The Ongoing Peril Of ESG

When evil ensues, it is because good people used bad methods to obtain what they think is good.[i]

ESG: Born In The UN

In 2004 Kofi Annan, the UN Secretary-General sent a letter to 55 finance and asset management CEOs worldwide. The letter called on them to adopt environmental, social, and governance (ESG) factors into their investment practices. In time this “letter” grew into the Principles for Responsible Investments (PRI) initiative.[ii] ESG is the stepchild of Kofi Annan and the UN. It is the vision of a world that could be kinder, gentler, and more responsive—ignoring all of our differences to make a difference. Instead of this vision, ESG has devolved into a metastatic word salad created by overly empathic clerks.

The reader’s pushback is genuine in pointing out that, “Hey, the CEOs responded positively to the letter from Kofi Annan. The leader of the UN!” My push back is of course, you responded in the affirmative to the head of the UN and said, great idea. He is the head of the UN.

Word Salad Guidelines

The guidelines in the US and EU regulations are drafted by persons who have never worked in private industry. They have zero concept of the crushing weight of regulations on a company or an industry. Out of one side of their mouths, they lament the concentration of wealth in the hands of a few. Out of the other side of their mouths, they are crowing about ESG. The very costs of compliance force business combinations that perversely concentrate power and wealth.

The EU’s Sustainable Finance Disclosure Regulation (SFDR) imposes comprehensive ESG disclosure requirements covering a broad range of metrics.  The next step is taking that to a business' entire supply chain.  Supply chain ESG accounts for the entire company footprint. It requires a deep dive into the supply chain to understand where materials come from, and who handled the material from point origin to the company’s doorstep.

Opinion Markets

Every one of our views is different. Environmental and Social have a series of issues impeding any logical implementation. The biggest is that both are subject to opinion markets on what definitions must apply to rate Environmental and Social compliance.

In an opinion market, you have no fixed points of reference. There are no black-and-white numbers or lines, only amorphous schmeers.  In looking at ratings supplied by rating agencies on 10 companies' debt and ESG ratings, the delta on debt rating was under .25σ, while the delta on the ESG ratings was over 6.0σ! These are the perils of an opinion market.

If I were to ask you, the reader, what is meant by "Robust ESG Compliance", you would most likely give your opinion. What if a regulator has a different opinion? It means that you are wrong. What if a company puts forth its ESG plans, but a shareholder disagrees? The company will be sued.

A parallel point is the definition of Art. What is Art? It is a painting, a sculpture, a song; and do you like it or not? I could not be less interested in a Jackson Pollock or Mark Rothko crap. However, I admire Francisco Goya, Gustav Klimt, and Utagawa Hiroshige. It is my opinion. If you disagree with me – you are wrong, not I.

The point is that regulators and shareholders may disagree with your ESG choices. So, the regulators fine, or the plaintiffs sue the company.  According to all trends I have been monitoring, the cost of ESG in regulatory compliance has grown five-fold over what was initially budgeted. To add emphasis, the US Securities and Exchange Commission recently created a Climate and ESG Task Force, and the Environmental Protection Agency instituted the Office of Environmental Justice and External Civil Rights. Each new regulatory task force will give rise to greater ESG-related enforcement actions. ESG litigation is also on a steep rise with shareholder derivative lawsuits, consumer protection litigation, and suits by environmental advocacy groups attacking the delta between what ESG is according to a company’s opinion, and what the plaintiffs’ opinions are.

Automation Of ESG Compliance

So, what do most companies do with a complex, semi-repetitive task?  They try to automate the task. Several startup firms are looking toward using AI to assist with compliance. The theory is that if you feed in enough data, companies and investors can identify what good ESG is and what is not ESG.[iii] By some magical formula, they will be able to assess the number of "utils"[iv] or good climate "Karma” points.

AI is a series of complex algorithms and differential equations assembled to process a great deal of data, get an answer, or at least generate some predictive values. That's not how we humans work. Humans are quicker, more intelligent, and we use our intuition well. It takes a six-year-old to be shown what a school bus looks like, and after a few exposures to a school bus image, they can correctly identify a school bus. It takes an AI programme over 10,000 images before it approaches 90 per cent accuracy.

Remember IBMs Watson on Jeopardy? While it did win, it required an investment of US$3 million by IBM to win the US$1 million prize, and even with all that computer power still, a few rules had to be changed. IBM was so impressed with their creation that they went on to have Watson address healthcare. IBM fed millions of documents into Watson to streamline cancer diagnoses and treatment. Watson for Oncology was and still is a rube.

"Perhaps the most stunning overreach is in the company's claim that Watson for Oncology, through artificial intelligence, can sift through reams of data to generate new insights and identify, as an IBM sales rep put it, "even new approaches" to cancer care. But, unfortunately, STAT found that the system doesn't create new knowledge and is artificially intelligent only in the most rudimentary sense of the term."[v]

Some of the recommendations of Watson for Oncology diagnoses were wrong, and the treatment recommendations could have been fatal.

The burden of ESG will be born and orchestrated by real humans doing real jobs and cost real money. There is no enterprise solution. All companies are different. Automation will fail.

But Wait, There Is More

Western companies, over the years, have been saddled with an immense amount of rules and regulations. The west has oodles of regulations on health, safety, pollution, sustainability, employee benefits, SOX, FCPA, KYC, emissions, pollution, OSHA, AML, trade regulations, and so many more. It is this very burden of regulations, this immense economic friction, that is driving up the cost of doing business so much that we, as western nations, began sourcing goods and services from other countries.

