Say what you will about environmental, social, and governance (ESG) focused investing: everyone has an opinion. Depending on which reality tunnel you’re focused on, ESG will either save the planet be a complete waste of time. It’s either an affront to capitalism a logical extension of the Ownership Society.
I’ll be honest, over the past year, I’ve grown rather weary of the debate, largely because it always seems to focus exclusively on the performance of individual portfolios over relatively short time horizons, which strikes me as silly when we’re talking about long-term investing and long-term planetary health. It’s left me hunting for a different framework — ESG 2.0, if you will — in which to think about the issue.
I wanted to get way below the portfolio management level and start talking to people in the trenches every day. Not picking companies or cleaning data sets, but building water systems, making supply chain decisions, and re-imagining actual business processes. After all, isn’t that the entire point of ESG investing? Enabling and encouraging the on-the-ground companies to “do the right thing” by the planet?
What follows is an interview with Andrew Howell, director of investor influence at the Environmental Defense Fund, one of the only organizations that exists that is trying to actually have honest conversations among all the stakeholders in corporate environmental action, and Matt Sekol from Microsoft, an absolute frontrunner in almost every ESG data point you’d care to dig up, a massive spender on climate initiatives, and also a partner to countless businesses trying to rethink their own business processes. I hope you find it as hopeful and reality-based as I did.
Dave Nadig: Let’s kick things off with a bit of context. I want to probe a bit deeper under the hood of ESG — we spend a lot of time thinking of it in terms of portfolios. I want to dig into the actual work being done by companies and organizations on the ground. Andrew, what’s your role and background at the Environmental Defense Fund?
Andrew Howell, Director of Investor Influence at the Environmental Defense Fund
Andrew Howell: I run what we call “investor influence strategy” — that is engaging with the investor world and financial sector to encourage climate action, particularly through the companies that those investors are investing in. I’m fairly new to the ESG world. I was a Wall Street analyst for most of my career; I worked for Citi, covering equity markets and stocks in different parts of the world. So I’m from the “investor” world.
Dave Nadig: And Matt, tell us a bit about your role at Microsoft.
Matt Sekol: At Microsoft, I’m a “WW sustainability industry advocate.” My job is to meet with customers across all sorts of different industries to help them understand how we can help them on their ESG and sustainability journey from a technology perspective. Whether it’s environmental sustainability, social issues like looking at employees as stakeholders, identifying climate risk, or addressing material issues.
Real-World ESG in Corporate America
Nadig: So, let’s get right into it. When we get to the actual individual company level, what’s really happening in corporate America today, beyond the political headlines?
Howell: The first thing is that there’s a lot of variability of the state of knowledge among companies on climate, the environment, and ESG. When engaging with a company on ESG, you don’t know what you’re going to find — and sophistication doesn’t necessarily correlate with size. Generally, the bigger the company, the more likely that they have the resources to invest in a team to focus on ESG or the energy transition. Generally, the longer they’ve been doing it, the better they are at it, and the more they know. But that said, there are some very large companies we speak with, who are surprisingly early in that journey and know very little.
Sekol: For some perspective on how nuanced this is inside of a business, I find that I’m constantly context switching. One meeting, I’m in front of the chief sustainability officer, who’s in charge of their corporate sustainability, next I’m talking to an chief investment officer about their ESG data strategy, and then I might talk to an IT organization on how to improve sustainability in their technology stack.
Our teams use inspiring work to get us in the door, but every corporation is trying to solve different challenges in this space, and there are many.
Howell: Ultimately, when we think about which companies need to do the most, it’s not the Microsofts: it’s the big emitters like oil and gas, utilities, and transportation. Some of those companies know a lot about energy transition — in some cases more than anyone else, because they are in the energy business. When you go into one of those companies, with big teams and resources, solutions are not easy. The technology is fast-evolving, like in carbon capture and storage, or in hydrogen, but they still need guidance. They still need to be pushed. That’s what we’re trying to do: to make sure that they’re getting the signal that society cares — both the investors and civil society — and that they need to move as fast as they can.
