability in ESG reporting and disclosures, and hence, it has become a key priority to investors and other stakeholders around the world today.
10. Flammer, Caroline and Hong, Bryan and Minor, Dylan, Corporate Governance and the Rise of Integrating Corporate Social Responsibility Criteria in Executive Compensation: Effectiveness and Implications for Firm Outcomes (December 27, 2018).
About the Contributor
Aaswash Mahanta is a researcher at IMPRI and an undergraduate student pursuing Economics Honours from Shaheed Bhagat Singh College, University of Delhi.