The underexploited potential of the ESG framework

By Sophie Sirtaine, devex.com

September 01, 2022

The environmental, social, and governance framework was created with two objectives: to help companies manage environmental and social risks — do no harm — and incentivize them to contribute greater social and environmental impacts — do good. To date, it has been used as a risk management tool at best and a compliance obligation at worst. As a result of cumbersome reporting systems and problematic applications of the framework, the very essence of ESG is at risk — and it is key that E, S, and G are not separated.

Globally, firms are required to report on over 600 ESG indicators, which has given rise to corporate “greenwashing” among other scrutiny. ESG factors are complex and continuously evolving. Rather than attempting to boil ESG factors to a single rating, we should recognize that many investors crave a more sophisticated and nuanced approach. We need to explore an integrated approach for sustainable finance that incorporates ambitious yet feasible ESG approaches, thus realizing the potential for ESG to drive positive social impacts while simultaneously achieving economic and climate objectives.

In 2021, sustainable finance volume surged past $1.6 trillion as the market responded to investors’ appetite for financial instruments with ESG goals. Growth was driven by global ESG funds, which saw a record $649 billion in investments by end of November 2021, compared to an all-time high of $179 billion of official development assistance in 2021. One can only imagine the transformational role ESG can have if these investments were put toward financing initiatives and programs that truly advance ESG commitments.

There’s no denying that the way ESG is applied can be problematic. Yet, one of many proposed solutions — dismantling the ESG framework to focus only on the E, and more specifically on emissions — is equally concerning.

Climate change mitigation and reaching the net-zero target through stringent carbon emission reduction cannot be overstated. And focusing on E for emissions has its advantages: It's relatively easy to measure and applicable the same way to a business in China, Germany, or Mexico. However, spotlighting the E implies that the S and G are not vitally important nor connected — and that cannot be further from the truth.

There are three reasons why the S and G should stay a part of the ESG framework to ensure its potential is realized.

First, the main environmental, or E, issue that people around the world will face over the next decades is coping, adapting, and transitioning to climate change-related environmental events, biodiversity loss, and system changes. That means that the E is not just about mitigation — adaptation is just as crucial.

Second, adaptation is largely a social, or S, agenda. It is about ensuring those affected by climate events and deterioration of their means of living are not left behind. It is about ensuring societies, economies, and investment portfolios — many of which are held by sovereign and pension funds on behalf of their citizens and members — do not buckle under the impacts of a changing climate. They need to effectively transition and adapt, and those affected will need access to financial means and social support.  

This is particularly important as low-income nations are expected to suffer most from climate effects, while the environmental effects of their activities are relatively minor. To put this into perspective, according to 2020 data, the entire continent of Africa contributes 3.8% to global emissions. And between 1990-2015, when humanity doubled the amount of carbon emission in the atmosphere, the poorest 50% of the global population contributed just 7% of global emissions. The E imperative for the lowest-income populations is therefore not mitigation, but adaptation — and that is an S issue.  

This highlights the direct links between the E and S, particularly when the S is seen to encompass the wider society and not only the workforce of the enterprises being assessed on their ESG performance — a narrow interpretation of S that persists in much of the ESG arena.

A move to dismantle the three letters would misguide investors by suggesting these links do not exist or do not matter, when in fact they are fundamental to achieving sustainable development and a peaceful world.

Third, governance, or G, is vital to drive transparency, which in turn enhances accountability and a focus on results. This can help promote resilience and adaptability when a disruptive environmental or social event occurs. A focus on G is also essential to understand and manage the risks that may be faced by those who are not part of investment decisions.

For example, the growth in digital financial services — including the rapidly growing fintech sector — has enormous potential to improve financial inclusion, thereby reducing social inequities and boosting households’ and communities’ resilience to climate change and crises. However, the rapid growth has also accelerated consumer risks — and often at a faster rate. At the Consultative Group to Assist the Poor, we are advocating for responsible digital finance ecosystems that provide more effective and holistic governance approaches.  

Put simply, a world that is not inclusive is not sustainable. Social inequity leads to unrest, conflicts, and ultimately to an unsustainable development for all. Promoting climate change adaptation, financial inclusion, women empowerment, and access to essential services are key imperatives.

While the current approach to ESG investing may be broken, the way forward should not be a reductionist and misleading alternative. Let’s reestablish ESG as a fundamental framework to achieving a better world by defining the standards for a truly positive impact and using them forcefully to do good and drive positive outcomes. Both people and the planet deserve this much.

Sophie Sirtaine is the CEO at the Consultative Group to Assist the Poor. She is responsible for leading the CGAP operational team to develop, resource, and deliver CGAP’s five-year strategy. She is also a member of CGAP’s executive committee. With over 20 years of experience in the World Bank, Sirtaine has held various positions, including as director of strategy and operations in the independent evaluation group, and she led the World Bank’s banking sector crisis response in several EU countries during the 2008-2009 global financial crisis.