Where does the impetus for ESG come from, and is it fit for purpose?

A satellite view of a river through a desert, with a thin strip of green along the river.
Photo by USGS / Unsplash

One of the questions that has been lurking unarticulated at the back of my mind for a while is the question of who or what is the animating force behind ESG disclosures. I don’t mean in the immediate sense of “who is the author of ESG reports” because that’s a mostly trivial observation (though perhaps telling in its own way) but in the sense of “who or what is making companies disclose?” My initial assumption was a laundry list of possibilities; the Paris agreement context sets an expectation for action; the issue of social license or a nebulous idea of what a “responsible” corporate actor looks like is perhaps part (maybe even a big part); the existence of the standards themselves (like net zero targets, SBTi, the GHG Protocol, the Sustainability Accounting Standards Board, and so on) has a chastening effect, enabling companies to compare themselves to their competitors; and of course the perhaps most compelling reason of them all is that certain jurisdictions require it. But which jurisdictions and what exactly is demanded? How much is required and how much is voluntary?

None of these possibilities on their own seems fully satisfying, so they have to be agglomerated together to sort of add up to a constellation of forces that might explain why the contemporary ESG regime exists and takes the form it does. But I recently read a paper that has me rethinking many of my assumptions, and that helped me understand the historical trajectory of US regulatory moves around corporate disclosure, leading to a far more compelling understanding of the ‘why’, and in the process provoking a bunch of incredibly important questions about what ESG could look like, and who it could serve better.

The paper was published in the Yale Journal on Regulation in 2020, titled “Not Everything Is About Investors: The Case for Mandatory Stakeholder Disclosure” by Anne Lipton – the Michael M. Fleishman Associate Professor in Business Law and Entrepreneurship at Tulane Law School. Lipton traces the history in the United States of calls for ESG-style corporate disclosures, going back to the earliest grants of corporate charters in the 19th Century and moving forward through several distinct eras and approaches to regulating corporate power to benefit society. Her conclusions are that the current regime in the United States is a result of a series of historical compromises, treating the needs of investors as the first (and only) legitimate interest in transparency of corporate information:

The American system of exclusively marrying corporate disclosure to public investment is unusual. In many other parts of the world, all but the smallest corporations are required to disclose basic information for public consumption. Yet America’s regime is no accident: …it is the result of a series of historical compromises whereby mandatory disclosure for investor audiences was used to quell calls for more generalized disclosure. As we shall see, that compromise was doomed from the outset, because an investor-oriented disclosure system tilts corporate behavior more toward wealth maximization and away from social responsibility, which only heightens the need for corporate accountability to the public. (p.537)

One consequence of the current investor-oriented system has been to awkwardly shoe-horn efforts to ensure corporate accountability into a system of disclosures that are framed according to “material relevance” for investors (material in the sense of having bearing on corporate performance and consequently investor decisions). Sustainability issues clearly sit uncomfortably under this umbrella, and Lipton describes the current situation in the United States as follows. Its worth quoting at length:

In recent years, a growing number of commentators have opined that when it comes to the social impact of corporate activity, the informational needs of investors and the public are not so far apart. So-called “sustainability” metrics (sometimes called “ESG” or “environmental, social, and governance” factors), it is claimed, are material to investors’ evaluation of long-term financial performance because sustainable practices ultimately contribute to, or predict, corporate health. Corporations may generate goodwill from customers, employees, and surrounding communities if they are perceived as good citizens, which may translate into higher sales, better employee retention, and productive relationships with regulators. Attention to sustainability matters may also signal that the company is well-run in other respects. In that way, the claim is that investor and public interests are aligned, so that sustainability disclosure designed for investor audiences will both satisfy public needs, and encourage investors to use their influence to provide the social control that the general public demands.

If all that sounds too good to be true, it probably is. The sticking point is that it is not likely, as an empirical matter, that sustainability practices improve corporate performance across the board.

