ESG’s ‘Social License’ Will Endure Even If the Letters Don’t

It’s been a bumpy stretch for adherents of investment strategies based on environmental, social and governance data.

Much has been written about how Vladimir Putin’s February invasion of Ukraine raised geopolitical questions about why ESG-focused funds were even invested in Russia. Then markets tanked, with many huge ESG funds getting slammed for posting losses worse than those suffered by benchmarks, thanks to their massive holdings in beat-up tech stocks.

In a new paper entitled “Does ESG Really Matter—and Why,” consultants from McKinsey & Co. run through the many reasons why ESG has attracted such intense criticism of late. But they ultimately conclude that, regardless of the current turbulence surrounding its specific components, ESG’s underpinnings and the “social license” adherence to them will remain important for companies far into the future.

Detractors complain ESG is often just public-relations cover rather than true corporate belief, where greenwashing is employed to profit off of unwitting environmentally and socially conscious investors. The concept itself is also seen as an odd bird, a weird combination of ill-defined elements whose focus should mainly be on environmental sustainability.

The nebulous nature of ESG is clearly illustrated by the lack of agreement on its meaning. For example, while credit ratings from Standard & Poor’s and Moody’s Investors Service are in sync about 99% of the time, ESG scores from six of the most prominent ESG ratings providers are found to be comparable closer to 54% of the time, according to a paper cited by McKinsey. And even when ESG can be measured appropriately, there’s often no meaningful relationship with a company’s financial performance. (Bloomberg LP, the parent of Bloomberg News, also provides ESG data, analysis, indices and scores.)

But even with its inherent problems, what ESG represents at its base is critical to modern corporate decision-making, McKinsey says.

“While acronyms will come and go, the substance of what matters long term to companies and their stakeholders won’t change,” said Hamid Samandari, a senior partner at McKinsey who was part of five-person group that co-authored the article.

Companies are increasingly going to be under pressure to ensure they can “build purpose into their business models in a sustainable way and respond to their stakeholders’ growing focus on the impact of the company’s actions on the environment and society,” added Lucy Pérez, who’s also a senior partner and co-author.

The group examined the question of whether companies that show an improvement in ESG ratings over several years exhibit higher shareholder returns, as has been claimed by proponents. While they find some early indications of a correlation, they contend that the numbers are inconclusive.

McKinsey instead says the main reason for a company to focus on ESG is to maintain and enhance its so-called social license. Regardless of the current debate, many companies are advancing on the sustainability front to improve their long-term financial performance. More than 5,000 companies, for example, have made net-zero commitments as part of the United Nations’ “Race to Zero” campaign, and most businesses are being forced to adapt to the climate crisis. Moreover, some 90% or more of companies in the S&P 500 now publish ESG reports.

For the best outcome, companies should focus on ESG improvements that are informed by and support the evolution of their business models, even if the improvements don’t directly lead to higher ratings, the McKinsey authors wrote.

And there are tangible risks for companies that don’t take action.

“If companies, particularly those with significant externalities, such as high-emitting industries, hold out for perfect data and a ‘flawless’ rating process, they may not have a business in 20 to 30 years,” they warned.

Bloomberg Green publishes Good Business every week, providing unique insights on ESG and climate-conscious investing.

Photo: Climate activists from Extinction Rebellion gather in London last year/Bloomberg