Inconvenient truths of the ESG movement

By Peter S. Kim

Over the past few years, the environment, social, and governance (ESG) movement has morphed into a global phenomenon as governments, corporations, and investors rush to embrace its implementation. In an era where the public backlash against large corporations is at an all-time high, the need to rein in corporate profits generated at society's expense is hard to argue for all stakeholders.

However, inflationary pressures and the threat of recession challenge the trend just when it is seeing some meaningful global momentum. The rising skepticism threatens the long-term future of the movement and future generations.

ESG is a polarizing concept as it has a differing economic impact on countries, industries, and companies. For example, ESG implementation could be punishing for emerging economies relative to advanced peers. Just like the WTO had to make exceptions for emerging nations, ESG will find differing stances from countries whose environmental priorities pale compared to the need for economic growth. Therefore, the politicization of ESG will be unavoidable as we begin to account for the financial cost of ESG implementation among nations.

We are at the first and easiest stage of ESG initiation as companies are asked to show responsibility to shareholders, their employees, and an increasingly discerning public. As a starter, companies are to implement ESG principles and policies and provide information and reports on related performance in a more consistent and standardized format. The reporting and communication measures are easy, as they are relatively inexpensive to implement via existing investor relations (IR) activities.

The second stage is to move beyond IR duties to integrate ESG principles into financial management. There are a couple of tools for companies to use in their favor. First, the enhanced transparency made possible by data technology helps gather and process information. Artificial intelligence (AI) and big data tech are making it quicker and cheaper to construct evaluations that would have been too expensive and time-consuming before. AI allows the efficient interpretation of non-traditional financial information, which would have taken thousands of manual hours.

Institutional investors traditionally bore the primary responsibility of ESG criteria via a loose implementation framework. There is rising evidence that many funds are taking advantage of the process of using ESG as a marketing tool. We are seeing financial institutions being investigated for using ESG for their commercial gains. It is commonly accepted within the financial industry that ESG is now a critical part of attracting customers, making it an essential part of the asset management industry.

For example, a critical mass of pension funds and insurers have started to award funding only to asset managers with ESG capabilities. Investors are encouraged to explicitly request and reward research that includes ESG aspects and to identify systemic points systems for well-managed companies. Unfortunately for profit-focused investors, the idea that funds that integrate ESG factors can improve investment returns is a question yet to be proven conclusively.

The third and most challenging stage awaits the ESG movement: financial sacrifices by corporations. While the first two stages are not taxing on corporate profits, the third stage will require a trade-off between ESG implementation and corporate profits. There is rising criticism over "greenwashing" by companies, a term used to describe claims of being environmentally friendly as a means to achieve profits. For Korean manufacturers, the road to zero carbon will require a lot more than a strategic shift.

Europe's ESG movement has more than a decade's head start on the U.S. The European ESG standard is led by the Sustainable Finance Disclosure Regulation (SFDR), a central regulation requiring financial service providers and issuers of financial products to assess and make public disclosures of ESG considerations. Encouragingly, the U.S. regulatory body, the Securities and Exchange Commission, recently introduced reporting requirements similar to the one from the European Union.

The SEC proposed a common ESG disclosure framework for funds. The proposal suggests that at least 80 percent of the funds park their money in ESG-qualified investments. Also, the funds must disclose their portfolio's carbon footprint and weighted carbon intensity. It is the most detailed framework given out so far in the U.S., with specific guidelines for greenhouse gas calculations.

Until recently, the world has been unquestioning in its support for ESG. The ESG implementation has gone through the easiest and least costly phase of its evolution, as the public declares support without an actual implementation roadmap or a timeline. However, as we move from declaration to implementation, companies, investors and even governments will have to reveal their level of commitment through economic sacrifices. With the rising interest rates and possible global recession, the task has become exorbitantly difficult in the past 12 months. As we approach the New Year, the year 2023 could be remembered for the ESG movement hitting a crossroads for its future. For the sake of our future generations, let us hope that it is just a speedbump and not the beginning of the end of ESG.

Peter S. Kim (peter.kim@kbfg.com) is a managing director at KB Financial Group.