Witold Henisz, vice dean and faculty director of Wharton’s ESG Initiative, has been leading research on environmental, social, and governance factors long before ESG became a trending topic. In this podcast, he explains the importance of making the business case for ESG and addressing climate change, and why it’s so difficult to put hard science behind the numbers.


Dan Loney: Let’s start with ESG as the concept and the framework. What is the connection to this terminology?

Witold Henisz: Let’s make sure the listeners know what ESG actually stands for: E is for environment, S for social, G for governance. The collection is the set of environmental, social, and governance factors that, by the SEC definition, materially influence the things investors should care about. It’s the things that materially influence a firm’s revenues, costs, or efficiencies, and should be incorporated into financial models, into investment valuation, into strategic assessments, but are often left out. They’re often not addressed. They’re often taken for granted. The whole ESG movement is about putting them in.

Loney: This has been very important component of your research. What drew you to looking at ESG and climate risk in the first place?

Henisz: For 25 years, I’ve been working in the S dimension and continue to do a lot of my work there. I look at political and social risk management. I’ve looked at how stakeholder engagement by firms — managing the relationship with government officials, with communities, with civil society organizations — is a key value driver. I did a lot of that work in the extractive space of oil, gas, mining, and heavy manufacturing like semiconductors or pharmaceuticals. You might have the formal rights to do something. You might have all the permits, all the licenses. But if you don’t have the support of all the external stakeholders — not just those in your value chain, but those secondary stakeholders, the community, the government, the civil society — you might get stopped in your tracks by protests, by strikes. Or you might operate for a while and then get sued. There might be a regulatory inquiry. You might get shut down.

When you tell that story, it’s really obvious. But because those costs are in the future and unknown, firms often don’t manage them particularly well. They under-invest upfront in the relationships that could help forestall certain risks. For a long time, I tried to make that argument clear. And I tried to work with alternative data because there isn’t publicly available data that often helps. I tried to help make the business case that more attention to political risk, to social issues, was actually good business. The ESG movement needed exactly the same thing — an eye for a different approach to data and analysis, and a way of making the link between these ESG factors and the P&L [profits and loss].

The Business Case for ESG

Loney: Make the financial case for addressing climate change at this point.

Henisz: I think it’s increasingly easy and straightforward. There are going to be assets that are literally underwater. Whether it’s a real estate investment or a factory close to a port, if we don’t do something about the 4- or 5-degree scenario we’re on, certain assets are going to be underwater by 2030, 2040. And you should be incorporating that into your valuation models.

We’re probably, hopefully, shifting away from a heavy dependence on fossil fuels to more green sources of energy. Investments made today in an oil field that are going to pay off over 40 or 50 years might not pay off, because no one might want that oil in 2050 or 2060. Similarly, counting on there being fossil fuel vehicles in 2050 or 2060 may or may not pay off, depending on how fast we have the uptick of electric vehicles. So, we have to think about the investments we’re making today that have a sufficiently long horizon with an eye to what the future is going to bring in terms of environment policy, environment prices, and the use of different sources of fuel.

Loney: Part of the ESG discussion is the path that a lot of corporations and their leadership are taking in this space. One of the important cases is Engine No. 1, which has won seats on the board with Exxon Mobil. You were involved with that. How did that develop?

Henisz: Engine No. 1 began with its core business model really focused on the idea of bringing in ESG factors. But most people first became aware of them because of their campaign to unseat four board members of Exxon Mobil. They built a brilliant 78-page deck that analyzed the business case for Exxon Mobil doing more on the energy transition and highlighting that the company was actually destroying shareholder value by not attending to the energy transition.

[Exxon Mobil] had forecasts for the future price of oil that were rosier than OPEC. They had forecasts for the future demand of electric vehicles that were more pessimistic than just about anybody in the world, and they were making investment decisions accordingly. That was leading to a massive waste of shareholder capital — estimates of over $200 billion of shareholder value destroyed. There was also the question of CEO Darren Woods’ pay and the corporate governance of the factory, the G factor. During the time that he destroyed $200 billion of shareholder value, he got $70 million in bonuses. Is that good corporate governance? Does that make any sense?