Matt Sekol, Microsoft
Sekol: What I find is there are a ton of people for who this is their second, third, or fourth job at the company. They get a call from the CEO that, “We need to prioritize this. Go do this as your second job,” and they start into sustainability. The question is: are they focused on corporate sustainability, or are they looking to mitigate an ESG risk, because those are two different conversations. I might explore what their sustainability goals are or if they are they trying to address a material issue. From there, I explore where can we help.
Nadig: Is that really that different of a conversation? Naïvely, ESG can seem a bit like a big giant bucket without a lot of differentiation. How do you break these apart?
Sekol: Sustainability is the impact of the company on the world, and ESG is the impact of the world on the company. Sustainability is table stakes.
The table stakes of sustainability, diversity, and good governance are universal, and everybody should focus on these things. For example, “I should lower carbon.” Great, let’s focus on that by finding the data to drive operational reductions.
The ESG challenge is broad: ESG involves stakeholders, materiality, and prioritizing risks. ESG risks and opportunities have a much bigger learning curve than sustainability because it might involve examining issues that are unique to your company. There might not be standards or best practices to follow.
As a result, companies are all over the place. People who are early in this process tend to gravitate towards sustainability, and then I can get them talking about ESG. It’s rare that I see somebody new start with a broad ESG approach and then back into sustainability, but I have seen it happen. These things flow into each other.
Internal Sustainability and ESG Pressures
Nadig: I think it’s reasonable to ask why, though? Is it just political pressure driving companies to prioritize ESG and sustainability? Employees? Investors?
Howell: “Why” is a great question, and there is not a clear answer. There are different pressures which impact companies differently depending on who runs them, how they’re owned, where they are regionally, and what kind of employees they have. The most obvious pressure point that we talk about is shareholder pressure, and there’s no doubt that that has been rising. We had, of course, the activist vote at ExxonMobil last year [Editor’s note: led by ETF issuer Engine No. 1], which saw three of their board members replaced. That put boards on notice globally in the energy space, especially the oil and gas space, but really every company took notice. This is something that the shareholders are paying attention to.
One element of that particular story that was not as well covered at the time, which is really critical, was that the proxy advisors switched their view: the activist investor managed to convince the proxy advisors, and that got the big passive shareholders to then change their vote.
The employee point is also interesting. You hear anecdotally that some companies in sectors like oil and gas are finding it harder to recruit talent. There are different reasons for that, but it could be an alignment of values, people wanting to work at a place where they feel like they share those values, at least to some degree.
The results are clear in that the vast majority of companies have at least tried to put one foot forward in terms of sustainability. You can’t ignore ESG anymore.
Nadig: Does any of this actually translate into the real world though? Sure, there are new board members, but do ESG programs inside companies actually “move the needle,” as it were, in terms of business processes day to day?
Sekol: From my perspective, and what I see working at Microsoft, sustainability has hit the B2B space. At Microsoft, we have supplier mentorship programs for carbon reporting because we’ve made carbon commitments. We hold mentoring and engagement calls with our suppliers to say, “What are you doing? Do you understand why this matters? Do you know how to do this? Can we help you do this?”
Businesses across the value chain are sitting in the middle of this pressure, whether it’s from consumers if they’re B2C or from B2B customers as their suppliers. Again, in that case, it’s more “Hey, you need to report this carbon impact data because I’m reporting, and you’re part of my Scope 3.” [Editor’s note: Scope 3 refers to the Greenhouse Gas Protocol’s corporate supply chain metrics.]
Beyond that, what I see in the supply chain is that while there’s a huge focus on carbon right now, there’s an emerging risk coming up more often: forced labor. The thinking goes: “If that supplier has forced labor at a plant, I’m going to have to shut my entire pipeline down. That’s a risk that goes beyond my forced labor public statement. I probably need to figure out how to better engage that supplier to really understand it.”
The Anti-ESG Movement and ESG Score Complexity
Nadig: You mention folks digging into their supply chains, but one of the big criticisms we hear all the time is that while an individual company might do the right thing when you roll all of these disparate activities into a single score that investors use to build portfolios, you’re creating a gameable system. There’s some truth to that, no?
