A broken yardstick

At this point, it’s safe to say we’ve reached a bit of a turning point regarding companies and their attitudes toward social and environmental issues. More and more, companies openly are expressing their support for issues like reducing carbon emissions, diversity and inclusion and generally conscientious corporate governance.

In fact, we now have a purported measure of how well companies are doing regarding these areas—ESG, which stands for environmental, social and governance, and represents a measure of a company’s sustainability within its operations.

But ESG so far has been a flawed measure at best and has come under a good deal of criticism. For instance, in May, Elon Musk famously branded ESG a “scam” after his electric car company Tesla was knocked from the S&P 500 ESG index. Meanwhile, oil giant ExxonMobil was ranked in the top 10 despite the company’s oil and gas operations generating nearly 5 percent of total global emissions.

While Musk might be a controversial figure, his remarks hit the nail on the head. Because ESG represents such an ambitious effort by companies to get their social and environmental acts in order, the measure currently tries to capture too much, often in areas that are essentially incomparable, and the results are often head-scratching at best.

Because the ESG measure can help companies reap financial benefits in terms of revenue, funding and valuation, it’s even more important that ESG genuinely represents what it purports to. But, ESG is a deeply flawed measure and needs to change if companies actually are expected to adhere to the aspirations it represents.

ESG has become a distraction

Although ESG is well-intentioned, in practice, the measure is quite confusing. ESG attempts to capture a company’s ethics and sustainability, but the measure covers so many different facets of a company that it clouds our vision rather than truly measuring a company’s total impact.

The pursuit of a measure like ESG certainly is worthwhile, however, focusing on too many and often conflicting goals has led to a point where it has become a distraction in the face of one of the world’s most pressing problems: climate change.

One example of how ESG is flawed is the seeming impossibility of weighing one well-meaning objective against another, such as promoting diversity versus safeguarding the environment. Both are admirable goals, but they are not really comparable. Another concern is the lack of standards in ESG scoring as well as transparency in the actual reporting process.

As a result, a company’s ESG score can be wildly out of sync with the damage the company does to the environment. For instance, stocks from oil and gas companies might be eligible to be a part of mutual funds that tout so-called socially responsible investing just because companies finance projects in developing countries.

ESG is not merely an academic or feel-good exercise. A good ESG score can bring companies tangible financial gain. Financial benefits to companies that have better ESG ratings than their competitors are clear. The heart of the matter is that ESG could offer misleading data about companies that can affect stock prices and, in the end, their capacity to finance themselves and grow their operations. This “materiality” effect of ESG reporting—its capacity to affect a company’s valuation—is what makes ESG ripe for abuse.

Boiling ESG down

In July, The Economist published an op-ed that suggested boiling down ESG simply to the letter “E” might be a good place to start. The article argued “E” should stand not simply for the environment but also for emissions. While this is on the right track, it still misses the point.

Even if ESG reporting were to be restricted to climate change impact, companies still would be able to mislead customers and investors because we lack enforceable standards. Typically, companies only disclose a portion of their carbon footprint—that which is generated on-site. However, this means they can omit the larger supply chain-induced pollution, which often can account for more than 80 percent of a company’s total emissions.

Direct emissions generated on premises typically are referred to in carbon accounting as Scope 1, while those linked to energy consumption from operations are known as Scope 2. This leaves out the larger share, referred to as Scope 3—all the emissions generated along the value chain. Scope 3 includes buying from suppliers, transporting goods, getting employees to work on-site, as well as emissions linked to goods that are sold.

The first step in improving ESG reporting is to incorporate accountable measurements that factor in Scope 3 emissions. While companies have less control over these indirect emissions, a wealth of tools is available that can help companies monitor Scope 3 emissions.

Next is to reassess sustainability terminology altogether. Currently, corporations can claim to be carbon neutral by purchasing offsets for their carbon emissions. Airlines, for example, can pretend to sell “carbon neutral” flights because they finance offsets. But allowing companies to hide behind such distracting tactics evades the central issue. Climate change is a real global problem and being “neutral” alone makes no sense if the world at large is not neutral.

© The KonG | stock.adobe.com

Enforcing consistent GHG emissions standards

We are all coming to the realization that climate change is the challenge of the century. The United States recently passed a historic milestone in the fight against climate change as part of the Inflation Reduction Act, also known as the bipartisan infrastructure law. Despite its somewhat misleading name, the law will provide $369 billion in funding for clean energy projects.

But the U.S. still is falling short of requiring more greenhouse gas (GHG) accountability from companies.

In contrast, the EU pushed for stronger GHG regulations in the last two years through its Green New Deal Package in the form of sustainable finance disclosures regulation, the Corporate Sustainability Reporting Directive, an EU taxonomy for sustainable activities and an updated cap and trade system.

Thankfully, similar regulations seem to be on the horizon in the United States. The Securities and Exchange Commission has proposed that, as of 2024, all companies listed on stock exchanges include climate-related disclosures as part of their registration and incorporate that information in their audited financial statements.

Merging financial and climate reporting with tech

Regulations alone will not be enough. The third step in improving ESG value would be for companies to adopt extensive carbon assessment and accounting that clearly can define and analyze emissions in their entirety.

Technology must now play its role in making carbon reporting as easy as financial reporting. Companies can integrate automatic emission quantification into their computer systems to make carbon accounting as essential to doing business as financial accounting. The grand vision is that, while billionaires argue over their Twitter accounts about what needs to be done, financial and carbon accounting will start to merge.

ESG no longer will be a “scam” because it will have become as quantifiable and auditable as a company’s finances. This will truly be the modern-day revolution for capitalism. We finally can begin to measure return on capital not strictly in financial terms but also in terms of true, planetwide well-being.

The author is co-founder and CEO of Paris-based Greenly, a provider of carbon assessment and accountability solutions for small to large companies.