He also appointed to the board a series of executives who underperformed their industries when they were CEOs and had absolutely no energy sector experience. So, no one on the board could give him any realistic or tangible advice on the energy transition and what to do about climate transition because none of them knew anything about the energy sector. Again, that’s just bad corporate governance.

You put all that together, and you’ve got a very strong case that they needed more oversight and more awareness of the energy transition on the board. And Engine No. 1 mounted a campaign to do that. I became involved as an adviser to Engine No. 1 on a different project, what they call the total value framework, which I co-developed with a group from a major consultancy to generalize the case of Exxon Mobil. Try to analyze which companies are destroying value to stakeholders, and think about when that might hit shareholder value. We did that for the entire S&P 500, and now it’s been extended to the Russell 1000. That was a major research project to build a data set that would allow them to look not just at one company but at a whole set of companies, and make investment decisions and engagements accordingly. I continue to work with them on that project.

Loney: A lot of people talk about that move to win board seats by Engine No. 1 as a pivot moment. Do you think that that is the case?

Henisz: I think there are a couple factors in play. When they first started, everybody kind of wrote them off. “You own .02% of the stock. Who are you guys? You’re going to unseat three board members? Really?” And then it gathered momentum. People were like, “Wait a minute. This is credible. This is serious. Look at this analysis.” Then three of the four proposed board members were ousted, and I think the next morning just about every board member in a publicly traded company anywhere in the world reading that newspaper article said, “I don’t want to be them. I want to keep my job. What am I missing? What do I need to understand about the hidden risks or the missed opportunities from ESG factors? I better get a report about those at the next board meeting. I want to make sure that I’m doing my job, and I can stand up to this kind of attack.”

I think that amplification of the message — not just the headlines, not just the fact that it was Exxon Mobil, not just David versus Goliath, but the fact that every publicly traded company in the world’s board is suddenly starting to talk about ESG factors at the next annual meeting — was the biggest impact that Engine No. 1 has had to date.

How to Measure Progress on ESG Issues

Loney: That puts an even greater focus on ESG data. How can we better use that data to move that needle forward?

Henisz: Let’s start with the current state of the data that we have. Most of it, honestly, is quite bad. It’s based on voluntary, unaudited disclosure by corporations. They either put stuff in their sustainability report or answer these really long surveys that companies sell them. And then different companies sell us the data.

We’re only getting a snapshot of what the company wants to share and what some third-party data provider can cobble together. Even if that data was accurate, there’s like 100 factors, sometimes 300 factors. How do we weight them? How do we put them together? We’ve got performance measured in one set of units here, and performance on another factor in a different set of units here, and another factor here. Should they be all equally weighted? Probably not. Carbon emissions matter more for Exxon Mobil than it does for Facebook. Teenage depression matters more for Facebook than it does for Exxon Mobil.

But how do we shift the weights? And how do we turn tons of carbon and number of teenage girls in depression to dollar values that might hit shareholder value? Those are the questions the current ESG data sets don’t answer and, frankly, need to be answered. The total value framework was a big step towards doing that, but we’ve got a long way to go. We’ve got to really measure the impact that companies are having. And that’s more akin to impact investment or impact valuation.

We also have to have a point of view about when those positive or negative impacts are going to hit shareholder value. Some firms, some cases, that’s going to happen really quickly. That happened with Exxon Mobil. Other cases, maybe Facebook, there’s a more difficult pathway. There’s more protection for the firm from these stakeholder forces, and it’s harder to build a business case, even though the firm is creating harm. It’s harder to say that shareholders are going to bear the brunt in the short term. We really need to think through both of those, and very few ESG data sets allow us to do that.

Loney: What kind of role will regulators have in this process as we move forward?

Henisz: We’re starting to see greater requirements for disclosure of things like the emissions you release and greater attention to your risk mitigation mechanisms. What would happen to you if there were a 4-degree scenario? How many of your assets would be underwater?

