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Author of the article: Michal Moroz, Business Development Manager, Association of Critical Infrastructure
The art of risk management lies in the ability to work with probability. To describe it simply, you set out a range of possible threats, from the usual to the seemingly absurd (such as a two-year global pandemic or a tornado near Hodonín). Then you describe the impact that the threat could have on you if it actually occurred. And it remains “only” to determine the degree of probability that it will actually occur. If you get a combination of high probability and overwhelming impact, this means a significant risk that you should actively manage. Which means not ignoring it and dealing with it somehow. These principles can be applied almost anywhere. And although it sounds trivial, believe me, it’s art.
So what are the threats to business from introducing something as seemingly socially beneficial as ESG? There are an unexpected number of them. Just put the opening question in context and ask it a little differently. For example, how to survive ESG in a polarised political environment, a turbulent geopolitical situation and an unprecedented economic crisis? In a world of overt and covert lobbying…? This brings me to the key source of ESG-related threats, which is indeed the wide range of interests of all possible influence groups, the so-called stakeholders.
The essence of ESG is to achieve compliance, modern compliance. But what kind of harmony are we actually striving for here? With the company culture? With the policy of the parent holding company? With EU standards and Czech legislation? With decrees and guidelines from regulators? With the rules of the exchange? With rating agency methodologies? With investors’ expectations? With the interests of workers and unions? With the preferences of our customers? Or with the demands of various influence groups influencing public opinion? Or is it all of them?
Let’s face it, that’s an unattainable ideal. The interests of our stakeholders are not necessarily aligned. If they do not differ in substance, they often differ in the manner, extent or intensity with which they seek to achieve their objectives. Moreover, individual stakeholders influence each other, which by definition is especially true for groups of influence. They are able to influence politicians and public opinion thanks to their focus and organisation. Their importance may not be directly proportional to the percentage of the population whose opinion they represent. That is why they are usually able to push through a distinctly minority view. After all, that is the essence of their business.
The danger is that their true motives may not be obvious at first glance. Most people in civilised countries would undoubtedly agree that we should protect nature, support the disabled, not judge others by the colour of their skin or bribe to win contracts. But the devil is usually hidden in the details. Or rather, in what ways we want to achieve these virtuous goals. Sometimes a good cause can hide behind a cynical partisan interest. A recent example? For example, the suspicion that German anti-nuclear activists were financed by the Russian fossil fuel lobby.
Anyway, ESG has become a new buzzword in recent years. Governments, stock exchanges, banks, insurance companies, in short, all those who do not want to be left behind, are talking about it. Logically, it is promoted and accentuated mainly by those stakeholders who are able to assert their interests through it. Thus, it is natural that as ESG’s popularity grows, so does its criticism. This is mainly coming from those whose interests are directly threatened by the ESG, or who simply cannot see their interests reflected in it. Which is nothing to be offended about. In their analysis last year, analysts such as McKinsey mentioned* the reality of the growing criticism of ESG:
“Critics argue that the importance of ESG has reached its peak, and attention will increasingly shift, they say, to the more fundamental elements of Maslow’s hierarchy of public and private sector needs . .. in the future, today’s interest in ESG may be remembered as a mere fad and will go the way of similar acronyms used in the past.”
The wish father of the idea? No doubt. Strong words? Yes. Surprising? Not even a little bit. They are just the natural counterpoint to the opposite extreme represented by green/woke activists. Both extremes are, of course, wrong. Only a delicate balance on a system of bowls and scales representing the interests of individual stakeholders makes sense. Only the future will tell whether such a balance is achievable. The attempt by some to predict it is more like divination from a coffee grounds. There is only one thing that can be said for sure – if it will be the so-called. on the force, it won’t be without major conflicts.
To avoid unnecessary conflicts when implementing ESG in companies, we can ask ourselves some basic questions. Everyone should think about them, whether they go into ESG out of conviction or out of compulsion. The search for answers will stimulate the mind, allow us to consider the issue from different angles, and the chosen solution may not end up polarising us more than is strictly necessary.
