Don’t Be a Dodo: Get Your ESG Game On
By Eric Israel, Skytop Contributor / February 8th, 2022
Eric is the world’s first sustainability chartered accountant. He was the independent assurance leader for Royal Dutch Shell’s first global Sustainability Report in 1997. Eric is the co-founder of KPMG’s Global Sustainability Practice and PwC’s Conflict Minerals Practice. He was the U.S. Director for the Global Reporting Initiative (GRI) and is passionate about coaching the new generation of professional accountants on applying integrated thinking within new and emerging reporting frameworks.
The New Kid on the Block
As of January 2022, Tesla’s market value is $1.014 trillion, which makes it the world’s 6th most valuable company. In comparison, Toyota and Volkswagen, the world’s two largest automakers in 2021, have a market value of $279 billion and $131 billion respectively and are the 30th and 103rd most valuable companies. So how did a relatively new company become the most valuable car company in the world?
The quick answer is disruptive innovation and flawless execution. Unlike those legacy automakers, Tesla was not burdened with decades of history. As a new company they made electric cars cool and desirable, and its co-founder and CEO Elon Musk leads and executes all product design, engineering, and global manufacturing. Tesla was founded in July 2003 and went public on the Nasdaq exchange in 2010. A $1,000 investment back then would be worth over $150,000 today. So, what makes Tesla so successful? What is the ‘why’ of Tesla? What is its relevance or purpose?
The Focus on the Future
Tesla’s success and mission is founded on sustainability: “to accelerate the world’s transition to sustainable energy”. The company’s efforts to minimize its environmental footprint can be found in Tesla’s 2020 Impact Report. This sustainability report reads like a car brochure, with many great things to say about their products. But it is also clear that the company has plenty of room for improvement. Interestingly, the report doesn’t include a statement from its outspoken CEO, Musk, and does not reference any of the leading sustainability reporting standards.
So based on Tesla’s success, it is not surprising that shareholders, specifically large global financial investors, are pushing and holding companies accountable for environmental and social performance progress. BlackRock, the world’s largest asset manager with over $10 trillion in assets, has been focusing on sustainability since 2012. They are rightly concerned if (legacy) companies are doing enough to adjust their businesses for the massive changes the economy is undergoing. BlackRock’s CEO, Larry Fink, said it well in his latest annual letter to chief executives and shareholders: “As your industry gets transformed by the energy transition, will you go the way of the dodo, or will you be a phoenix?”. It seems Tesla knows the answer to this existential question and is rewarded accordingly.
Stakeholder Capitalism, Demanding Change
And it goes further than just words. Last year, BlackRock and two other institutional investors, Vanguard and State Street, gave powerful support to virtually unknown activist investor Engine No. 1 to push Exxon Mobil to reduce its carbon footprint. This stunning development demonstrates that mainstream investors have become serious about what they call “stakeholder capitalism” and that the dynamic between board, management and shareholders has changed. Sustainability is sometimes dismissed as an ideology that doesn’t belong in the corporate world. Fink clearly disagrees and he has argued in his annual letters that “over the long-term environmental, social, and governance (ESG) issues – ranging from climate change to diversity to board effectiveness – have real and quantifiable financial impacts”. The predictable world of boardroom elections has ended. Shareholder value is still king, and investors are now demanding meaningful action if management isn’t making needed changes fast enough.
ESG, The Next Phase of Capitalism
Just like sustainability is good for Tesla’s business, this is also true for investors as demonstrated by an ESG investment market that is growing rapidly. According to research conducted by Bloomberg, ESG assets are forecasted to become $53 trillion by 2025 and will be a third of global assets under management. This means boards and management can expect that pressure from investors for effective action to make changes continues. As more mainstream investors sign up to net-zero emissions targets, they will need to put pressure on their portfolio companies to do the same to achieve those targets. Granted this may cause disruptions within the supply chain, but it also presents opportunities for companies meeting meaningful ESG standards. Investors continue to rethink their decarbonization strategies and will demand change from management. This can result in early impairment of carbon intensive fossil fuel assets and replace this with cleaner energy solutions. Are these demands for impact transformation changing capitalism, the beacon of American business for more than four decades?
