Sustainable investing has taken off in recent years, drawing dollars from more than just Patagonia-loving millennials. But there is trouble in this apparent ethical asset paradise. With over 600 ESG frameworks in common use, the growing number of socially conscious investors still lack a single reliable source of information on where to put their hard-earned money. (Earlier today more than 50 business leaders said they signed on to ESG reporting standards established last year by the World Economic Forum.)
I’m all for metrics, but not for the reasons you think. We need a single standard for measuring ESG as a way to generate more transparency from companies in countries that operate opaquely. ESG has to be as rigorous as GAAP—and have the same consequences for falsifying information. ESG need not only be about progressive values, it is best suited as a tool for transparency—and that’s something even the most hard-bitten, Milton Friedman-loving capitalist can get behind.
Why Emerging markets are fraught and how ESG can help
One big reason to embrace ESG is to help create a better system for evaluating investments in non-transparent, unregulated, undemocratic markets such as Saudi Arabia, Iran, Russia, China, and other autocracies. A critical attribute claimed by ESG disciples is the ability to foster social change and force transparency and accountability, but that is not possible in the context of government that itself fails to live up to those standards.
These markets have their appeal. China, with 1.2 billion potential consumers, has long been coveted by U.S. companies. I have invested in Esports and platform marketplace companies that do business all over Asia, the standard bearer of this technology. Russia and Saudi Arabia, both with thriving consumer ecosystems, have lucrative intersections of high-end fashion and fans, offering new revenue streams. Still, Western investors, both in public and private markets, have steered clear of Russia for decades because it is difficult to properly assess investments. Along with Russia, China, Iran, Saudi Arabia, Venezuela and other autocratic countries have flouted laws and regulators attempts to bring accountability and rein in corruption. China has gone even further, touting its supposed environmentalism, yet remaining the world’s single largest polluter by carbon emissions.
Authoritarian countries are no better when it comes to the social vertical, the “S” in ESG. Russia has long imprisoned economic dissidents, similar to Saudi Arabia and Iran. Similarly, China publicly persecutes and discriminates against the Uighur ethnic minority and is a serial violator of human rights, religious freedom, freedom of the press, etc.
What is 1ESG?
The starting point of evaluating any investment, whether it is in the early-stage start-up space where I invest, or the hedge-fund space where I used to invest, is the environment in which the company operates, the regulatory regime. If you start with the wrong regulatory regime, none of the other elements, the E (environmental), S (social), and G (governance) are operative. The starting point matters. That’s why I am proposing a 1ESG framework, in which the “1” refers to the overall regime, the host country’s form of government. Companies operating in countries that choose to defy ESG principles by definition lack transparency and accountability. They can’t get past step one.
The threshold for geopolitics and nation-state governance is critical, because, as I’ve witnessed, it carries profound consequences. Contrast China with democratic India, which shares similar laws and commonly held principles with the west. For investors in Indian companies, the opportunities to exit are plentiful and regulation means far less obvious graft. Any good investment in a company there will succeed or fail on its merits, without the vagaries or politics of state cronyism or encroachment.
Governance is the foundational element of the ESG triumvirate, though seemingly the least sexy of the three. Good corporate governance generally comes down to the need to be accountable and transparent, both at a board and executive level. One of the best examples of why that matters is the case of Luckin Coffee, the Starbucks of China. Luckin earned a listing on the NASDAQ until it was revealed it had fraudulently reported nearly $300 million of revenue. The Chinese government’s insistence that any Chinese company be exempt from inspection or regulation by the board that oversees all U.S.-listed companies, enabled that fraud to continue undetected. So much for due diligence.
ESG already has buy in, and that’s good
Traditionally, corporates have nearly exclusively prioritized shareholders’ interests of profit above all else, but there are signs of change. The Business Roundtable, a group comprising 181 CEOs of top companies has instituted a dramatic shift in declaring that corporations should elevate their duty to a broader set of stakeholders, including employees, customers, and the broader community, which is where climate imperatives come in.
On the investment side, approaches that seek both financial returns and environmental or social gains have soared in popularity. Interest isn’t confined to a single generation. Gen Z, which will soon comprise 1/3 of the global population, identifies the most with the climate imperative and, according to studies, supports ESG and environmental mandates. And 77% of millennial investors identified ESG issues as their top priority when deciding among investments. But older generations are also embracing the mantra of doing good while doing well, as investors need not sacrifice returns to make the world a better place.
The role of asset managers
The zeitgeist may be slowly shifting, but change won’t happen without the group controlling the purse strings of the capital — asset managers. They are critical players in the flow of enormous amounts of capital to companies. The largest asset managers, State Street, Vanguard, BlackRock, and Fidelity, combined have an immense influence, collectively holding nearly 40% of all US publicly-listed asset ownership and a full 1/5 of the total S&P500, across active and passive client accounts.
Asset managers are starting to use their power to influence. BlackRock’s CEO Larry Fink has taken a stance by declaring his firm’s intent to solely back ESG-friendly investments. With BlackRock’s clout, if they can move beyond classic greenwashing, they have the ability to create dramatic change. Others see the potential to move the needle in autocracies. “If asset managers were willing to live up to their claims and take a steely-eyed, honest view of ESG principles by putting words into action, this would have a chilling effect on China, or any unrepentant serial ESG violator,” says Mark McDivitt, former global head of ESG at State Street, who recently departed to help lead Context Labs, a climate-aligned software company focused on elevating and quantifying ESG measures.
I am not saying that companies in non-democratic countries are completely uninvestable. What I am saying is such investments are clearly inappropriate for ESG principled funds, and likely far too risky for individual investors. A single commitment, and foundational top down model like 1ESG is needed. If a company cannot dictate its own path, independent of state meddling, then ESG capital should not be available to it. And the gatekeepers need to be the entities with the purse strings taking a principled stance.
Andrew King is a partner in a venture fund that focuses on climate and ESG investing.