ESG – “environmental, social & governance” - is the buzzword of the decade, used by stakeholders across the globe to drive behaviour change in business and finance.
With the risks of climate change and the social costs of modern slavery at the forefront of policy-making, measuring the ESG impact of activities is very important.
But bad ESG measurement systems are dangerous as they can make ESG performance worse.
ESG measurement systems must operate at the right level of granularity.
In order to manage something, you have to measure it. Otherwise it is all hearsay and opinion, and open to greenwashing. So ESG measurement is very important, and how we go about measuring ESG will determine whether or not climate risks get managed or modern slavery in supply chains gets reduced.
Humans are, by their nature, competitive and goal-oriented. Set us achievable goals, and we will achieve them. But it is the system which rules us rather than the other way around. How we measure ESG will drive how we improve our ESG performance.
Bad ESG measurement is dangerous because it will incentivise the wrong behaviour and penalise good behaviour.
Right-sizing ESG measurement
Here’s an example. Let’s take T-shirt production in Bangladesh – a relatively simple product, made at vast scale in Bangladesh, one of the largest exporters of staple garments in the world and a country with many natural challenges.
We know that Bangladesh has its issues – on worker safety following the Rana Plaza disaster in 2012 and on ecology and environment due to inconsistent enforcement of regulations.
Moreover, Bangladesh grows almost no cotton and has very little industrial infrastructure to manufacture man-made materials. This leaves open significant ESG risks for the T-shirt buyer, as most of the ESG footprint in Bangladeshi products sits in the deep tier supply chain where raw materials are produced. So that means, for example, the cotton fields of Uzbekistan or the Chinese industrial complex where polyesters and man-made fabrics are manufactured.
Are all Bangladeshi T-shirts the same?
Some of the greenest garment factories in the world are based in Bangladesh, and many brands now enforce significant controls over the sourcing of raw materials used in their products, also obtaining proof of source (of materials) at shipment to make sure.
And, of course, the opposite is true. Bangladesh also has factories with some of the worst labour conditions using materials from sources that have not undergone due diligence and where little respect is paid to the local environment.
So what do we think of a Bangladeshi T-shirt? Green or not green? Socially-acceptable or not? ESG okay or ESG terrible?
One-size-fits-all is wrong
The temptation to aggregate in order to measure ESG is there for everyone, especially in the financial world. Aggregation means grouping activities and products together in order to make it easier to understand and to measure.
We want simple and practical answers, and a system which is easy to understand and also to verify. Aggregation, for example, might seek to treat all T-shirts from Bangladesh the same - applying a weighting based on product (T-shirt) and source (Bangladesh).
But one T-shirt is not the same as another, even if made in next-door factories. Factory A could be socially-responsible with a cared-for local workforce sourcing organic and recycled raw materials from accredited sources, using green electricity and taking care over how production waste is managed. Factory B could use forced labour with no age restrictions and source its materal in the grey market with no regard for source whilst polluting a local river with effluent.
There are no short cuts – ESG measurement is a “micro-activity” which requires systems and processes that drill into the details. What is the product made of? What are the raw materials, where have they come from? Who are the workers and how are they treated? What are the factory conditions and how does it interact with its local environment?
And these issues apply universally, not just to T-shirts. There is no simple answer to ESG measurement – only detailed work to build proper measurement systems that correctly test, reward and penalise ESG attributes of specific economic activities at an appropriate level of granularity.
Bad ESG measurement is dangerous
Grouping activities and products together can end up rewarding bad behaviour and penalising good behaviour.
This happens, taking our example, if both the good factory and the bad factory get aggregrated and given the same ESG score. In this case, then factory B has no incentive to improve and factory A might well start to save money by taking short cuts on its standards.
What incentive is there is to improve if it is not recognised by the system? And it is not just about T-shirts. This point applies universally.
Painting with a broad brush can make ESG issues worse not better.
We must not fool ourselves here. We have to pay attention to ESG measurement systems. We need to right-size the measurement of ESG performance, especially in supply chains. This means paying attention to the details. In supply chains, this means typically working at individual product-level (or SKU) for "E" and at factory-level for "S" and for "G".
If we can't measure ESG accurately, it can be better not to measure it all.
Our company, ES3G, is a specialist in the measurement of "S" at workplace level. Our technology measures "S" scientifically and authentically in real-time encompassing all-the-workers, all-the-time in factories, farms, fields and mines. We work alongside specialist firms that measure "E", providing our results by API and so enabling non-credit rating agencies and commentators to create scientific ESG scores.