Efforts at curtailing corporate excesses – whether on carbon emissions, gender equity, or something else – have inevitably absorbed this characteristic, arguing that the interests of wider society are aligned with those of investors. But the empirical research Lipton cites demonstrates that sustainability isn’t always a win–win and there are, or can be, tradeoffs. When we assume the interests of investors and the planet itself are necessarily aligned – which, surely even on the face of it, must be false – then we have hobbled ourselves substantially. It shouldn’t have to be in the interest of investors to reduce greenhouse gas emissions – it should only need to be the right thing to do to avert serious catastrophe, and we must find ways to ensure it happens regardless of the profit or loss involved for investors.

Lipton agrees, arguing that 'while the interests of investors and the general public may overlap when it comes to certain aspects of corporate social performance, they are by no means coextensive.' (p.531) A consequence of the investor-focussed regime is to twist the arguments of socially-minded stakeholders to fit the existing investor-prioritising regime. In reality, in cases where stakeholder groups (activists, members of the public, or researchers like myself) make calls for greater corporate disclosure our arguments by necessity hinge on its relevance to investors. But this adds a layer of disingenuousness to our appeals: 'information about matters that fall into the sustainability category— labor conditions, political spending, anti-corruption measures, environmental impact—is primarily sought because it is of societal relevance, and only secondarily (if at all) because it might benefit investors.' (p.532)

This is not just an unfortunate side effect, but a serious misrepresentation. Lipton cites a recent proposal put forward by the Episcopal Church to Anadarko Petroleum (which it had a financial stake in) requesting the company report to shareholders it’s policies and processes for the prevention of human rights violations, and attendant risks to reputation, etc. Lipton comments that:

Though it is possible that the Church was simply trying to protect its economic stake in Anadarko, a more likely explanation is that—as a humanitarian organization— its concern was for the people affected by Anadarko’s operations.

This is not to criticize the Trust, the Church, or other proponents seeking disclosure of social information; it is simply to call attention to a form of prevarication that has become so routinized within the securities framework that it is treated as unremarkable. But these misrepresentations are not harmless; they are disabling. The need to emphasize financial risk and shareholder return inhibits a fuller discussion of the societal need for such information, let alone a serious balancing of the costs and benefits of requiring it. (p.555 – emphasis added)

Lipton’s argument has utterly convinced me that this sort of prevarication (and I have made the exact same move myself) is deleterious, and simply not a good basis for appeals. There may well be instances where sustainability disclosures are materially relevant, and in fact the TCFD framework encourages business to think along these lines. From my reading of these sorts of disclosures for the 2022 Net Zero Snapshot however, it became clear that there is substantial latitude in the framework for companies to ignore, overlook, or downplay both the physical and transition risks of climate change on their future business. It’s simply too easy to make into a box-ticking exercise. I think Lipton is right then, and appeals to alignment of ESG with investor interest is only likely to become an increasing drag on our arguments, twisting them away from their true orientation toward social benefit and reducing their moral clarity in the process. This seems especially important if political resistance to ESG coalesces further.

Lipton’s proposal for the United States is to design and adopt an ESG regime that is more responsive to the full range of stakeholder concerns and interests – and in the process to better strike a balance between the (very real!) burdens that disclosure brings, and avoid the contortions that ESG has invariably been twisted into. There are real costs to the current US framework for ESG after all:

The failure to systematically grapple with the need for public-interest disclosure encourages what can only be described as scattershot disclosure requirements, inserted haphazardly into the securities laws whenever Congress (or a specific member) latches on to a particular issue. As a result, recent years have seen somewhat random disclosure add-ons, such as minor environmental liabilities, the safety record of mining companies, violations of sanctions against Iran, and the sourcing of certain minerals often obtained from war-torn areas, which are transparently intended more for the general public than for shareholders. (p.557)

Lipton’s perspective is a shot-across-the-bow of the common view of these sorts of initiative, that even ‘scattershot’ provisions are “better-than-nothing”. But Lipton’s analysis cuts through the pessimism inherent in that position, which resigns itself to settling for a disclosure regime that is less than ideal and which truly suits no one. Another unintended consequence for Lipton is the discursive effect of the existing regime, which legitimises investor interests above all others:

There is another unsettling side effect of relying on securities disclosures to inform the general public about corporate behavior. By reducing broader social issues to their impact on shareholders, we risk contributing to a discourse that suggests that investors are the only members of society who matter. …These effects are not harmless; for example, focusing on the business case for diversity rather than its moral justice may reinforce negative stereotyping. (p.560)

I think careful readers will be able to recall seeing evidence for this themselves – those online grumblings against ESG often do have some small grain of truth to them, in that ESG disclosures are really more concerned with justice (in both diversity and climate at least) than they are about providing business with a competitive edge. They might also do the latter, but we shouldn’t delude ourselves about the perfect alignment between business interest and moral justice. We shouldn't need to either.

