And a mega-market opportunity for tech startups.
Written & researched in collaboration with Gabi Skoff.
My post last week discussed some of the recent forces driving ESG into the mainstream. This transformation is no shallow trend; it reaches deep into the heart of the financial services sector, with significant backing on an institutional level. The ESG revolution has arrived. But while behavioral changes and leadership support are fundamental to creating systemic changes, a sustainable transformation with holding power cannot be supported without the proper tools. And in this new normal of ESG integration, transparency will be key.
Gaps and Risks to Sustainable Change
While data supporting the ESG revolution abounds, the gaps in data to support the standardization of ESG indicators remain vast. Even as new research from the University of Oxford finds wealthy private investors are more likely to invest in companies with higher sustainability ratings, the ratings themselves are issued by a befuddling quantity of disparate third-party entities. This has produced a sustainability reporting tool (SRT) ecosystem that is inconsistent and unstandardized, making comparability difficult, especially across geographic regions. That these ratings and indices are so heavily relied upon for investment decisions makes clear that there is an urgent need for mechanisms and tools.
Data used to produce ESG ratings and indices is patchy and inconsistent. For example, some information, especially concerning the “E” for environmental in ESG, is more easily quantified and commonly proffered in the form of a company’s greenhouse gas emissions or water usage. But other data, like actions to close the gender pay gap, for example, and other metrics to support the “S” for social indicators is less commonly captured and tracked. Transparent standards, and the tools to verify them, are needed to clarify how a company performs across all ESG indicators.
As the market currently stands, there is a significant risk that greenwashing, a phenomenon plaguing consumer markets from fashion to food across the globe, will pollute the waters of sustainability. (For an insightful look into “sustainable fashion,” read the latest Business Casual column Fashion’s Fallacy.)
By way of definition, greenwashing is a consequence of and reaction to mass consumer appeal in ethically sourced and environmentally sustainable products, where companies following the trend falsely frame their products and practices as sustainable to gain a business advantage. As a result, we see the consumer market awash with “sustainable” or “ethical” products, with few mechanisms to ensure the companies hawking them take accountability for delivering their environmental and social impact promises. Therefore, the best mitigation of the risk posed by greenwashing, which has the potential to kill consumer confidence in this space, lies in tools and mechanisms that enable transparency.
Illustrating the relevance of this concern in ESG investing is the case of BlackRock, one of the world’s most powerful financial institutions, managing over $6 trillion in assets. The corporation announced in a letter to clients in January 2020 that it would now assess ESG “with the same rigor that it analyzes traditional measures such as credit and liquidity risk.” But how can a company that is the second-largest institutional shareholder (with a stake of about 6.7%) of the oil and gas giant, ExxonMobil, realistically purport to prioritize sustainability? Likewise, Blackrock’s new, hardline approach to sustainability was all but sidelined with its acceptance that companies’ sustainability reports had been “de-prioritized” due to COVID-19.
The Need for Transparent Tools
The Blackrock example both provides evidence of a turning tide for ESG normalization and demonstrates that there are serious risks at play without the proper mechanisms for inducing transparency and accountability. Without sufficient transparency, the transition to sustainable investing will falter. If industry leaders like Blackrock can make big claims about ESG integration while at the same time continuing to sustain an inherently unsustainable investment portfolio, little impact will be achieved, and market confidence in the space will decline. For ESG to be intertwined with every investment and business decision, material action must be matched to ESG claims. Impact must be quantified and observable, and firms must be held accountable for their impact, or lack thereof.
ESG staying power will require tools (hello tech!) that help to track and quantify impact, provide transparency, and give consumers and business managers the tools they need to make data-driven, value-based decisions.
Interestingly, the evidence emerging around this issue brings tentative hope. A study from Harvard, Corporate Sustainability: First Evidence on Materiality, identifies a tangible difference in economic value between performative ESG statements and material actions. The 2015 study found that “investments in material sustainability issues can be value-enhancing for shareholders while investments in immaterial sustainability issues have little positive or negative if any, value implications.” The study, which uses both calendar-time portfolio stock return regressions and firm-level panel regressions to arrive at its conclusion, creates a clear, positive link between economic value and material sustainability for the first time.
In the five years since this report was first published, the market has begun to embrace sustainability. We may soon be able to prove that investments in immaterial sustainability actually have a negative value implication. In fact, we are starting to get there. According to McKinsey, “Evidence is emerging that a better ESG score translates to about a 10 percent lower cost of capital, as the risks that affect your business are reduced.” In a not-so-shocking parallel to investing in women, the data indicates that implementing good ESG practices simply makes good business sense.
An Opportunity for Tech Startups
Still, as a report by KPMG demonstrates and as my own experience has taught me, when it comes to sustainability, there exists a disconnect between what CEOs want to do and what they actually do. They know these issues are paramount, but the incentives and/or tools for value-based and value-accretive decision making do not always align.
There is a clear and strong market opportunity for tech startups solving the ESG infrastructure gaps.
Ultimately, transparency has proven to be a critical facet in the fight against greenwashing and other ESG factors. Transparency initiatives, which help companies to track, trace and report their impact, are already paving the way for consumers and investors to make more informed choices, but we still have progress to make. More robust tools for ESG infrastructure will produce more accountability and open the path for ESG principles to become an integrated part of every investment and buying decision. At that point, market incentives will finally align with modern consumer preferences.
As consumers, investors and political leaders are starting to demand actionable change, startups working on unique solutions will be best positioned to ride the wave. If you’re one of them, let’s have a chat!