Gartner : The Truth Behind ESG - Time for a Rethink?

Last weeks Economist (July 23-29th, 2022) included a special report on the state of ESG. The title of the special report was, "In Need of a Clean Up". The report explains nicely what a sham most of the ESG movement is. The difficulties are in defining and agreeing what E, S and G means to measuring and reporting different things. There are even shady sounding tactics the investment community uses to generate much needed fees and capital. If you have any interest in ESG, you will find the report interesting.

The E in ESG

I almost blogged a few months ago on one topic most effectively covered in the article "Internalizing the Externalities" inside the report. I had just reviewed an article that explained the methods by which the Global Reporting Initiative was developing to help with reporting of environmental impact. GRI has developed a tiered scoping model that reflects three possible ways to capture the impact of an organization on the environment about them. The three 'scopes' look something like this:

1. The effects a firm has on its environment based in its own day to day operations
2. Scope 1 plus the impacts of a firms energy suppliers have on the environment
3. All of the above but for an entire supply chain

Firstly, scope 1 has merit. Scope 1 is the easiest to track and define since it ties in with how much current public reporting is done. The challenge is to agree what needs to be measured. The focus apparently is carbon emissions, which is of course valuable. But there are other externalities a firm would ignore.

Secondly scope 2 gets more interesting and more complex. It's more interesting because this targets one of the most impactful parts of any supply chain on the environment. But its not as simple as that. Another article in the Economist special report notes that Tesla gets praised for its focus on electric vehicles, but dinged for digging up half the planet looking for rare earth elements. Again, we are back to what is to be measured and who reports it.

Who Pays for What?

Which leads to scope 3 which should solve it all. Let's assume we could agree on what to measure and how. Scope 3 suggests we look at the sum at a supply chain level. Sounds good, right? Yes and no. As with any cost accounting model, the issue is not necessarily the sum. It's the contribution of each stakeholder and their share of the sum that matters more. Without that you cannot differentiate penalize any single firm, or figure out how to reward the participants for changed behavior. Perhaps Activity Based Environmental Accounting (ABEA) needs to be invented?

Several other articles in the Economist's special report demonstrates how you can't trust the investment community either. When a rich global investor extols the benefit of any investment in the media, you can be sure they are hoping you invest in their promoted offering. This is so that the value of their investments go up. That way they make more money. That's their number one job. If we dumped such stocks after seeing such worthy marketing messages, such messages would dry up in a heart beat. Think about it. Follow the money.

Anyway, I didn't publish that blog. But above I summarize it now due to seeing the Economist pretty much say the same thing. But the special report adds some extra value.

How to Measure E in ESG Easily

In "Internalizing the Externalities" the economist explains the science that should be addressed. In economics externalities in this context are all the impacts a firm has on its environment around them. Externalities are not accounted for in business accounting. Externalities have been used in the past. When a firm is caught dumping chemical by products in the rivers next to its plant, it can be fined and suffer other penalties. Knowing such penalties may be levied leads to changed behavior: perhaps innovation to figure out how to transform such bad chemicals into something useful for someone else. As such, externalities are internalized.

This is what is needed with the E in ESG. But central governments everywhere have proven themselves ineffective at such things. Carbon taxes is what is needed, and they have been growing in importance and use, but they remain ineffective as the level of tax are not punitive; and their roll out or adoption remains low.

Carbon taxes, and perhaps other environmental impact taxes, applied at GRIs scope 1, is the answer. A focus on scope 1 only and development of the right kind of punitive environmental impact taxes (EITs) is what central governments should spend our taxes on developing. But its hard work and less fun they piling up the bureaucracy, hiring your friends, and paying the bills with our tax dollars. Such punitive environmental impact taxes should be applied everywhere just as Value Added Taxes (VAT) is applied the world over.

A better way forward

VAT is calculated as a flat tax at every point along a supply chain. It's impact is transparent as it is a public rate added to sales price. As such, scope 3 would be accommodated. And the challenge of determining allocation of the tax would be addressed by the flat rate and the action or externality taxes. VAT also has exemptions (lo, the politicians are involved, don't forget) so there would be ways to offset or protect areas that have other priorities.

We could reduce our taxes by shutting down swathes of regulatory and paper-pushing government agencies, and lobbyists that are created by rich firms to limit their impact. And governments would get smaller, and then could focus on what it should do best as a shared service for all: taxes. The challenge is that government is so big, so complex, and so conflicted, it may not have the fortitude to move in that direction.

The Economist special report is an excellent read. Any supporter of E, S, or G, will come away both depressed and hopeful. Depression will come from the realization that much of what goes by ESG today is a sham. Hope will come from the recognition that there are ways to make improvement. For our collective benefit let's hope governments get back to what they are supposed to do.