In 2004, the term “ESG” was officially coined with the publication of the UN Global Compact Initiative’s Who Cares Wins report. ESG is simply another way of measuring the centuries-old concept of socially responsible investing. The UN’s report defined the three main pillars of ethical finance as environmental, social, and governance (ESG).
These new metrics tapped into a worthy desire among investors to see not only good financial returns on their investments, but also improvements in societal outcomes.
However, the launch of ESG metrics also led to significant marketing opportunities for fund managers. Labeling funds “ESG” allowed them to charge more fees and acted as a get-out-of-jail-free card if their funds performed poorly financially. After all, they were serving two masters: financial return and ESG.
But ESG has been hard to define and measure over the years, shifting most recently from conversations about corporate social responsibility (CSR) to ESG. Investors can easily see the financial return a fund has provided in the last year, last five years, last 10 years, and in the life of the fund, but the returns to ESG are much tougher to measure, let alone measure. Financial returns are quick, objective, and reliable.
On the other hand, ESG measurements have proved much more nebulous because the interpretation of ESG is so subjective. In short, there are too many indicators and too little quantitative work linking transparent measurement to outcomes.
THE CHALLENGE WITH ESG RATINGS
Many ESG ratings do not have an intrinsic standard. Instead, they vary based on a subjective grading system assigned by different rating organizations. Different raters assign factors different weights, resulting in different grades. For example, KLD Research & Analytics assigns heaviest weight to climate risk management, product safety, and remuneration. Another rater, Moody’s ESG, assigns greatest weight to Diversity, Environmental Policy, and Labor Practices.
But it’s not just the weighting that differs, but also the way they actually create the metrics and scope of metrics that are included in the overall scores. Two rating agencies can produce two entirely different ESG ratings based on their subjective assessments.
Recent research by professors Florian Berg, Julian Kolbel, and Roberto Rigobon in the Review of Finance documents substantial discrepancies across the different rating agencies. They find that differences in measurement and scope contribute to 56% and 38% of the divergencies across scores, respectively, and weights contribute 6%. Florian Berg, together with coauthors, has also found that ratings agencies have gone back into retrospective data and rewritten it to have more favorable correlations with financial performance among firms, thereby manipulating the rankings. Few have been upfront about these substantial concerns with the ratings.
Even if we take the ESG ratings at face value, higher ratings are not predictive of lower corporate governance problems, according to recent research by Ruoke Yang in the Journal of Financial Intermediation. While unfortunate and sad, the low predictive power is not surprising given the incentives that agencies have to invest in detecting greenwashing and the incentives that firms have to superficially signal efforts to improve their public image.
Admittedly, measuring environmental performance is not easy. But the difficulty does not absolve us from the responsibility of actually measuring what we care about. For example, if natural gas companies are effective at producing energy with low emissions—thanks to advances in fracking technology—then they should be environmental stars, particularly in light of the industry that they are in. And yet, they do not appear in ESG funds.
Although investors’ dual desire to get a high return on their investment and improve the world in the process is good, ESG has not evolved to a point where it can adequately address both desires.
A BETTER MEASURE OF CORPORATE HEALTH
The good news is there are plenty of exemplary companies that are both industry leaders and doing a great deal of good in the process—here are a few from our prior research:
Costco has led the retail industry in customer satisfaction, employee satisfaction and stock performance for 40 years. They track the number of employees who have graduated from college, unlike any other retailer.
Southwest Airlines has been an industry leader for 50 years, in financial performance, customer satisfaction, and employee loyalty, having never laid off an employee.
Welty Construction has grown to 100 times its size 20 years ago by delighting customers, employees, and investors. President Donzell Taylor began a program of hiring former addicts to empower meaningful change for them and the community.
Many more examples abound, but we need more than examples of companies that are both profitable and do good in the world—we need a set of organizing principles. Put differently, what are the practices that create good in a company and, in turn, scale to create good in society?
We believe that the answer resides in the concept of economic engagement—a term characterized by companies that treat their employees and customers like partners, focused on serving customers profitably—and can be summarized with five factors:
Customer service: Serving customers is not only morally sound, it provides a company with a strong, valued, and typically profitable customer relationship.
Shared economic understanding: Providing all employees with a common cause based on an understanding of value enables them to agilely respond to customers’ needs.
Transparency: Offering financial transparency enables employees to see the relationship between performance and results, to continually learn from one another, and to avoid bad behaviors that would be exposed.
Shared compensation: Everyone in the company has a stake in the increased value they are jointly creating, making employees truly partners in the business and raising employee compensation.
Employee participation: Everyone is involved in improving company performance, in whatever way they can, regardless of position.
Our economic engagement survey tool, anchored in academic research and collaborations out of Harvard Business School, uses three different items, or questions, associated with each of the five pillars, leading to a total of 15 metrics that we use to evaluate companies.
After 10 waves of research with 50 to 150 companies in each, what we discovered was astounding: Companies in the top quartile of economic engagement were enjoying double the profit growth of their peers.
The aims of ESG are good: Companies should seek to be environmentally friendly, sustainable, and practice good governance. No one disputes that. But the devil is in the details, and sadly the measurement of ESG has been fraught with subjectivity over the years. The proof ultimately has to be in the pudding: if a metric does not show up in financial returns, either the market is completely broken or something is wrong with the metric and its measurement.
We propose a different lens to think about ESG by focusing on economic engagement. These objective, repeatable measures of behaviors deliver consistent financial returns and improve the lives of not only the employees of a company but also society at large.