Why ESG is failing sustainable development

In today’s global economy, markets are the principal means to allocate capital. Financial markets are both the reservoirs and canals of financial systems. Capital flows into stock exchanges which then funds businesses. Finance flows through global bond markets. 

Therefore, markets are also the principal means for finance to support sustainable economic activity and delivery of the Sustainable Development Goals (SDGs). As once stated by the UNEP FI "the purpose of the financial system is to be a facilitator of economic activity in ways which support an inclusive and sustainable real economy."

Governments and financial markets regulators define the parameters and incentives within which market participants operate and make decisions. They have a critical role to play in solving for market failures which market-led solutions cannot resolve on their own. Providers of capital – most notably institutional investors and the public sector – send seekers of capital signals about their preferences which in turn influences business behaviour and capital allocation decisions.

The 2030 Sustainable Development Agenda and SDGs agreed to by all member states in 2015 provides the world’s roadmap towards a more sustainable and equitable future for all – importantly, connecting public and private sector actors in a shared vision and enabling new ways of working collaboratively towards solutions through collective ownership of the SDGs and associated targets and indicators.

As we stand here today, we are not yet on a sustainable path, and we are long way from achieving the SDGs. The devastating health, social and economic impacts of an on-going global Pandemic have exposed the realities of global inequalities and interdependency between economic, social, and environmental outcomes – serving as a harbinger for the looming climate crisis.

Our economic system has evolved to maximize financial value, confusing the means (financial activity) with the ends (society’s needs). It seeks infinite rewards from a finite system, and maximization of financial returns with few safeguards. Consequently, economic activity is contributing to a number of negative social and environmental outcomes and creating systematic risks for investors, businesses, the financial system, governments and society because:

• Negative externalities are not adequately priced into the economic system. They matter to corporate profit and loss statements to the extent that price signals promote economic development that is fully sustainable.
• Current risk perception does not account for all material externalities, and therefore is unlikely to address the root causes undermining sustainability. The increasing focus on climate related risks in financial decision-making is an example of shifting perceptions of risk. Ironically, viewing sustainability through an Environmental, social, and governance (ESG) risk and financial materiality lens still systematically underestimates future financial risks and fails to identify emerging opportunities. 
• Data and information being used to make decisions is not decision useful. A comparison of deforestation risk and environmental ESG scores emphasizes this point. Correlation between the environmental ESG score of one prominent ESG provider and deforestation risk scores for 143 companies covered by the annual Forest 500 review shows that environmental ESG scores currently do not capture well the assessed risk of company operations and trade. In fact, companies with documented poor engagement with deforestation risk-reducing measures receive some of the highest environmental ESG scores.[1]
• Increasing levels of short-termism and speculation in financial markets. Taking equity markets as a case in point, in the NYSE, after the second world war, investors held assets on average for 6 years; in 2017: 7 months. Today, when including high frequency trading, the average is a few dozen seconds (high frequency trading represents 50% of transactions in volume).[2]
• Markets heavily discount future cash flows, such that impacts on future generations are in effect ignored.
• The consequences of our economic system are not equally shared around the world and are not equally shared by people in the same place. The people who have the most power to change the system benefit most from maintaining the status quo and are currently less likely to experience the consequences.

Interest in ESG has never been higher. And there has never been more confusion about what ESG and sustainability actually means and what it will deliver. There has been a proliferation of ESG metrics and products for rating a company’s ESG performance and ESG related investment strategies and products. Principles for Responsible Investment (PRI) signatories reached 4,000 this year.[3] Global ESG assets are expected to exceed US$53 trillion and represent more than one third of total assets under management by 2025.[4] If ESG could save the world, then arguably the SDG financing gap should be contracting rather than expanding and we should have solved the SDGs several times over by now.

To achieve the SDGs and to put the world on a more sustainable and equitable path, we need a transformational shift in mindset and decision-making. We need to recognize we cannot solve market failures purely with market-based solutions. We need all actors, including governments and regulators to create an even playing field and bring economic, social, and environmental impacts on people and the planet into the net of the primary economic system. We have a unique opportunity to create the new normal and build forward better. The magnitude of the challenges we face a humanity, need action today. 

