Environment Society and Governance (ESG) On The Level

Kofi Annan, former Secretary General of the UN, is the father of ESG. Most investors are unaware that Kofi Annan’s idealism has created a paradoxical scenario for all corporations. In 2004, he wrote to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative under the auspices of the UN Global Compact and with the support of the International Finance Corporation (IFC) and the Swiss Government. The initiative aimed to find ways to integrate ESG into capital markets, and the 50 CEOs enthusiastically wrote back and agreed. Heck, after all, it was Kofi Annan writing to them. The ESG models became part of the UN’s 17 points on Sustainable Development. [2]

ESG is a poorly formulated concept. According to the UN “there are over 600 ways to assess corporate ESG activity, but there are no globally accepted standardised corporate disclosure requirements.” [3] In all aspects, ESG has devolved into an opinion market of inchoate wants, ideals, and signaling.

Yet much of the market of investors and pension scheme managers require ‘ESG’ to be an integral part of the companies in which they invest. It’s like ‘UL Approved’ or an ASME number on your fruit juicer. Who knows what it means, but the juicer must be OK. The stampede to ESG has been substantial. The funds seeking ESG-rated investments represent a third of the USD $51 trillion pension funds under management. You may not have a clue what ESG is, but you may need an ESG tag.

So, let's break it down.

E Is For Environment

I get it. I don’t want canals catching on fire and birds dropping out of the sky because of pollution. But ESG actions can have perverse consequences. The concept of the ‘E’ seems to have fixated on carbon footprint and the phasing out of all fossil fuels.

Thus, the hardest hit industries have been natural resources such as mining and oil and gas. In the oil patch in 2017, there was over $65 billion in direct investment into oil and gas from PE. In 2020, it did not break $20 billion. But it got worse. In value terms, private equity deal activity decreased by 99 per cent in Q2 2023 compared with the previous quarter’s total of $1.1 billion, and fell by 22 per cent compared to Q2 2022. Related deal volume decreased by 46 per cent in Q2 2023 versus the previous quarter, and was 13 per cent lower than in Q2 2022 [4]. Investors do not like fossil fuels or mining, but they should.

The shift to clean energy requires metals. The transition to renewable energy requires millions of tons of copper, aluminum, lithium, manganese, nickel, cobalt, graphite, and rare earths. Metals need to be mined and refined. The Biden administration has shut down permitted mines in Arizona, Minnesota, South Dakota, Alaska, and Nevada, preventing the mining of copper, nickel, gold, lithium, rare earths, and oil and gas. I add in oil and gas because energy is a major component of the cost of metals. The exploration, demolition of ore bodies, hauling, refining, and delivering a finished metal is energy intensive. For example, 78 per cent of the cost of copper is the energy needed to mine and refine the metal to a finished product! If we do not mine and refine metals in North America and the EU, we are left buying metals dug by “artisanal miners” [5] in unstable countries, refined in and sold to the West often through an economic adversary, China.

China produces 90 per cent of the world’s gallium and 60 per cent of germanium. Likewise, it is the world’s number one graphite producer and exporter, refining more than 90 per cent of global graphite [6]. Lastly, Chinese-based refineries refine 85 per cent of the world’s rare earths. The West should feel very vulnerable.

But on the flip side are the carbon emissions from China. There comes the question, why bother, when China is emitting more CO2 than the US, EU, and India combined? Further, 80 per cent of the emissions are coming from coal. As of July 2022, China had 1,118 operational coal-fired power plants, with an additional 168 plants permitted for construction [7]. It appears the world needs to burn a lot of Chinese coal to become green and ESG compliant.

S Is For Society (Not Social Or Sustainability) [8]

The broad category has many definitions, so depending upon who you are speaking to, S might include labour relations, diversity, equity and inclusion (DE&I), human rights, community rights, stakeholders, social progress, politics, and ill-defined groups. The key problem is the broad range of what people believe to be social relevance for a company. Judges, for sporting events, have written criteria of requirement on how athletes are to perform to obtain a score. In judging a performance, there is some opinion, however, the impact of a single individual’s viewpoint is constrained.