1/ The question of meaningfulness
This is perhaps the most prominent objection of critics who argue that the imposed ESG is contrary to the very essence of capitalism. According to them, the purpose of private companies is primarily to generate profits for their shareholders. A disproportionate emphasis on environmental protection, social responsibility and good corporate governance detracts from this goal. Therefore, ESG should not be mandated, but should remain a voluntary element of corporate strategy that customers either appreciate or reject. And the responsibility for this decision should be borne by the management that decides to do so towards the shareholders.
Another major objection to ESG is the lack of a demonstrable positive correlation with better performance. And if we do find a link, critics say it can usually be explained by other factors.
On the other hand, a fundamental pillar of the ESG defence is the lack of consideration of the social licence, i.e. the question of whether businesses or entire industries are acting in a way that is fair, reasonable and deserving of trust. That is, in a way that takes into account the interests of all stakeholders, not just shareholders. In their view, critics overlook the fact that managing and addressing massive, paradigm-shifting externalities is a prerequisite for sustaining long-term value.
Reactions to criticism of ESG generally agree on three main points. The external factors mentioned above are becoming more important, ESG measurement will improve over time and ESG-compliant business success is possible. McKinsey analysts agree:
“While legitimate ESG issues have been raised, it is likely that the need for companies to understand and address their externalities will become critical to maintaining their social licence.”
Are you noticing? No, for their profit, success or to keep their business. But to maintain their…social license. This smacks of a paradigm shift.
2/ The question of feasibility
Meeting the sub-technical requirements of the individual components E, S and G is in itself possible. However, taken as a whole, critics say they will present an unmanageable challenge that will impose incredible ancillary costs on companies.
Finding the balance needed to implement ESG in a way that resonates with multiple stakeholders will also be difficult. Because if the company is not able to meet all expectations, it will have to choose who to satisfy and who not to satisfy. A solution that satisfies all requirements will be unattainable. Realistically, it will either be a solution full of compromises or a solution that will be completely unacceptable to some parties.
So the question of feasibility is really primarily a question of decision-making capacity to set priorities.
3/ The question of measurability
Individual ESG dimensions can only be assessed if clearly defined metrics are defined and the required and verifiable metrics are recorded, respectively. auditable data. But can ESG really be accurately measured in all its complexity? Critics say no.
According to them, the biggest shortcoming is the huge (and, it should be added, objective) differences in the evaluation methods of individual ESG rating providers. Different assessment and scoring providers will provide different assessments.
For example, the McKinsey analysis mentioned above provides a stark contrast when comparing ESG scores with credit scoring. While the rating methodologies of the renowned S&P and Moody’s agencies correlate at 99%, the ESG ratings of the top 6 providers correlate on average only at 54%.
So, is ESG measurable at all and how do you decide which way to evaluate it?
4/ The question of proportionality
The key in this respect will be the forthcoming EU-wide regulation. And hand on heart – when you say European regulation, what is the first thing that comes to mind? Words like adequacy, moderation or achievability are unfortunately not. The forthcoming CSRD is proof of this.
Some of you may have heard of the Corporate Sustainability Reporting Directive. If you haven’t, but you’ve recently been through GDPR or you’re preparing for NIS2, take heed and know that the real challenge is yet to come. Unlike these two standards, the CSRD will have a direct and dramatic impact on your business.
And in contrast to the EU’s approach to ESG, it will be necessary to monitor and assess how the rest of the world is doing in this regard. Because it is one thing to regulate one’s own market, but it is another thing entirely whether and how to remain alone in this regulation. The question of adequacy is therefore certainly relevant, as it is closely linked to our competitiveness.
5/ The question of liability
Another major challenge will be the question of accountability. Which one will take precedence? The more specific one – the individual one – towards shareholders and employees? Or the more abstract one – the collective one – towards society or the planet? We shall see, but collectivism is winning.
However, from an ESG perspective, the growing importance of so-called delegated responsibility is crucial. This is closely related to the competitiveness mentioned above. Only a naive person would believe that the rest of the world would go along with the EU and regulate as strictly as we do.
But then what? First we will declare carbon neutrality, mandatory electro-mobility, a switch to renewables or decentralised energy. And in turn, our market will be flooded with cheaper products from countries where no one is concerned about social responsibility, emissions or biodiversity. After all, Chinese companies have already dominated the production of solar panels and batteries, and may eventually dominate electromobility and other sectors.
