Head to Head: Is it time to change the terminology around ESG?

As our understanding of sustainable development evolves, so, too, should our characterization of responsible investment.

For instance, consider the United Nation’s Kunming-Montreal Global Biodiversity Framework, which recognizes biodiversity loss as a global risk. This has prompted institutions that cater to specific investment preferences to revisit the classification of ESG assets to align them with the implications of this new policy.

Read: 91% of Canadian institutional investors say climate change is top ESG concern: survey

That said, the advent of these guidelines often results in superficial activities surrounding ESG terminology. These activities aim to extend the set of permissible assets, sometimes resorting to fabricating evidence to meet guideline requirements — also commonly referred to as ‘greenwashing.’ In response, more sophisticated, ESG-aware investors, whose fiduciary responsibility necessitates maximizing their earnings over an extended horizon, must update their ESG approach for purely financial reasons.

In this context, ESG guidelines should delve beyond a company’s mere inclusion in a list and instead strive to gain insight into firms’ fundamentals through exploiting their ESG performance.

For long-term investments, the physical risk that companies face is more informative than regulatory or reputation risk, which inherently carry degrees of political uncertainty. The latter risks also tend to diminish in relevance, or materialize less, as governments lose their incentives to commit to certain ESG goals or as financial players encounter community pushback.

Read: Prioritization of energy stocks over decarbonization goals a barrier to ESG investment metrics: survey

This shift of focus from transition risk to physical risk underscores the need for a profound re-evaluation of ESG terminology, enabling investors to more effectively assess the tangible and measurable risk implications of ESG issues that could undermine organizations’ future operations.

Hugh O’Reilly, president and CEO, Acuity Global Inc.

ESG isn’t in need of a name change; it’s in need of an extreme makeover.

ESG has to move from elevating form over substance to a set of practices that welcomes scrutiny, responds to challenges and demonstrates its value. A name change or engaging in ‘greenhushing’ — in which ESG is adhered to but not talked about — won’t meet the challenge that ESG faces.

Until recently, ESG lived a charmed existence. Who could complain about a way to evaluate companies on the basis of sound ESG practices? But ESG has moved from an evaluation methodology and a basis upon which companies could be pressured into improving their practices to what purports to be an investment strategy.

Read: Research finds pensions struggle to determine metrics for ESG goals

ESG proponents — I was, and still am, one of them — claimed ESG was something of a holy grail: not only did the investments ‘do good,’ but they also performed well. ESG funds became something of a trend in the investment world. When demand for oil collapsed during the coronavirus pandemic, ESG funds did extraordinarily well because they typically didn’t hold, or were underweight in, oil and gas stocks. The performance of these funds has since fallen off.

ESG as a means to evaluate the behaviours of companies is clear, but its role as an investment strategy is much murkier. Is being underweight or not investing in fossil fuel companies sufficient? What if companies have good environmental practices but have poor labour relations practices or use aggressive tax planning to avoid paying their fair share?

To meet these challenges, a mere name change won’t work. ESG needs to be clearer about what it is — a means to evaluate companies — and give investors the ability to use that tool to determine if companies with high ratings are, indeed, better investments.

Read: ESG investing can help investors identify, address systemic risks in portfolios