When we recognise and insist on the true nature of ESG imperatives as focussed on social benefits and curbing corporate power, whether or not they apply a net-positive to the individual firm or not, the terrain of disagreement is shifted, and ESG detractors have a completely different kind of battle to fight in making their objections. They may argue that justice and morality should not enter into business decisions, but at least that is a political (and perhaps ideological) position that one can agree or disagree with more substantively, rather than the current approach which cedes ground in advance. “Why should companies have to care about X if it doesn’t improve the bottom line?” is harder to rebut than the alternative: “Why should companies have to disclose their negative social impacts?” Well obviously because businesses operate within a society, and can only turn a profit because it exists and functions. Without a functioning society, business cannot function. End of story. One of these things is far more important than the other. Personally, I find the clarity of this argument refreshing, and far more defensible.

Lipton ends the article by describing what a new regime of corporate disclosures aiming to benefit a broad suite of stakeholders might look like, pointing to the European system “both as a model and as a point of contrast”. In the European context:

The EU draws a distinction between social and financial reporting. Whereas all limited liability companies are required to disclose some information about their finances (with obligations increasing as the company scales up in size), only large companies designated as “public-interest entities” must issue sustainability reports aimed at a noninvestor audience. These “public-interest entities” are mostly publicly traded businesses listed on local stock exchanges, and though some countries have required sustainability reporting even of unlisted companies, the result is that, globally, reporting on social performance intended for a noninvestor audience is still conditioned, to some extent, on the presence of widespread public investment.

Lipton articulates a better, fairer approach to disclosure, but I don’t want to get bogged down in the details so I will just encourage anyone interested to go check out the full paper and its conclusions. And if you are in a position, perhaps at a firm large enough to have some input on the direction of future regulatory requirements (both inside and outside the US) I cannot reccomend it enough.

The result of a more targeted, and more comprehensive disclosure system aimed at disclosures to meet the needs of a wide range of stakeholders would be dramatically beneficial. Lipton takes pains to emphasise that her approach 'proposes reporting requirements that are both more and less expansive' (p.563) with some real upsides to doing away with the current ‘scattershot’ approach to tacking-on single issues. Lipton also addresses some of the objections that some might raise about the unintended consequences of greater corporate disclosure, noting for instance that:

Poorly designed disclosure can do more harm than good. Most obviously, disclosure may have anticompetitive effects… for example, mandatory disclosures may be associated with reduced R&D spending and product releases. But these narrow data points must be balanced against the more general anticompetitive effects of unbridled corporate power. There is reason to believe, for example, that the European economy has become more competitive, while the U.S. economy has become less so, in part due to the ability of large American companies to manipulate the regulatory system. A focus on microincentives at the firm level is penny-wise and pound-foolish to the extent it overlooks the collective advantage that secrecy confers on corporations over those who seek to cabin their power. (p.569)

I was going to write more in this post on some of what I have learned of other national ESG regimes, and their impact on disclosures through the Net Zero Snapshot process, but I think this post has gone long enough already. What is clear, however, is that the current ESG regime – especially in the United States, and its outsized impact on determining the disclosures of the international games industry – is in need of a major overhaul to better address the critical urgency of reducing greenhouse gas emissions. As Lipton notes: ‘Far from pursuing investor wealth, much of the sustainability movement is designed to make corporate profits difficult to achieve unless management attends to the needs of noninvestor stakeholders.’ (p.532) Stakeholders like the players, and the makers of our games, and all those who want to be able to play without costing the earth. We deserve better. We should demand better.

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Have a great holiday period and new year – plenty more to do, to discover, and to write in 2023.