Redesigning ESG: Prioritizing Decarbonization for Real Impact

In a world drowning in a sea of 2050 net zero goals, sustainability reports, and empty rhetoric, we must face the uncomfortable truth: words alone won't save us.

I have always been a staunch believer in the power of Environmental, Social, and Governance (ESG) reporting. However, the current ESG landscape demands a profound change. We must rise above the overwhelming wave of exaggerated claims, unverified company assertions, and greenwashing tactics that have permeated the more than $700 billion investing market.

It is time to hold ESG to a higher standard and demand real impact.

ESG ratings have become fixated on evaluating risk and return on company shares, neglecting the fundamental objective of creating tangible change, particularly in addressing the pressing environmental issues, with climate change at the forefront.

My concerns primarily lie with the "E" in ESG.

Without a robust focus on environmental sustainability, the pillars of social (S) and governance (G) will crumble. We must redefine how we measure the "E" in ESG, prioritizing criteria that yield the highest environmental impact scores.

Urgency is upon us, as we teeter on the precipice of irreversible consequences. With CO2 levels in the atmosphere currently at a staggering 420 parts per million (ppm), nearing an all-time high, and the projected crossing of the critical 1.5°C threshold within the next five years, immediate and decisive actions are required to curb greenhouse gas (GHG) emissions.

Consider this: The current trajectory puts us on a path towards a global temperature rise of 2.7 to 3.5 degrees Celsius, far exceeding our goal of limiting it to 1.5 degrees by 2100. The ramifications are dire. Research suggests that a 4-degree scenario would result in losses of around $23 trillion, nearly one-third of the global GDP.

From droughts to infectious diseases and extreme weather events, the world cannot sustain a myopic focus solely on social and governance issues while downplaying the inherent risks associated with environmental challenges.

Let's delve into the "S" in ESG and its intertwined relationship with the environment. Climate change is projected to plunge 130 million people into poverty over the next decade, with climate-induced migration potentially reaching 200 million by 2050.

Shockingly, 1 in 7 people worldwide lacks access to cooling systems, putting their survival at risk. Despite Africa contributing less than 3% of global emissions, its people bear a disproportionate burden of climate change. They face challenges such as reduced economic growth, frequent extreme weather events, and the scarcity of food and water.

Moreover, just 10 months ago, Pakistan suffered devastating consequences from severe flooding, resulting in the tragic loss of over 1,700 lives, displacing 8 million individuals, and inflicting an economic toll exceeding $30 billion. Remarkably, the country is responsible for a mere 1% of global greenhouse gas emissions.

These extreme events serve as a wake-up call, reminding us that the consequences witnessed in Pakistan will not remain confined to a single country, emphasizing the urgent need for collective action, global awareness and a paradigm shift in our approach to ESG practices.

BAT Outranks Tesla in ESG Ratings

To illustrate the absurdity of the current system, let's examine the case of British American Tobacco (BAT) outweighing Tesla, a pioneer in sustainable transportation and clean energy, in S&P’s ESG ratings.

Yes, a tobacco company that sells over 600 billion cigarettes annually, a major cause of cancer, has been lauded as a leader in sustainability on the Dow Jones Sustainability Indices for the past two decades.

How does such incongruity persist? It stems from divergent ESG ratings and a lack of transparency in rating methodologies. Three critical words come to the fore: scope, measurement, and weight.

Some rating agencies assign less importance to the "E" when compared to the "S" and "G." A recent Massachusetts Institute of Technology study revealed a correlation of 0.54 among leading agencies’ ESG ratings, whereas credit ratings displayed a correlation of 0.92.

Compounding the problem is the fact that ESG ratings do not necessarily influence the cost of capital. The pricing effects show negligible real economic impact. When a firm receives a downgrade in ESG ratings, the knee-jerk reaction is to focus on governance, a relatively low-hanging fruit, rather than taking substantive action on pressing environmental issues, which are inherently more challenging to address.

Conversely, when methodology changes lead to upgrades, we witness companies being upgraded without actually implementing any concrete changes—solely a result of a methodology tweak.

Studies indicate that due to inaccurate evaluation and noise in ESG ratings, stock returns tend to be biased downward by approximately 60%. It is a shame, for if utilized wisely, ESG ratings could help investors achieve higher returns, enable companies to access reduced capital costs, and contribute to emissions reduction—the most urgent need of our time.

Furthermore, some companies included in ESG portfolios have far worse records in terms of environmental and labor compliance than those in non-ESG portfolios.

Misleading output is often confused with actual impact. Investing in a company with a high ESG score does not necessarily equate to concrete measures being taken to reduce carbon emissions.

Some ESG ratings assign a higher score based on ambitious environmental targets, without considering the actual progress made towards achieving them.

A Harvard Business Review study highlights that the proliferation of sustainability reports by corporations does not necessarily result in a decrease in global GHG emissions.

According to the Carbon Disclosure Project, only half of the companies disclosing to them report on their Scope 3 emissions. Absolute transparency regarding Scope 1, 2, and 3 GHG emissions is essential, with a focus on the double materiality principle.

We must factor in the realistic social and financial impact companies have on the environment, with GHG emissions taking precedence. The recent EU Corporate Sustainability Reporting Directive offers promise in this regard, but the true challenge lies in how it will affect the cost of capital, borrowing expenses, and investor portfolios.

The divergence in ratings, coupled with ambiguity in the legal and regulatory frameworks surrounding GHG disclosure and environmental impact measurement, hampers companies' willingness to act and distracts from the real change needed.

To redesign the ESG trajectory, we must expedite the development of an effective climate change legal and regulatory landscape that spurs action.

A prime example of an impact economy is the recent Swiss vote to achieve climate neutrality by 2050. The law adopts a carrot-not-stick approach, offering financial support to homeowners for replacing electric, gas, or oil heating systems with climate-friendly alternatives like heat pumps. Additionally, businesses will be encouraged to invest in green technologies, providing incentives for such endeavours.

Regulations should prioritize utmost transparency in GHG emissions, while the financial sector must be compelled to factor in a firm's future social and environmental cost of carbon in their financing decisions.

Concrete, transparent, and reliable ESG evaluations must swiftly and directly impact share prices, purchasing decisions, and the cost of financing.

It is time to shed the cloak of sustainability jargon and embrace a results-driven approach to ESG.

We must demand accountability, transparency, and immediate action in the face of the climate crisis, ensuring that real change is made to protect our planet and future generations.

Billions of lives and the fate of our planet depend on it.

The time for meaningful change is now.

Hakan Bulgurlu CEO