Wharton’s Eric Orts talks about his new book, The Ethics of ESG: Critically Assessing the Environmental, Social and Governance Movement.
Transcript
How Has ESG Evolved?
Dan Loney: There continues to be a deep discussion about the path of ESG. Some of the discussion is around the ethical side of things. You have various levels of investment, which can be designed to capitalize on the potential profit that can be gained. But you also have to focus on the benefits that can be brought forward to the public at large. How do those two balance each other out? A new book tackles these ethical questions. Wharton's Eric Orts is co-author of The Ethics of ESG, and he joins us right now.
Eric, you and I have talked about ESG in one form or another for about 15 years now, as long as I have been connected with Wharton. As you look back over this time, how do you think the world around ESG has evolved?
Eric Orts: Good question. I think since we've been talking, ESG really has come into being. The origin story of ESG is that the United Nations met with a number of large institutional investors and said, “Hey, we want you to do something about large topics that are affecting the whole world, including the climate change problem, biodiversity loss, social issues like human rights, using slavery to produce goods.” There was a push to get the investing community on board with some kind of general project. And that's where ESG, which stands for environmental, social and governance criteria, got its start. And then it developed.
The institutional investors had a very large hand in pushing development of ESG criteria. The primary direction was to try to measure when these different factors — and there are many factors — that are not traditional financially material factors that you would see in annual reports to the SEC, for example — to what extent do they affect the bottom line? To what extent are they financially material?
The idea was that there was a lot of low hanging fruit on this issue. There's also an idea that if you take, for example, climate change, there's a long-term economic effect that may not have been taken into account by a lot of businesses that are just looking very short term.
The basic idea in the original conception — at least as the institutional investors saw it — was that you were improving the financial materiality measures, and that this would help to have a win-win solution. You'd get some gain on issues like climate, etc. But that would be because you'd be having long-term financial gain.
The problem is that also in this picture was the United Nations. And notably not in the picture particularly strongly were nonprofit organizations that care about issues like climate and human rights and other things, because their interest is not only in financial materiality. They care about actually making a difference that the world feels. In other words, you really have a reduction of human rights violations, or you have a reduction in traffic and sexual trafficking. You have a reduction of greenhouse gas emissions. And it's not just because you care about the long-term economic health of investors. It's because you care about everybody having a collective achievement.
That kind of tension, which really goes back to the time when we were talking 15 years ago, is still there. There's a tension between these two kinds of forces, and what we see now is an updating of that. We also have seen a politicization of this issue, so it's not just business trying to do one thing or another. It's also become politicized. The acronym ESG has joined the acronym DEI as a targeted enemy for some political forces.
Part of the problem is that there's a lot of misinterpretation. One of the problems with an acronym is it means different things for different people. When one side that has a lot of influence, and is currently in power in Washington, has targeted the whole idea, then you're going to have a retreat from it. Because no business really wants to get in the line of fire of the White House right now.
Focusing on the Real Goal of ESG
Loney: The book tackles that balance that needs to be looked at even greater. The morality of how you approach ESG as we move forward, both from the business side, but also from those concerned about the environment and climate change, and more. Correct?
Orts: Exactly. The subtitle is that we critically assess what's happening with ESG. We try to go beyond, “Yes, it's good,” “No, it's not good,” into understanding, what are different people talking about in this debate? We have different perspectives that are represented.
Some of the contributors — Lisa Fairfax at Penn Law School and Joseph Heath at University of Toronto are examples — really think that this will work if we focus the understanding of ESG on shareholders, so that we continue with what I would call mainstream ESG, which is trying to explain to people, “No, this is really just about financial materiality. It's really the same kind of thing that businesses have been expected to be doing for a long time before you had ESG. It's just improving that process, and we really have to stay with that.”
Now, others of us, and I'm included on this side, are saying, “Well, wait a second. This really doesn't always make sense, and it's confusing.” If you're saying, for example, “We're measuring our environmental impact, and part of that's climate.” But if you're then saying, “But it's only when it's affecting the financial materiality,” that is not covering what most people understand if you say, “We're acting to help the environment.”