How great is the friction?  Let's look at the cost per km for high-speed rail. China, $17-$21M/km, EU $25-$28M/km, US $25-$39M/km, and California $56M+/km.[vi] With each bit of regulatory burden increases the cost of doing business. At a point, not in the distant future, western nations’ companies will be unable to export goods and services. They will be too expensive and can be alternately supplied by non-western nations. Capital markets will also accelerate the shift to SE Asia and the Middle East.

Why Does ESG Persist?

It persists because there is a demand for ESG-qualified investments, most originating from state and large multinational pension schemes whose boards of trustees who have required ESG investments. There are trillions of dollars chasing ESG funds and investments. Yet, I have yet to speak to a fund manager who thinks ESG is a good idea.  Most consider ESG a market perturbation on which to trade – not invest.  The long side is traded on new ESG entrants and on the short side of those whose ESG credentials are being questioned.

A cold quip from one manager cut to the bone of the ESG inauthenticity.  Referring to electric vehicles, solar, and wind. “You need a bunch of artisanal child miners and to burn a lot of Chinese coal to have green energy.”

Many US based government and private pension schemes have recognised the costs of ESG and are aggressively pushing back, requiring that the pension managers ignore ESG and look at only total return.

E Is For Environment

For the most part, the E has dissolved into questioning a company’s carbon footprint. The overarching problem addressed is global warming caused by burning fossil-based fuels.

The number of coal plants constructed from 2000 to 2022 from Global Energy Monitor:

From the International Energy Agency, “Coal accounted for over 40% of the overall growth in global CO2 emissions in 2021, reaching an all-time high of 15.3 billion tonnes.” If carbon emissions cause climate change, there is zero ESG or the prognostications from the farce of COP27 can do to change a thing.

The developing nations are not going to throttle their development. Russia, China, Indonesia, Malaysia, India, Mexico, Brazil, etc…nor should they. It is their sovereign right to develop as they see fit. What does this tell us?

If we cannot stop climate change, we must prepare for it.  We must anticipate rising sea levels and the changing geography of climate zones.  If climate change cannot be stopped, E becomes our collective preparation for its arrival.

S Is For Social

Like the Environment, ‘S’ has devolved into a mono issue of diversity, equity, and inclusion (DEI). The concept behind DEI, like ESG, started as a noble and proper cause.  All points of DEI are important. However, the noble cause has been destroyed by those who think they are right.  Both ESG and DEI will ultimately fail because of ignorant heavy-handed governmental imposition as opposed to enlightened education. But when?

G Is For Governance

Of the three, governance is the most beneficial to companies. Modern management has learned that looking at risks, corruption prevention, board independence, and designing for more skin in the game for management with benefit-linked outcomes will give one company an advantage over all of their poorly managed competition. Cheers for good governance.

So What Is One To Do?

Many former champions of ESG are backing away as the restrictions being placed on the companies are too constraining and prescriptive. It is killing the margins. The expected savings on energy and sustainable operations are eaten up, plus more, by the cost of compliance and reporting.

ESG standards should be made voluntary. No one needs more regulators assessing an opinion market. It is too expensive and damaging. Just as some prefer different categories of investments, such as real estate, defence, food, and aerospace, some can choose ESG.  If a company chooses to claim its ESG status, it is their choice. If the company gets it wrong, so be it. The market will sort it out by shifting investment or with litigation. Bring ESG back to its roots as a philosophy, not a prescription.

Footnotes:

[i] Bits stolen from T.S. Eliot, Reinhold Niebuhr, and C.S. Lewis and assembled to my liking.

[ii] https://www.unpri.org/

[iii] There was an earlier theory about an infinite number of typewriters and an infinite number of monkeys could produce all of the world’s greatest works. Email has disproved this theory.

[iv] A hypothetical unit measuring satisfaction.

[v] https://sciencebasedmedicine.org/ibm-watson-versus-cancer-hype-meets-reality/

[vi] https://www.worldbank.org/en/news/press-release/2014/07/10/cost-of-high-speed-rail-in-china-one-third-lower-than-in-other-countries

L. Burke Files DDP CACM
Mr. Files is an international financial investigator and due diligence expert who has run cases in over 130 countries and has visited over 100 countries. Mr. Files has tackled investigations running from a few hundred thousand dollars to over 20 billion. Along the way, he became familiar with the knowledge of what people need to do, for due diligence, preventing corruption, and to avoid helping criminals launder money. He brings this experience of hands-on investigating and problem-solving experience to his lectures on Due Diligence, AML, and Anti-Corruption. Prior to founding FE&E, Inc., he served as the Director of Corporate Finance for American National an investment bank focused on development stage venture capital. He was also employed by Oppenheimer/Rouse as a commodities specialist trading customer accounts in Agri-Business, 24-hour gold and silver, and foreign currencies. Mr. Files has authored six books, and many white papers and articles. He has been quoted in major publications including The Guardian, The Financial Times, Forbes, US Newsweek, and more. He is the author of the award-winning book Due Diligence For The Financial Professional 2nd Edition. Mr. Files serves on the board of directors for several private companies, funds, and non-profits. The companies include Unicus Research a specialty advisory service for fund managers and family offices, SGS Glazing a specialty glazing design and estimating firm, and NSI a premium spirits company.