ESG advocates use a variety of jargon to describe their activities and goals. Some are pretty straightforward to define, others are rather ambiguous and slippery. Today’s column will help you cut through the clutter and ask the right questions of ESG advocates.
Here are a few general terms worth explaining:
Not all ESG-related behavior is really legitimate ESG behavior. Sometimes firms simply engage in “greenwashing.” This label is used pejoratively against those who are not doing ESG “right.” While the term greenwashing was coined in the late 1980s, it really only took off after the United Nations created the ESG label in the early 2000s.
Greenwashing means using environmental language to deceptively label companies, products, or activities as more environmentally friendly than they actually are. Perhaps a company pretends to have environmentally friendly policies while continuing to pollute, or does something showy (like planting a few trees) but of limited significance.
“Greenwashing” may seem like it would only be used against those who are undermining or avoiding ESG goals, but it has also been leveled by the SEC at ESG-labeled investment funds who purport to advance ESG goals but whose activities are deemed to be cosmetic or insufficiently radical.
Another ESG term is the “license to operate.” While that sounds like a legal term, ESG advocates use it to mean some kind of social approval or popular mandate. Unpopular companies, therefore, have a low or non-existent “license to operate.” Companies are charged with a duty to develop buy-in and approval of various stakeholders, many with limited knowledge of how the company, or business in general, actually function. Put another way, companies are expected to “give back” to their communities. Or else.
Or else what? That part is usually left unsaid.
Though this “license to operate” may sound like a fictional bogeyman, I mentioned the term to a friend who works for a major mining company and he said management there spends a significant amount of time and energy worrying about their (social) license to operate. This term has roots in the idea of corporate social responsibility, which suggests that businesses can be illegitimate even if they have not violated any laws.
Tobacco and alcohol companies, firearm producers and distributors, gas and oil producers, and firms developing natural resources all start with a questionable license to operate. They must “give back” to various community organizations to justify their existence.
Diversity, Equity, and Inclusion (DEI) is another acronym full of landmines and obfuscation. What these terms actually mean depends on whom you ask. Sometimes, advocates say, it simply means good business practices like not discriminating based upon race or sex, taking sexual assault claims seriously, and promoting based on performance rather than nepotism. None of those things, however, requires DEI offices or consultants. They certainly don’t require Chief Diversity Officers.
More often, DEI advocates pressure companies to have employee, manager, or board member quotas based on ideas of intersectionality — layers of identity ranked on how “oppressed” or “privileged” individuals and groups might be. Equity in this sense means equal outcomes, not equal treatment or equal opportunity. And Inclusion means accepting gender and race-based ideology – being an “ally” and making the right public statements, or at least donating to the right causes. This UPS report is a perfect example.
Corporate Social Responsibility (CSR) arose in the 1990s and early 2000s to expand the scope of what businesses ought to do. CSR helped birth the idea of the “environmentally conscious consumer.” It also suggests that businesses should consider the environmental and social impacts of their activities, beyond what is necessary to generate shareholder returns or comply with existing laws and regulations.
Companies are criticized for paying wages deemed too low by outsiders, or for not “giving back” to the communities in which they operate. Eventually, concerns spread to how companies sourced materials and subcontracted in other countries, whom they were also supposed to hold to widely varied definitions of ethics, safety, health, and pay equity.
The ideas of Corporate Social Responsibility strongly infuse Environmental, Social, and Governance criteria today.
Finance has become the main target of ESG advocacy. Here are a few related financial terms that preceded the rise of ESG and are still important:
Divestiture – Diverting investment from “problematic” firms or industries (fossil fuels, tobacco, alcohol, firearms, etc.) to pressure them to change their policies and activities. Divestiture usually involves a concerted campaign to get many people, especially those managing large amounts of capital such as fund managers, to do the same.
Impact Investing – Choosing which companies to invest in based on non-monetary goals. This can be done by using general strategies, actively managed funds, or passively managed exchange-traded funds. Investors accept lower returns because they believe they are advancing other social objectives.
Fiduciary Responsibility – The traditional, long standing legal obligation to pursue the highest monetary return for a client, investor, or owner. This responsibility undergirds strong property rights, innovation, and entrepreneurship. It is an essential piece of a well-functioning profit and loss system.
Stakeholder Capitalism – The idea that companies have responsibility to advance the goals and interests of various stakeholders, even at the expense of profitability. This model allows the social, environmental, and even political goals of non-owners of capital to influence how resources and property are used.
Sustainable Finance
Various bonds and instruments are created to fund activity that advances social or environmental goals. These range from Green Bonds and Blue Bonds focused on environmental impact to Gender Bonds and Racial Equity Bonds focused on DEI-related objectives.
Compliance (regulated) Markets
Carbon allowances – a measure of total emissions individual companies are legally allowed to produce. Allowances vary by jurisdiction and often use “one ton” of some pollutant as its basic metric.
Carbon credits – carbon allowances that are bought and sold between companies – usually through some kind of exchange.
Cap & Trade AKA emissions trading schemes – programs that set total carbon allowances in their jurisdiction, allocate those allowances among companies, and allow companies to buy or sell their allowances (carbon credits).
Voluntary Markets
Carbon offsets – carbon-reducing activities that pull greenhouse gas emissions out of the environment, like planting trees. Companies pursue these activities to increase their ESG scores and potentially to strengthen their license to operate.
Carbon neutrality – offsetting a carbon footprint by as much carbon as you produce, resulting in a theoretical net-zero emissions for an activity.
Net zero – The same as carbon neutrality but with respect to all greenhouse gas emissions, not just carbon dioxide. A few other major greenhouse gasses are Methane, Nitrous Oxide, and Fluorinated Gases.
Climate-related SEC disclosures (450 pages)
Scope 1 – greenhouse gas emissions created by a company’s operations
Scope 2 – greenhouse gas emissions from the production of energy a company uses
Scope 3 – emissions generated by a company’s upstream suppliers and downstream users, with special focus on supply chains
While this overview of terms may feel overwhelming, it illustrates the breadth and extent of Environmental, Social, and Governance criteria now used in financial and business decisions. While the spread of ESG is alarming, its individual goals, terms, and ideas are not overly complicated.
While I have attempted to clarify the ESG advocates’ terms, the devil is in the details. One of the weakest parts of ESG is the ambiguity and disagreement, even among its advocates, as to how to define and measure many of their objectives. Without objective measurements or standards, regulators, lawmakers, and investors will not be able to judge the ESG merits of individual companies.
