By Witold Henisz and Engine No. 1.
Engine No. 1, which won an against-the-odds board challenge against Exxon Mobil Corp (XOM.N) earlier this year, just published a framework for investing that pushes for a value to be assigned to how corporate activities affect climate and society. Their "total value framework" provides an inside look into how the San Francisco-based firm picks companies to invest in.
The uncomfortable truth for large swaths of the ESG “industry” is that current approaches to measuring ESG performance in scores or ranks look good in ESG reports, but they are extremely difficult to incorporate into the analyses that investors and companies use to actually make decisions. In a new report, Engine No. 1 explores the flaws inherent in today’s ESG data and measurement, which have kept ESG analysis mostly disconnected from other financial or operational analyses of a given company. They also introduce a new framework, which they believe addresses these flaws and gives us a new vision of value as investors.
Engine 1 tells it like it is: "Instead of ESG scores and ranks, which in effect constitute little more than emojis and are as difficult to incorporate into spreadsheets or algorithms, we try where possible to quantify the impact in dollars." Greenwashing is rampant. Managers simply rebrand existing funds with an ESG label after introducing relatively superficial changes in exclusions or investment strategy. And we all know exclusionary screens aren't going to change the world. It's not enough to sell a stock and hope it goes out of business. To make matters worse, the largest-growth segment in the ESG space has comprised low-fee funds that largely mirror passive indexes and dilute the distinctiveness of ESG funds because simple filters often underperform their respective benchmark. In other words, garbage- and passive ESG is going to give the whole space a bad reputation.
They share some interesting findings. Using traditional ESG measures to analyze groups of winners and losers found no consistent patterns or correlations. A recent paper from the MIT Sloan School of Management by Berg, F., Koelbel, J. F., & Rigobon, R. has the unfortunate title of Aggregate Confusion: The Divergence of ESG Ratings. They note, "By one count, there are now more than 230 corporate sustainability standard initiatives; another study, meanwhile, found twenty different reporting schemes for employee health and safety data alone."
Worse, current ESG ratings don't agree on very much.
Even if they're looking at the same company:
This Is Not Helpful
To address the above issues, Engine No. 1 ties ESG impacts directly to financial value creation. Their Total Value Framework represents a major breakthrough and you can read more about it here.
About the Authors:
Engine No. 1 is an investment firm that drives performance through impact. The firm was founded on the shared belief that a company’s ability to create long-term shareholder value depends on the investments it makes in its employees, customers, communities, and the environment. Learn more at www.engine1.com.
Witold J. Henisz is the Deloitte & Touche Professor of Management at The Wharton School, The University of Pennsylvania. He is also Director of the Wharton Political Risk Lab and the founder of the Wharton ESG Analytics Lab. His research examines the impact of political hazards as well as environmental, social, and governance factors more broadly on the strategy and valuation of global corporations.