‘Society’ is the softest of standards. It has led to some of the most egregious errors in corporate choice-making and implementation attempts. It has impacted choices of the sources of western Chinese cotton, “artisanal miners” for cobalt and rare earths, the definition of forced labour and child labour, and the recruitment of employees or students based on their outer crusts, resulting in the primary driver for ESG litigation. With a growing emphasis on the importance of DE&I in the workplace, employers face increasing employment discrimination and shareholder derivative actions related to DE&I missteps. A monumental misstep was Bud Light’s use of Dylan Mulvaney to check the S and DE&I checkbox for the investors. Corporations have endured shareholder derivative lawsuits based on claimed misleading statements on their diversity and equity. The lawsuits claim a corporation’s directors failed in their duties to ensure the corporation complied with anti-discrimination laws or authorised inaccurate statements to the public regarding the corporation’s commitment to diversity, equity, and inclusion.

G Is For Governance

Governance is at the heart of any business, small or large. It is about establishing rules and procedures for information gathering, analysis, and action. Corporate governance includes corporate structure, board composition, business ethics, and anti-corruption. According to the World Economic Forum: “Behind each breach of a company’s environmental or social commitments lies ineffective corporate governance, be it inadequate anti-corruption practices, perverse incentive structures, contradictory lobbying activity, or ill-equipped leadership.” [9] This is a biased overclaim, but near all corporate failures can find a deep root in poor governance.

Enforcement

Think it’s all nice chatter? It's not. The Western regulators are serious about ESG.

The EU Corporate Sustainability Reporting Directive (CSRD) covers the rules concerning the social and environmental information that companies must report to their shareholders and the public. The objective is for the public and investors to have access to information needed to assess a company’s risks and opportunities arising from climate change and other sustainability issues.

The US did not pass mandatory reporting standards but industry has adopted a best practices model crafted by the Sustainability Accounting Standards Board [10] that has become the benchmark for US ESG compliance. The SEC launched the ‘Climate and ESG Task Force’ to develop initiatives to identify ESG misconduct consistent with increased investor reliance on climate and ESG-related disclosure and investment. The third pillar of US-based ESG enforcement is private litigation and shareholder derivative actions taken against those companies perceived to be ‘ESG washing.’

These rules are part of a growing body of non-financial reporting required by public companies or investors in private companies on areas of perceived risk such as environmental matters, social matters, treatment of employees, human rights, corruption, and diversity in company boards and senior management, in terms of age, gender, educational, and professional history. This growing body of non-financial reporting is driven, in part, by the UN’s 17 Goals for Sustainable Growth.

The non-financial reporting standards are expensive. Further, the standards are so ill-defined that the reports enter an opinion market's value vacuum. All it takes is one dissenter, a whistleblower, a regulator, or a disgruntled shareholder, to cost a company even more money to defend its position or interpretation of their ESG standards. The cascade of nonfinancial reporting is supposed to help companies disclose and discuss risks with the investors and the public. In practice, it adds expenses to the company and compounds the risks.

A company conducting business in the EU or US should expect to be held to the highest of the various standards for reporting, and be prepared to source ESG information and compliance down their entire supply chain.

The 17 Goals, ESG and DE&I are well-intentioned, but in practice, the slightest error can be disastrous. Most of the mischief in this world is done by and through “good” intentions. The cause of evil is ignorance, not malice.

On The Level ESG-Compliance

Whatever a company chooses to do or must do to comply with disclosure requirements, management must avoid soft targets or ideas. Management must craft quantifiable standards of where they are and how they will evolve and grow to embrace a given set of standards. Absent hard standards shared with the public and investors, a company should expect to find itself a defendant from opportunist rent-seeking litigants and regulators who want to make a name for themselves. The company may also find they are no longer eligible for funds that desire ESG-compliant companies. If a company chooses to be ESG-compliant, do it right. If a company chooses not to be ESG-compliant, share that too. In the middle pretending or flailing lies the peril.

1   https://www.keystonelegacy.com/news/the-roots-of-esg
2   https://corpgov.law.harvard.edu/2018/10/04/un-sustainable-development-goals-the-leading-esg-framework-for-large-companies/
3   https://www.undp.org/future-development/signals-spotlight/rethinking-governance-esg
4   https://www.mining-technology.com/deals-dashboards/global-private-equity-activity-mining-industry/
5   Child slave labor is a more appropriate descriptor blowing “social” out of the water.
6   https://www.csis.org/analysis/chinas-new-graphite-restrictions
7   https://www.aljazeera.com/economy/2023/8/30/chinas-coal-habit-clouds-climate-fight-as-emissions-top-us-eu-combined
8   https://sdgs.un.org/sites/default/files/publications/651Making_Investment_Grade.pdf The “S” has come to mean so many things to so many people. The various definition of “S” just illustrates the point I am making
9   https://www3.weforum.org/docs/WEF_Defining_the_G_in_ESG_2022.pdf
10   https://sasb.org/

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.