Adam Smith’s ‘invisible hand’ still exists, so free trade capitalists can relax. What is different now is the realization that self-interest also includes improving society. This is no longer just a political process but has also become an economic factor. This thinking is also reflected in the World Economic Forum’s ‘The Great Reset’. This initiative aspires to come up with a set of dimensions to build a new social contract that honors the dignity of every human being. Although this may sound lofty, investors have realized that ESG issues have real quantifiable financial impacts. For this reason, investors will become more engaged and continue their demands for impact changes. For companies it is therefore critical that they get to grips with understanding ESG and its impacts. Companies who demonstrate a strong ESG commitment from the top and have established ESG objectives focused on value creation are well prepared to engage in this ‘next phase of capitalism’.
The Hurdles of a Global Standard
Demonstrating this understanding in a sustainability report or an impact report as shown by Tesla provides transparency and accountability. Sadly, we still don’t have generally accepted sustainability reporting standards. Whilst commitments were made at the COP26 meeting last year to develop an international sustainability standard, this will take years to develop and implement. Moreover, there is an increasingly complex regulatory landscape, and it is unlikely to see global ESG regulation convergence soon. Companies and investors will need to navigate this. They must find the right reporting and disclosure strategy even if this is likely to change over the next couple of years. As the sustainability reporting landscape continues to evolve, investors will need to balance the opportunities associated with promoting sustainable finance. Concurrently, investors will continue to ramp up pressure on government and companies to ‘walk the talk’ when it comes to ESG. This is consistent with what Fink said in his annual letter: “But business can’t do this alone…We need governments to provide clear pathways and a consistent taxonomy for sustainability policy, regulation, and disclosure across markets”.
Greenwashing and ESG Abuse
The increased focus on management’s duties to act on ESG issues will make this risk personal. Education will be critical and the current lack of training on ESG issues for both management and staff increase this risk. This also applies to the fiduciary duties in the boardroom and reporting processes. The current absence of reliable sustainability reporting is likely to become an Achilles‘ heel for meaningful action. The lack of reporting and verification processes creates an opportunity for greenwashing. Sad to say this is already happening on a large scale. Research conducted by the European Commission, which focused on greenwashing in 2021, found that 42% of online green marketing claims from various business sectors are false or deceptive. It demonstrates that business is inclined to use ESG abusively. Making misleading claims on ESG issues will make companies targets of legal actions. A good example of this is the SEC probe against Deutsche Bank’s investment arm for possibly overstating ESG credentials in their 2020 annual report. The allegations were initiated by an internal whistleblower and indicate that financial regulators focus on exaggerated sustainability claims.
Last year the SEC formed a task force to investigate sustainability claims misconduct and issued a ‘Risk Alert’ for ESG investing processes and representations. It pointed out its observations of deficiencies and internal control weaknesses in ESG approaches. For example, the SEC found ESG approaches that were unsubstantiated, potentially misleading, and did not adequately address relevant ESG issues. Other examples relate to inconsistent disclosures, inadequate internal controls, and compliance personnel with limited knowledge in ESG. In other words, they found a mess or in more professional language they found material weaknesses that will need to be addressed. Predictably the number of climate related lawsuits nearly doubled between 2017 and 2020. Last year we saw the stunning landmark case where a Dutch Court ordered Shell to reduce its emissions, thereby beginning a new climate litigation era. Subsequently the SEC has become more specific about what companies need to disclose in their annual financial reports related to climate change. It is obvious that there are significant legal and reputational risks associated with ESG – and greenwashing.
Staying Optimistic and Bold
Tesla has proven to be a spirited business leader by using sustainability as the foundation for its innovation, but as Einstein once said, “Great spirits have always encountered violent opposition from mediocre minds”. In the United States, sustainability has always been more controversial than in the rest of the world. It is therefore unfortunate that sustainability has become a political issue that has manifested itself in conspiracy beliefs resisting sustainability programs. Conservative players are using these conspiracy theories to undermine a global response to sustainability such as climate change as if this would damage American society. This is a new phenomenon that can potentially disrupt progress made towards a sustainable world, further emphasizing the need for immediate action and results.