One really interesting development that we've seen here adopts that point of view, and that's in Europe. The European Union has adopted a series of corporate sustainability and financial sustainability regulations that attempt to solve this by saying, “No, you also have to report on something called impact sustainability. The actual effects you're having on the climate.” So you're moving toward a double materiality standard in Europe. On the other hand, in the United States and other countries, there's not that view.
China has adopted an ESG interpretation. And once China says, “We're doing ESG,” then everyone in China has to do ESG. The system works a little differently.
What you have is a continuing evolution of what we're really talking about here. Whether we're going to continue to call this ESG or not, I think is an open question. Because a number of people have said, “What are we really looking at? Maybe we should drill down and just look at the climate, for example, or other particular issues, without trying to put everything that is not an ordinary business concern into this bucket called ESG that's not very well defined.”
Loney: The hope is that, by being able to do that, you can get more people, countries, on board? To have a better understanding of what the actual attainable goal is, so you can get more people focusing on that area and have a better outcome down the road?
Orts: Yeah, exactly. I saw the political backlash against ESG coming early on, when it was first being proposed, and when schools like the Wharton School were standing up ESG programs. We've adjusted to this criticism as well, over time. But in some ways, the criticism is correct, because there was a way in which the institutional investors who had a good spirit about this — I think they really wanted to do good with this. But the way it comes across to people is that, “Wait a second. Who gave Vanguard and the big institutional investors the right to decide to push on this issue?” And their defense was, “We're just being financially responsible here. That's all the ESG is.” But when you call it ESG, it's hard for people to believe it.
When you have a critique — to some extent, I think it's valid — of elites. You know, a criticism of the elites of the world, pushing down their view on other folks. That's part of what's driven a populist backlash, I think, in the United States. To some extent, I think what that means is you really do have to integrate this into a legitimate political shift.
This is my own personal opinion. I'm not representing all of the authors in this book, and it's a co-edited book. But what I think you have to get down to is everyone agreeing to some kind of a regulation. When I first got into this, Wharton paid for me to go to the original Earth Summit. This is showing how old I am, because I was just starting here. It was in 1992, and this radical liberal lunatic named George H.W. Bush was hosting the U.S. sign on that. There was a major treaty that was agreed about climate, saying, “We need a framework for dealing with this.” There was a major treaty agreement about biodiversity. I also was amazed to see a huge business contingent that was there. Already, then, businesses were getting involved and saying, “We understand this is a problem for everybody.”
I think what we need to get back to is a consensus, where you have everyone agreeing that this is a problem. And then it works through the regular political process. You can't just say, “We're going to do it. All the big companies and big investors of the world are going to do this.” Because then I think we run into this political backlash.
One other footnote there is, I don't think that's going to last forever. If you talk to a lot of the big businesses and investors, the science doesn't really lie. People still have to orient the risks that their businesses are taking, etc. I just heard from a top executive in an insurance company in my class yesterday. One of my colleagues calls it “green hushing.” They still recognize [the risks]. If you're an insurance company, you can't say, “Well, it's not politically favorable to worry about the climate problem anymore,” because it's changing your risk profiles. If you write insurance in California, you can't pretend that wildfires aren't breaking out more frequently and burning more houses down, right? That's true of a lot of big, major players. So, I think you'll see the pendulum shift back eventually even in the United States.
The other thing to say is, this is really mostly a U.S. phenomenon right now, this backlash against ESG. In many other countries, you still have this development of new standards, new legislation, etc., that we're going to see.
Loney: That leads me to believe that we are still far away from having some middle ground that we'll be able to find, where all parties are in unison of focusing on the importance of this topic. Understanding that there's a financial component to it, but also working through the moral side of this as well.
Orts: Yeah, I think that's right. I've been teaching business ethics and sustainability and the business law side for a long time, and it's not really new. This is an issue that we have, a tension that we have in our system. On the one hand, our market-based, rules- based system has been incredibly productive and beneficial for many people. At the same time, it doesn't always consider some of the ethical issues or social issues that are really important to maintain the actual system.
I think ESG is part of that more general process that we're always negotiating as long as we have that kind of system. And I hope we continue to do that, because the world, the livelihood of many billions of people, is depending on us to get that right.
