• December 5, 2022

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ESG, or Environmental, Social, and Governance (ESG) matters, have quickly evolved from lofty corporate objectives to integral elements of corporate strategy. Recently I described the pitfalls of measurement with ESG software. Given the interest in this topic, I offer a deep dive on the topic with my colleague Adam Stahl, an energy security executive and former policy officer for the US Department of Homeland Security. See our earlier discussionon how cybersecurity impacts climate policy.

1. What is ESG and why has it gained increased attention in recent years?

It’s hard to ignore the dramatic uptick in global sustainability investing, up $30 trillion this year, some 70 percent from 2014. Consumers and shareholders are increasingly attune to companies’ roles as responsible global stewards, particularly on climate change and social welfare. Corporate responsibility policy encompasses an organization’s product life cycle and supply chain, carbon footprint, employees, customers, and community.

Advocates argue that ESG investing is a “win, win”, yielding returns on par with traditional investing while enabling stakeholders to foster a more socially conscious ecosystem. Conversely, skeptics cite over-accentuated return rates and inconsistent applicability of ESG standards across companies and sectors.

A complex question is the degree to which companies should be responsible. It has become a mainstay in the U.S. political landscape with rules about financial and other corporate disclosure

2. How has globalization impacted ESG issues?

Commercial activity has long been examined and critiqued through non-market lenses— political, environmental, military, etc. It is deeply engrained in America’s political identity and was a key ingredient in our founding (Sugar Act of 1764, Stamp Act of 1765).

Traditionally, however, these non-market behaviors were harnessed by governments for national security and diplomatic purposes, deriving from nation-states, and not corporations, which sought to levy costs to alter adversarial behavior to achieve a specific objective (territory, power, regime changed, etc.).

In the past fifty years, we have seen significant power and responsibility transfer from nation-states to multinational corporations (MNCs). The rise of the internet age and expanded access to emerging markets, driven largely by the collapse of the Soviet Union, catalyzed the growth of a modern interconnected global economy, led by booming MNCs operating in all corners of the earth, including in environments with vastly different political, labor, environmental, and social systems than our own. As MNCs margins grew, so did scrutiny of their practices, including relationships with foreign governments, production operations, labor conditions, and their policies and rules.

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Today, accelerating digitalization (spread of cell phones, social media, etc.) interacting with social and environmental issues as well as global events (War in Ukraine, COVID-19, etc.) have placed greater onus on corporations.

3. How has war in Ukraine impacted corporate responsibility and our broader understanding of ESG issues?

Putin’s invasion of Ukraine speaks to the growing potency of public sentiment in driving MNC behavior in the 21st century global economy. In addition to NATO-led sanctions, the withdrawal of investment and business operations from major corporate players within Russia was seismic and swift, not seen in both scope and scale, seen since the modern day global market came to bear.

Yes, the highly visible manner with which Moscow invaded (further aided by social media, technology, the 24-hour news cycle, and preemptive declassification of Russia’s plans) was undoubtedly a contributor, but it also spoke to the mounting reputational risks and costs of being associated with a “commercial pariah”, one that enables, both directly or indirectly, to human depravity. Within weeks, over 450 corporations had suspended, withdrawn, or significantly curtailed operations in Russia.

Within just three days of their invasion, British Petroleum announced its abandoning its stake in major Russian oil company, Rosneft, costing the company a whopping $25 billion. Shell and Exxon exited Russia shortly thereafter. Tech companies, financial giants, automobile manufacturers, and companies in between, also followed suit.

While the pace of divestment was impressive, the war did expose gaps in what many have described as a “hands off” approach to socially-minded investing, specifically relating to geopolitics and human rights. For instance, prior to February 24th , Sberbank, a Kremlin-backed bank long subjected to international sanctions, enjoyed higher ESG ratings than many of its Western counterparts.

Although differing in complexion, China’s democratic crackdown of Hong Kong comparatively received silence from the world’s largest private institutions.

4. How do linkages with China impact ESG, particularly from a forced labor, environmental policy, and human rights perspective?

The international community and companies alike have made meaningful strides in curbing illicit trade practices. For instance, growing global outrage to Chinese sponsored forced-labor, primarily targeting the Uyghur community, an ethnic and religious minority in Western China (most acute in the commodity concentrated region of Xinjiang), has led to ambitious global regulations to curb forced-labor production. This includes marquee U.S. legislation, The Uyghur Force Labor Prevention Act (and other global versions in Europe), requiring all American imports to prove products are not contaminated with Chinese forced labor. Although progress has been modest, it is also important to caveat that several forced labor “unknown unknowns” still exist in the global supply chain, the scope and scale which the trade community is still grappling with.

Prrogress has been made, but glaring limitations and inconsistencies exist within ESG ecosystems, which is, in part, a byproduct of the trade community’s complex relationship with Beijing. While ESG-compliant companies tout net-carbon goals, many continue to purchase or remain deeply ingratiated with carbon’s highest emitters, are direct or indirect beneficiaries of forced labor, and/or closely associated or complicit with the Chinese Communist Party, and their repressive practices.

This holds particularly true in the energy and finance industries. The refinement and production of EV materials and solar panels remains problematic. While dislodging Beijing’s grip on certain commodities will take time, the international community has only partly begun to understand the depth of companies’ production lines implicated in Chinese-forced labor practices.

Despite all the risks and objectional practices (systemic censorship, tracking of persons, and other attacks on democracy/human rights), the world’s largest investment firms remain bullish on and deeply entrenched in China. Some have plans to triple their exposure to Chinese assets, undoubtedly driving significant investment flows back into Beijing’s economy. Others have even began issuing Chinese-based mutual funds.

These are some of the moral inequalities that give ESG critics pause. If ESG investing is going to remain legitimate, it needs to incorporate geopolitical concerns, democracy, and human rights.

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