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Focus, Focus, Focus: A Common-Sense Way To Reduce ESG Sprawl

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Let’s ask CEOs to focus on two stakeholders that they care about and can make the biggest impact. Rating agencies and investors can then monitor these focus areas to sort through the current clutter associated with hundreds of ESG issues in sustainability reports.

The terms “ESG” and “stakeholders” are grab-bag categories that can mean anything to anyone. Lack of focus in my view has led to a number of issues in the field. For instance, when Tesla Motors got kicked off the S&P ESG index recently, the ratings committee at S&P clearly prioritized “S” and “G” over “E” at the company. Tesla CEO Elon Musk predictably screamed that “ESG is a scam.” How did S&P decide that “E” is more important than “S” and “G” for Tesla?

A similar problem arises with ESG scores and ratings. How does the rating agency know the weight attached to individual elements of “E,” “S,” and “G” (which stand for Environmental, Social, and Governance) and the trade-off of company having a higher “E” with a lower “S.” What does a composite score mean in a world where we cannot observe either the inputs to the black box decision model or the model itself?

Similar confusion is seen in the hundreds of pages in a typical sustainability report. Companies feel obligated to devote equal footage to hundreds of micro-initiatives they undertake under “E” and “S.” Part of the blame lies with regulator-prescribed lists of tens of “material” ESG factors that a company belonging to an industry is required to consider. How many 10-plus factors can really be material for a company? Do we ever ask the CEO to maximize or concentrate on working on 10-plus priorities in the non-ESG world?

The way out of this confusion: focus, focus, focus. I suggest that analysts and investors ask CEOs to declare two stakeholders they care most about (other than shareholders, of course). These would ideally be domains that the company has some comparative advantage in either social welfare or at reputation-enhancing ESG actions relative to other domains.

One way this could work, for instance, would be if a company chooses to focus solely on its customers and labor. An investor or a rating agency or the S&P index committee now knows how to rate that company: by concentrating on KPIs (key performance indicators) related to customers and labor. Investment analysts can begin to model the impact of those two stakeholders on cash flows and on the performance of stocks and bonds.

In fact, many companies have implicitly signaled which stakeholders they focus on in their internal planning process. If they issue a green bond and commit to a net zero goal, they surely care about emissions in “E.” If they issue a sustainability linked bond and promise to improve diversity hiring, they have declared that they care about diversity in “S.” If the CEO’s compensation package has been tied to a specific KPI, for instance, diversity or a climate goal, the board has implicitly stated which specific stakeholder they care about.

Consider a few diverse examples:

· In August 2020, Alphabet issued a $5 billion sustainability bond, whereby interest costs are linked to environmental goals (clean energy, clean transportation), racial equity targets (financing Black businesses), affordable housing and supporting small businesses via low interest loans. Should investors and rating agencies concentrate more on these “E” and “S” initiatives to evaluate Alphabet’s stakeholder orientation?

· In May 2021, Amazon issued a $1 billion sustainability bond, the proceeds of which are to be used in five areas: renewable energy, clean transportation, sustainable buildings, affordable housing, and socio-economic advancement, defined as increasing opportunities for underrepresented groups to enter the technology workforce. Is Amazon telling us that their ESG priorities are lower emissions, community development via lower housing and entry of under-presented minorities into technology? Should we assign a greater weight to Amazon’s progress along these dimensions instead of boiling the ocean on hundreds of potential data points related to “E,” “S,” and “G?”

· In April 2021, BlackRock struck a financing deal for a $4.4 billion credit facility whereby lending costs are linked to meeting targets for women in senior leadership and Black and Latino employees in its workforce. The actual impact to BlackRock’s interest costs, should it default in its diversity promise, is tiny but the adverse publicity from such default would be immense. Hasn’t BlackRock effectively told us its ESG focus is diversity? If yes, should investors and rating agencies focus more on that goal while evaluating BlackRock’s ESG credentials?

To be clear, the capital raised via sustainability bonds for Amazon, Google or a BlackRock is a tiny fraction of debt in their balance sheets. Hence, these self-declared ESG targets clearly represent an attempt to signal the company’s focus in a specific area. Why have evaluators and rating agencies not responded by narrowing their focus accordingly?

Let us consider a few ESG KPIs linked to CEO compensation:

· In February 2021, McDonalds tied some of its CEO compensation to diversity hiring targets and to begin disclosing the racial makeup of its workforce.

· Barclays, HSBC, ING, NatWest and Société Générale, four top banks, have linked CEO pay to emissions generated in their operations or to financed emissions.

· 20% of Royal Dutch Shell’s long-term incentive plan (LTIP) is an energy transition measure that includes both input and output goals related to emissions.

To be sure, there are objections. Alex Edmans has argued against linking CEO pay to ESG KPIs because these KPIs can be hard to measure and entail unintended side effects. I have myself argued that companies that do not deliver stock price performance seem to be quick to link CEO pay to ESG metrics to perhaps change the subject.

However, I am trying to make a different point here: the specific area that the company has picked to link its interest costs or CEO pay tells me, the outside analyst, what the company cares about. That signal is invaluable in helping me understand the companies’ ESG priorities. I can then concentrate my limited time and effort in digging deeper on these two or three areas instead of the several hundred datapoints that the sustainability report throws at me.

Through improved focus, outside investors could also argue that the target area indicated in the bond or the CEO compensation contract is all wrong and some other area should have been the company’s focus. To me, that pushback itself is progress as it will center the analysis on a specific area of disagreement. You, the investor, could come up with your list of two or three ESG priorities and compare those with what the company seems to signal as its priorities.

So, investors and rating agencies, please listen up. Concentrate on a couple of areas in which the company signals its ESG focus instead of boiling the ocean and entertaining the false premise that a company can prioritize and maximize hundreds of ESG goals.

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