Howell: Are some of these critiques valid? The reality is yes, it’s a tricky space. It’s still inventing itself. Part of the reason why it’s taken so long for ESG to take hold alongside financial factors is that financial factors are, by definition, easier to quantify, expressed in dollars and cents. ESG factors are often not easily quantifiable. Maybe one reason why carbon has gotten so much attention is that it actually is quantifiable; you can actually trade it, and in theory, you can count it with some accuracy. Other things are a lot harder.
ESG scoring for companies is a messy process. The scoring systems compare a whole lot of apples, a whole lot of oranges, and a lot of complexity because the score that a certain company receives often reflects the values of the scorer in terms of how much relative importance they give to different factors included in that score. You can get a pretty accurate view of a company on one specific issue, but when you aggregate it up to a single score, it loses a lot.
I think some of those criticisms that are being lobbed at the ESG movement reflect this messiness. But it’s going to get a lot better, and we don’t need to throw the whole thing out.
Nadig: Do companies pay attention to all the scores? Or just to the reality of what their investors ask for?
Sekol: Most often, I see companies not really pay attention to the scores but use them as guideposts to what they should be thinking about. From an investor perspective, most of the asset management firms that I talk to get the raw data and try to make their own decisions.
But there are unique problems with the scores. If you’re a low-scoring company, you probably don’t even know that there’s an ESG score out there. You might not have a mature investor relations team that’s skilled up, which means your company might not surface ESG issues as a concern to the board.
The other problem is there are a lot of private companies that aren’t rated and ranked. On the positive side of scores, I have seen pressure on private companies to disclose and take action because they need to inform their stakeholders in a competitive landscape.
Howell: And it’s often hard to figure out what to measure! Here’s an example: we work with Scope 1 and 2 emissions [direct emissions and upstream energy usage emissions] associated with oil and gas companies. A lot of those are methane leaks. There’s no good data on methane leaks from oil and gas companies because they’re not actually measuring the methane themselves but instead use a factor-based system. They sort of translate the assets that they have, how many pipelines, how many different connections, et cetera, and that’s how they come up with a methane emission estimate. But no one really knows how much methane they actually are emitting. that’s going to change with satellites: it will become better, but it’s an evolution. It turns out you practically need a Ph.D. just in that topic to understand that one single data point, and there are hundreds of data points that these providers are putting out on companies.
Does ESG Deliver Performance? Risk Management? Or New Hires?
Nadig: And yet, for all their flaws, score-based ESG funds are the bedrock of the current ESG investing landscape…
Howell: The reality is those products have done pretty well for the companies that sell them. They have seen decent inflows. I think that is a good sign because it shows that there are investors. But I do think that over time, the scoring approach will increasingly be seen as somewhat problematic. On the one hand, the data will get better, and hopefully, those products will more meaningfully capture the essence of what people are trying to invest in — which is they want to encourage a transition and they want to support good ESG policies. So that’ll improve. But the reality is that there’s nuance, which maybe is hard to capture from a purely score-based method.
Sekol: Addressing ESG issues will reduce risk over the long term. In theory, wouldn’t your investments grow as a result? That’s one of the biggest things investors and board miss about ESG. ESG is not a short-term mechanism with immediate returns within a quarterly reporting cycle!
I see a little bit of this confusion with institutional investors, but when it comes to retail investing, it’s a hot mess. There’s a lot of confusion between some of these funds and what the goals of the fund are. The SEC has a draft proposal to address this, and the EU has already taken steps with SFDR.
Nadig: Right. ESG is a very big bucket. But one thing that’s very clear, at least from the institutional side, is that money is, in fact, moving. Depending on whose numbers you believe, it’s north of $30 trillion being allocated according to some sort of sustainable or ESG methodology. Is that money changing capital markets? Is it lowering the cost of capital for those firms and thus potentially damaging returns for investors supplying that capital?
Howell: A fund manager is going to say without a doubt that it [ESG investing] makes money, but I’ve always been quite skeptical of that argument. I think, in theory, the cost of capital argument could play a role, but the reality is there’s been no evidence of it to date. It’s always going to be hard to measure because there are so many things that affect any one company.