Governments can also lead by example and develop capability and market infrastructure in their role as a key market participant (for example, through their own procurement and impact management practices). As well as better reporting of financially material ESG factors, we need better reporting of enterprise and investor impacts on people and planet. And we need to recognize the limitations of reporting and transparency in driving change and focus also on transforming internal management systems to integrate operating sustainably and contributing positively to the SDGs into all business and investment decision-making – and building citizen capability to make more informed choices and avoid options that are impact washing. It is about changing the way we do business, invest, and consume. 

There is no reason to see real alignment with the SDGs as anything else than good business. According to the Business Commission on Sustainable Development (BCSD), "Contributing to and achieving the SDGs offer a compelling growth strategy for businesses and for the world economy as a whole."[5] Achieving gender equity alone could increase the size of the global economy by 26%[6] and US$12 trillion annual business opportunity could be unlocked if the SDGs were pursued in just four major sectors or investment systems - food and agriculture, cities, energy and materials, and health and well-being.[7]

The good news is that awareness about sustainability and the case for change has never been stronger and initiatives are rising at the country, regional and global levels and both public and private sector led. As a way forward we can: 

• Use recent and emerging design of building blocks which can serve as a foundation for a systemic transformation, for instance establishing country Integrated National Financing Frameworks (INFFs) for financing/funding SDG priority areas, promoting a new way of doing business and investing through the adoption of UNDP’s SDG Impact Standards that focus on internal management and decision-making for different actors in the system to optimize operating sustainably and contributing to the SDGs, and utilizing the SDG Investor Maps which concretely showcase profitable investment opportunity areas and business models aligned with national development priorities. 
• Work towards reducing fragmentation and enhance compatibility/interoperability of approaches – recognizing capital is global but that flexibility will be required to accommodate jurisdictional differences. (There has been a proliferation of standards, principles, and frameworks to assess the responsible nature of investments over the past few years. More than 185 multi-stakeholder initiatives exist, involving 5 181 constituent members.[8] Average new initiatives per year have more than quintupled in the last decade”). This is causing confusion and complexity and consequently facilitating impact/green/rainbow washing.
  • The International Platform on Sustainable Finance (IPSF) is developing a common ground taxonomy to improve the comparability and future interoperability of taxonomies around the world.
  • This year, the IFRS has created an International Sustainability Standards Board to develop a set of internationally consistent standards for disclosure of sustainability-related information. It’s work program has been welcomed by several actors, including the G20. Yet, it will be focused on enterprise value only.
• Take a balanced approach, looking to leverage the most effective levers across the system (capital providers, capital seekers, policy makers and regulators), which extends beyond ESG and enterprise value reporting and transparency.
• Recognizing, clearly defining the differences between, and making equally visible the impacts businesses and investments have on social and environmental outcomes with the impacts ESG factors have on business and investment performance.
• Strengthen collaborations aimed at systemic changes in investors practices and regulations at an international level, among the main initiatives:
  • A Task Force for Nature related Disclosure (TNFD) has been launched to work on better integrating nature and biodiversity to investors’ decision making, complementing the work done in previous years by the Task Force on Climate-related Financial Disclosures.
  • The G20 has endorsed a sustainable finance roadmap, that is a multi-year action document which sets out the key actions to scaling up sustainable finance. Among others, it includes actions aiming at: supporting greater comparability, interoperability, and alignment of approaches and further development of sustainable financial markets, enhancing quality and usefulness of information on sustainability risks, opportunities, and impacts, and improving the management of sustainability risk. It insists on the crucial contribution and synergies between IFIs, public and private finance.
• Take a more holistic and less transactional approach – focusing on making all business and investment decisions more sustainable, and accounting for all (positive and negative) material outcomes – not just positive, intended outcomes, and better recognizing and accounting for interdependency across the SDGs. Otherwise, we will continue seeding the need for future interventions and solutions which is akin to trying to empty the ocean with a teaspoon.

This blog was originally published on UNDP SDG Finance Sector Hub.