Unsustainable: Why ESG Inc. is Broken and What it means for the Global South
Unless you've been living under a rock for a few years, you've probably heard the term 'ESG' bandied about by nearly every company and consultancy you follow. ESG refers to an unstandardized set of non-financial performance factors used to evaluate companies' performance in environmental, social, and governance areas. You may have even noticed the frenzied stampede of stakeholders (companies, regulators, business publications, industry groups, etc.) contributing to the public conversation on ESG in the form of, inter alia, public ESG commitments and new regulatory frameworks. This stakeholder and regulatory pressure have created a growing need for companies to evaluate ESG impacts in their supply chains. All the while, the feverish ESG push has created a burgeoning industry (ESG, Inc.) that's unregulated, often myopic, nontransparent, and PR-driven. The result: unsustainable approaches to sustainability. In this post, we survey some of the shortcomings of current approaches to ESG and what they might mean for the Global South. We close with some select recommendations for evaluating ESG performance in the Global South.
No Standard of Measurement
In some ways, ESG is now where metrology was before the wide-scale adoption of the metric system. There are few universal standards of measurement and this is exploited by both PR-driven companies and ESG, Inc. In addition, there is a disturbing degree of myopia if not outright blindness in what gets defined as 'ESG friendly'.
Little consideration of externalities
ESG Inc. appears to exhibit a remarkable lack of consideration of externalities and consequences of ESG efforts themselves. The movement tends to advocate for, say, new regulations or expansion of renewable energy sources with little, if any, consideration of the externalities and secondary social effects, especially if these are in the Global South.
In fact, Westerners pushing for 'ESG friendly' regulations (without considering local context) might find that they've backfired in the Global South. For instance, academic literature suggests that the implementation of the Dodd-Frank Act, which contained a provision aimed at breaking the link between conflict and minerals in the DRC actually backfired and resulted in more conflict. The same myopic disinterest in unintended consequences characterizes the big ESG push of our era.
Perhaps the clearest way to understand this is to consider the mineral inputs required for common renewable energy sources and modes of transport. For example, according to the International Energy Agency, electric vehicles contain much higher inputs of copper, lithium, nickel, manganese, and cobalt that conventional vehicles. But there seems to be remarkably little, if any, reflection by companies, ESG Inc., or policy makers on the potential ESG impacts of electric vehicles themselves. When 21 companies make public commitments to transition their vehicle fleets to electric vehicles or consultants call the 'electrification' of transport 'transformational', ESG Inc. and publicly 'ESG-conscious' companies often agree wholeheartedly without reservation.
When a company announces a transition of its fleet to electric vehicles, how many disciples of the ESG movement consider the social impact of copper mining on indigenous communities? What about corruption, human rights abuses, and child labor in cobalt mining? What about the environmental impact of lithium and copper mining?
A similar argument can be made with renewable energy sources. Wind power makes heavy use of copper, among other minerals. Solar power makes heavy use of polysilicon; how many companies installing PV panels as part of their 'sustainability' PR drive have considered the possibility of slave labour in their PV panel supply chain? Would they even be talking about it were it not for the Uyghur Forced Labor Prevention Act? How do ESG rating agencies weigh the "ESG benefits" of a company purchasing PV panels or electric vehicles against the "ESG costs" that these purchases levy on the value chain? The answer is, they probably don't and even if they do, it's not always clear how.
Non-Transparent ESG Ratings Companies and Surveys
Companies are under increasing pressure from stakeholders to participate in myriad surveys, rankings, and public disclosure projects around ESG. As a result, a slew of ESG Inc. companies offering 'ESG ratings' of companies or even countries (e.g. CDP, EcoVadis, Dow Jones Sustainability Index, etc.) have seen tremendous growth in demand for their services and purported expertise, some have even become unicorns. The fundamental problem is the incalculable variety of methodologies used by such companies to define and measure the factors they consider to be relevant for ESG performance. For instance, ESG rating and survey companies can have vastly different standards for what constitutes 'acceptable' documentation submitted by a company under evaluation. Your company's internal policies may be rejected by one ratings firm but accepted by another; they may be given entirely different weight in scoring exercises by different companies. This is to say nothing of the sometimes needless complexity of such methodologies.
I speak from personal experience when I say many of the ratings methodologies used by such firms are very, very far from transparent. I have experienced firsthand how 'analysts' at such ratings firms can miss obvious information when evaluating companies for ESG performance only to 'correct' their mistakes if they are called out. Different 'analysts' at the same firm can produce different rating results. Improvements in a company's ESG policies year-on-year can have a null impact on their ratings because of 'weightings' in rating methodologies, which can, of course, by changed by the ESG rating company on a whim. Naturally, document-based ratings can also be easily manipulated by unscrupulous actors or even PR-driven firms looking to boost their public 'ESG performance'. In addition, there are ESG rating companies that offer products around topics such as greenhouse gas emissions with essentially no actual oversight or verification of the figures reported.
Even worse, at least some of these companies offer their rating services to larger firms as a solution for evaluating their own suppliers' ESG performance; but their paid-subscription business models essentially mean companies pay the ESG rating firm for the privilege of acting as their sales representative. Under such a model, the lack of methodological transparency inevitably means at least some of your suppliers will pay for the privilege of getting an ESG rating, but may perform poorly because their documents were rejected due to lack of a date, or a logo. This has a particularly deleterious effect on small and medium enterprises (SMEs) in the Global South which often lack the dedicated resources to 'perform well' on what is essentially a document-based rating system (to say nothing of contesting the misinterpretations of 'ESG analysts'). The lack of transparency and standardization in such 'rating services' has arguably created an overvalued, overhyped industry of performative posturing.