The environment we’re seeing right now [late summer 2022] is a perfect example. The dirtiest companies have rallied the hardest in this energy squeeze because the reality is, those guys, dirty or not, provide what the world really needs right now. That’s made it very hard to see any evidence of performance by weak or strong ESG companies because both have done quite well in this period. We don’t care about the very short term — as Matt said, this is a long-term thing — but it’s also going to be very hard to measure over that long term. It is hard for me to actually make that clear argument — that this is purely about performance. I think it’s about many things, but most importantly, it is about values.
I do think ESG-positive companies are going to be the ones you generally want to own because those companies are clearly thinking about the long term. But will you see that type of strategy really benefit you over the time horizon in which these fund managers are compensated and measured, which is often much, much shorter than any definition of “long-term?” There it’s going to be tough.
Sekol: Internally, corporates are the same. They get measured on a quarterly basis, so focusing on something that’s long-term like ESG is very challenging. If you have good management and if you have evidence that they’re focused on these issues in earnest, it should reduce risk and should give you higher returns, or at least more sustainable returns. In reality, though, this is hard to pin down. If you are talking sustainability, the efforts could even be concessionary.
Nadig: But there are benefits besides just attracting dollars, right? We’re in a bit of a labor revolution, and the latest 300,000-strong Great Places to Work survey of Millennials suggests that “Purpose” — which is shorthand for values alignment — is the number one factor, above compensation, in making career decisions. Do you buy that ESG is a way to attract talent?
Sekol: It absolutely is a talent retention tool, and it’s a talent attraction tool.
Company leaders don’t appreciate this aspect of it: If you have somebody working inside your business who understands your operations, and they’re passionate about this particular thing that everybody on the planet’s paying attention to — ESG and sustainability — you should promote the heck out of that person because they are a gift! Those employees understand how your business operates and can bring sustainability and diversity and all that passion to identify your risks and opportunities in a unique way that even the board won’t be thinking about.
Howell: We spend a lot of our time thinking broadly about frontline workers, people who are actually doing technical jobs in the field where their actions can actually have a big impact on the firm’s environmental footprint. That’s a behavioral, cultural phenomenon that does not happen with a lot of sectors of the economy, and that’s a big challenge for companies — it’s a human resources issue more than it’s a technical issue or a financial one.
In a Broad ESG Landscape, Where Do You Begin?
Nadig: Before we wrap, I’d love to just get a sense of where you think the focus should be. You’re both right at the face of the coal mine, as it were, working with companies to actually change their behaviors. If you could wave the magic wand, where would you put the attention?
Howell: I think that the focus should be on where the biggest emissions are, but the way in which those companies can bring down those emissions is going to vary a lot, based on technology but also based on the nature of the supply chain.
Trucks are a great example: medium- to heavy-duty trucks count for nearly 10% of U.S. greenhouse gas emissions, and that’s a big, chunky problem, but it’s got a very fat tail. If you look at the average size of a fleet for a truck owner, it’s only seven trucks. The vast majority of these trucking fleets are mom and pops, which are then hired by companies like Proctor and Gamble or whoever is moving stuff around. You need to get at those truck owners who aren’t necessarily directly controlled but are customers of those big companies. Then you need to get the big company to change, not by saying, “We’re going to sell these trucks and buy EV trucks,” but instead by saying, “Okay, we’re not going to hire these trucking providers unless they have a transition plan in place.”
That is a different type of change, and it can happen, but it’s slower, and it involves different people. This is what needs to be happening now because it takes time. The technology, like in the case of the road transportation, is pretty much solved; heavy-duty trucks can now move goods using battery-operated trucks as cheaply or cheaper than diesel. That’s the reality, the technology is pretty much there, and yet, we’re not there.
Sekol: I agree that we need to focus on the big emitters, but it’s not an excuse for everybody not to do their part. Every company needs to step up and figure out how to operationally reduce carbon emissions as much as possible. They need to figure out how they can make sure that their supply chains are resilient; they need to make sure they’re lowering climate risk against physical assets; that the employees and communities where they operate are sustainable, well educated, and well taken care of. Even two years ago, I wouldn’t have said that these are table stakes for business operations, but today they are.
All companies need to focus on it. I think there is still a mix of goals out there and other vehicles and levers that can be pulled across all sorts of different industries. It doesn’t necessarily need to come from financial services or regulations. It’s fascinating to watch the machine at work, and I’m optimistic that it’s coming together.
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