So if we want to maintain our competitiveness, we must inevitably do something about it. In the first instance, a combination of various protective customs and tax measures is proposed. But Europe seems to want to go further and is preparing to bring ESG requirements to the whole supply chain.
Critics argue that this is not feasible. And rightly so, in my opinion. Because how do you objectively check the veracity of data from suppliers in China, India, Arabia or third world countries? Paper can take everything and there is nothing your Asian supplier won’t promise you in an affidavit. And I can already see European customers flying to Chinese provinces to check on their suppliers there.
How can we objectively assess the origin and safety of the energy commodities, minerals or individual parts used by them? How do we objectively assess and account for the impacts of global logistics, especially maritime transport? And above all, how do we ensure that all these measures do not make goods more expensive? In the context of European inflation and rising unemployment, this may be a crucial aspect.
And the ultimate, and very seriously considered, metric will be delegated responsibility for your customers…
6/ The question of sustainability
Finally, there is the question of the sustainability of the whole ESG issue in the light of global economic and political developments. Before the war in Ukraine, investments in sustainable funds were literally booming and were the darling of investors. However, by mid-2022, global sustainable assets fell for the first time by 13.3%. While this is true for the stock market as a whole, it is still clear that sustainability has run into the barrier of the economic reality of the market in the emergency.
In contrast, the ongoing economic crisis is causing high asset volatility, rising market mistrust, unemployment and inflation. And the first banks are also failing… The biggest American bankruptcy so far was, coincidentally, one of the most progressive banks there, California’s SVB. The bank boasted on its website that it “serves those who are creating positive environmental change” and said it works with some 1,550 companies in the climate technology and sustainability sector. In this context, let me quote a few passages from a Wall Street Journal article that dealt with the SVB collapse:
“Most of the companies we lent to did not meet a fundamental market need. The bank was popular for its willingness to offer banking services to start-up businesses that were often not profitable. In some cases, they had no product. They were basically social credits.”
The WSJ then answers the question of what led the bank to overlook risk and spend money on products or services that no one wants to buy:
“A Washington handout personified by President Biden’s efforts to build a climate industry that would otherwise not exist. Congress’s $1.2 billion 2021 “infrastructure” bill was the launching pad for the frenzy around clean tech. In recent years, the volume of loans and credit lines provided to venture capital firms has increased significantly. How much of this would have happened if not for Biden’s pot of gold at the end of the green tech rainbow?”
Of course, the WSJ analysis does not omit other causes of bankruptcy, but those related to ESG policy clearly dominate. Finally, the author reflects on the White House’s response:
“If this were a regional bank in Texas that specialized in the oil and gas business, depositors would certainly be out of luck. However, the Biden administration immediately stepped in to bail out SVBs and promised to compensate all of these cleantech companies.”
A number of Republicans now blame the bank’s ESG policies for its collapse – claiming that the bank was too focused on turbo-financing climate and social engineering projects. At the same time, they admit that SVB and its clients were doing exactly what Washington told them to do – chasing money.
ESG is clearly becoming big politics in the US. So let’s not forget that we still live in a democracy and capitalism, not a planned economy (although some of us no longer have that impression). Our markets are still built on one thing – trust.
I don’t want to paint the devil on the wall. But I’m pretty sure of a few things. Namely, that in a collapsing banking system, ESG will be the last thing savers will be asking. In a time of rising unemployment, that will be the last thing employees will care about. And in the long run, inflation is the last thing voters will care about. A change in political direction can come unexpectedly quickly, and there are many examples in history that should warn us.
It may well be that in the next election Americans will re-elect Donald Trump to the presidency or a more moderate Republican who will base his election campaign on fighting this phenomenon. Or the Democrats will win again and ESG will continue to ride its wave. But then we run the risk that the US will purposely suck the brains and know-how out of Europe, leaving us with our strict regulation and uncompetitive businesses.
So what advice to give in conclusion? When you plan your ESG strategy, use common sense, work with probability, don’t forget your stakeholders and think in a broader long-term context.
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The above quotes are taken from this McKinsey analysis from 2022:
https://www.mckinsey.com/capabilities/sustainability/our-insights/does-esg-really-matter-and-why