No real accounting for GHG
Setting greenhouse gas (GHG) reduction targets and publishing GHG emissions data is a common feature of company ESG reports. But, in fact, ESG reports can be little more than greenwashing as companies often select data that presents them in a favorable light.
When it comes to GHG emissions especially, there is little in the way of universal accounting or disclosure standards. In effect, these data are often contradictory, unverifiable and inaccurate. The GHG Protocol (which divides emissions into Scope 1, Scope 2, and Scope 3) is arguably conceptually flawed and leads to duplication, manipulation, and inaccuracies. While alternatives and improvements have been proposed, there is simply an overwhelming level of complexity in multi-tier, multi-jurisdictional value chains to say nothing of the lack of data and capacity of many enterprises in the Global South. Without real, universal reporting standards and oversight such reporting is far too easy to manipulate and far too lacking in real impact.
Greenwashing uber alles
The growing pressure for PR-driven ESG means ESG reports can often be more performative posturing than anything close to a disclosure with real oversight. For many companies, the pressure from regulators, investors, stakeholders, and employees can lead to public ESG commitments that are completely disconnected from the company's reality. Often, this discordance can be due to a disconnect between the company's ESG function and other business units. For instance, a company's ESG function might push a commitment to increase recycled materials or diversity in the company's value chain whilst ignoring the company's lack of reliable baseline data in this area.
To take another example, many companies have made public commitments to reduce GHG emissions by a given percentage in the next 5-30 years, but this ultimately requires significant supply chain transparency. Even setting aside ESG concerns, international value chains at large multinationals are often characterized by opacity and lack of transparency; this isn't new, it's been this way for decades. In addition, upstream and downstream indirect emissions (referred to in the GHG Protocol as Scope 3) are notoriously difficult to measure accurately across multi-tier, international value chains with an often heavy presence in the Global South.
As a result of this pressure and lack of transparency, many companies have undoubtedly made public ESG commitments without understanding what they're committing into. They may well have committed to, for example, reducing emissions in their value chain while having no accurate data on their own suppliers' emissions, no oversight mechanisms, and no universal standard of measure. This leads to public ESG commitments and actions (in the environmental and social spheres especially) that are often panned as lacking transparency, oversight, and 'teeth'.
The Regulatory Storm
In conjunction with ESG pressure on industry, governments and regulators have begun to implement ESG-related regulation at a frenetic pace (inasmuch as that is possible in the regulatory world). The US Securities and Exchange Commission have taken a decidedly ESG-focused posture since last year. Germany has approved a Supply Chain Due Diligence Act. The US Government's Uyghur Forced Labor Prevention Act was passed in December 2021 and US Customs and Border Protection's recently released guidance for importers includes requirements for supply chain due diligence, documentation, and supply chain transparency for which many multinational companies with complex, cross-border value chains are undoubtedly woefully unprepared.
There will always be gaps in regulatory regimes, as evidenced by recent concerns over 'loopholes' in sanctions against Russian oil and gas products. But aside from the impact of the regulatory burden on companies and their suppliers, the current hunger for ESG regulation may herald more regulatory regimes with unintended consequences for companies in the Global South. What will be the real ESG impact as SMEs are squeezed from both sides by customers who want them to both lower their prices and invest time and money in meeting ESG benchmarks?
Select Recommendations for evaluating ESG Performance and Conclusion
If you are evaluating other companies (like suppliers) for ESG performance:
Take any ESG ratings of countries and companies with a healthy dose of skepticism. Examine the methodology used by the rating company closely if using any of these measures to make business decisions. Do not rely excessively on such ratings. Talk to your suppliers or the companies you are evaluating and do your own due diligence.
Consider whether ESG rating models that require payment are really the ones you want to use for your suppliers. Is it fair to ask your suppliers (who may not have dedicated ESG personnel) to pay a third party with opaque rating practices to issue them an 'ESG score'? You're already asking them for a lower price on products and services and now they will need to invest time and resources to complete often very complex questionnaires. If they are SMEs, they will, almost certainly, not have the time and resources to thoroughly review and contest any inaccuracies in the rating result so having paid for it and receiving a poor result is going to seriously endanger future engagement on the topic.
The operating principles of ESG-focused due diligence can be similar to those of reputational diligence (see here for our thoughts on OSINT in the Global South). In the Global South, keep in mind, however, that environmental regulatory agencies not immune to politicization. If speaking to human sources, keep in mind there can be marked cultural differences that can influence perceptions of whether something is or isn't 'ESG friendly'. Finally, the role of the state may also influence how and whether opinions on ESG-related topics are expressed freely.
Take note of the fact that with ESG topics, there will be different levels of understanding and development in different regions of the world. You owe it to your suppliers, particularly SMEs in the Global South, to provide support on these topics if you expect them to invest resources. You cannot simply expect them to become educated on these topics overnight. In many areas (like GHG for example) the data, infrastructure, and supply chain transparency simply are not present in many parts of the Global South; that's not going to change overnight, certainly not without the support of the customers demanding the change. Keep in mind, equally, that this desire for your suppliers to improve on ESG implies they will need more resources, which ultimately implies higher prices for you.
This post has taken a critical view of current approaches to ESG and pointed out several shortcomings. I do not mean to question the value of the movement in principle. It goes without saying that encouraging sustainable solutions in all the ESG areas across global value chains is a meritorious endeavor worthy of support. However, doing so effectively requires the proper foundations in oversight mechanisms and regulatory regimes, not to mention listening and dialogue with companies in the Global South who are often key links in the value chain. There is only one word to describe the frenzied speed with which ESG Inc. has monetized the topic without delivering value; global companies have jumped on the bandwagon with little to no oversight; and regulators have issued new requirements, all with little consideration of sustainability or real-world impacts in areas like the Global South: unsustainable.