This is a major and material risk for companies. Under the current guidelines being discussed, the SEC is demanding that firms both report their emissions and undertake analysis on different scenarios that could occur in the future with respect to the climate transition. That’s going to help investors, but it’s not going to be the end of the game. There are many ESG factors for which we don’t have strong disclosure standards yet, for which we’re still figuring things out.

Some of those scenarios aren’t as clear. Four degrees versus 1.5 degrees warming scenario is a pretty clear thing to model. But what about the future state of human rights law? Or the future state of customer damages, like the Facebook teenage depression? How do we model those? What sort of uncertainties do we face? How do they differ from the European Union to the U.S.? None of that is in the regulations yet, and it’s pretty difficult to put in there.

I think regulations are always going to establish a floor. And then companies like Engine No. 1, other asset managers — whether it’s BlackRock, State Street, AllianceBernstein, Parnassus, Morgan Stanley — they’re all going to be trying to figure things out above the floor. It’s good to raise the floor, but there’s always a lot of action above it.

Loney: Are we going to be able to effectively deal with these issues if we have these time windows starting to clamp down on us?

Henisz: I think it’s a really important observation, and it also highlights the limits of ESG investing. Some people think that ESG investing is going to solve all of these problems. It’s going to solve the problems of climate change, solve the problems of racial justice. All it’s supposed to do is incorporate ESG factors into an investment thesis. If the current policies, the current stakeholder opinions, don’t lead to that being internalized by shareholders, it’s not going to solve the problem. It’s only going to make sure we’re not leaving stuff out.

We may have to go further in terms of pricing carbon, in terms of addressing systemic racism, to really have the impact we want on a society. The ESG initiative and ESG investing more broadly is just about not leaving things out. But it’s not about getting things exactly right. We may still need more policy, more legislation, more regulation to achieve what we want as a society on some of these issues.

Challenging the Anti-ESG Movement

Loney: There is also this anti-ESG push out there that plays into our political discord.

Henisz: We’re certainly seeing a real surge in this anti-ESG movement. And it’s gaining a lot of power, especially with the new Republican Congress. I’m optimistic that we may be at the point of peak-anti-ESG. Because in recent days, North Dakota, which is a pretty red state, their legislature voted 90-3 against bills that would restrict ESG investing. Why? They said, “Why should we, the government, regulate the financial market’s ability to incorporate ESG factors? We’re not in the business of regulating. We believe in free markets. And it seems like the free markets value ESG.”

There’s been similar pushback in Indiana, in Kansas, in Wyoming, in a number of states. I was talking to representatives in Arizona yesterday about their efforts to push back against the anti-ESG. That ESG factors are material, by the SEC definition, and that the anti-ESG movement is imposing regulation as a solution is starting to highlight that this may not actually be about what they claim it is. It may not be about protecting pensioner’s value. It may be more about protecting polluters, protecting people who don’t care about their workers, or finding a political wedge issue, kind of like critical race theory or transgendered bathrooms, that resonate with some people but may not be as big of a problem as we think for society.

And maybe the costs of regulating, the costs of taking certain financial institutions out of the market, as our own Daniel Garrett’s research has shown, could be much larger than the political benefits in the short term.

Loney: What kind of growth do you expect for funds that have started to incorporate ESG components? And what’s the best way to attract more investors in that world of ESG investing?

Henisz: What we’re trying to do with the ESG initiative, and what the better investors are doing, is to build the business case. In some ways, talk less about ESG, and talk more about profits, losses, efficiencies, costs. Model the cost curves of the energy transition. Look at the unexplained variances on the profits and loss statement, and link them to ESG factors, but start with the P&L and focus on the P&L. Focus on the business case. The more we do that, the more sophisticated we get in looking at the energy transition, in looking at the changing workforce, in looking at ESG factors from a business standpoint, the better our investment decisions will be, the better the returns on those investment decisions will be, and the easier it’ll be for you as an investor, whether you’re red or blue when you go into the voting box, to say, “This just makes good financial sense. I don’t want to leave this stuff out. Let’s make sure it’s in.”