Making the Business Case for ESG

By Katherine Klein & Witold Henisz

Witold Henisz is a Wharton management professor, director of the Wharton Political Risk Lab, and founder of the Wharton ESG Analytics Lab. He’s also a subject-matter expert on one of the most pressing issues in business today, which is ESG. Many investors want to put their money into socially conscious companies that proffer environmental, social, and governance criteria, but actually measuring a company’s ESG impact is an imperfect science at best.

During a recent episode of the Dollars and Change podcast, Henisz sat down with Katherine Klein, vice dean for the Wharton Social Impact Initiative, to talk about the business case for ESG and why investors should deeply engage with firms to effect change. (Find more episodes here.) Listen to the podcast at the top of this page or read an edited transcript of the conversation below. 

Katherine Klein: One of the things that have been striking to me when I talk about ESG with friends is that their knowledge of the topic tends to be all or nothing. It’s either, “Yep, I know what ESG is. I got it. We can delve right in,” or, “Huh? What’s ESG?”

We want this conversation to reach everybody. So, what is ESG?

Witold Henisz: ESG is the collection of environmental, social, and governance factors that can materially affect a business. It’s a re-bundling of a set of risks and opportunities that have often been thought of as beyond business, or beyond the confines of what we think of in management, but increasingly are being seen as being part of it. On the environmental dimension, climate risk is the most prominent example. On the social dimension, we’re thinking about workers, customers, and communities. And in governance, we’re not only thinking about the board/management relationship, but also the relationship with political actors, the relationship with tax, and a set of other relationships with external stakeholders.

Klein: You just said these are the factors — environmental, social, and governance factors — that affect business. That’s interesting because I might have said, “These are the environmental, social, and governance factors that businesses affect.” Which way is it, and does that matter?

Henisz: Well, it’s certainly both, but the focus within the ESG conversation and measurement area is on how those factors will come back and impact shareholder value. The reason they have an impact on shareholder value is because firms are imposing costs on stakeholders. The climate risk or the pollution of a company is hurting communities, it’s hurting citizens, and they are taking action. The regulatory environment or where there are consumer buying patterns, that’s coming back and hitting shareholder value.

In each case, the firm is doing some harm or creating some benefit, and that in turn is coming back and hitting the company. The conversation around ESG is more about the latter, but it’s because of the former. So, they’re both right.

Klein: In the ESG space today, I think there’s sort of fundamental tension. On the one hand, there are investors saying, “Hey, I want to be investing in companies that are doing good things for the environment, for society, and that are in governance and governed well, full stop.” But, there are others saying, “I want to be investing in companies that are doing good things, or at least not doing bad things on these dimensions, because that’s going to lead to better financial performance.” Again, are we going to get to, “Yes, both”?

Henisz: I think it is “yes, both” — a typical academic answer. But I think it’s important to distinguish two groups of investors within the ESG space. For a long time, there has been talk about sustainable and responsible investing, or socially responsible investing. Those are more focused on the social consequences of firm behavior. Maybe that’s the first movement that you talked about in the last question. And there have been plenty of investors who, on moral grounds or values-based grounds, have said, “I don’t want to invest in companies that pollute. I don’t want to invest in fossil fuel companies. I don’t want to invest in weapons manufacturers. I don’t want to invest in companies that are engaged in gambling.”

Those investors are still there, and they are part of the broader ESG movement. But what distinguishes ESG from those other incarnations is that we’re really talking about the business case, that when you invest in a company that is involved in fossil fuels, that has not prepared itself for the climate transition, that’s a company that is going to underperform in terms of its share price. So, we’re bundling together the people who care about climate with the people who care about the bottom line. That makes for a winning coalition, and we can really affect change when we can make not just an ideological case but also an economic case around these factors.

Klein: ESG investing has gained considerable prominence. How big is ESG investing today?

Henisz: The headline number that you’ll see a lot is about $35 trillion of assets under management that claim to take into account ESG factors. What does that really mean? How much of that is really doing the hard work of understanding the business case around ESG? It’s a much, much smaller number. But it’s exciting that so many people care. I like the $35 trillion number, but I’ll acknowledge that it’s a pretty drastic overstatement of the amount of money that’s really doing sophisticated ESG analysis.

Klein: Got it, and $35 trillion represents about how much?

Henisz: About 30% to 35% of total global assets under management.

Klein: How do we measure ESG? I know you’re going to talk about how we measure it better, but how do we measure the ESG of different companies?

Henisz: I think your question highlights the difficulty. Unfortunately, the answer is going to depend a lot on who you ask, including which dataset you buy, and which rating agency you look to. I think historically a lot of the efforts on measuring ESG started with what the companies tell us. Let’s look at what the companies put in their sustainability reports, or let’s devise these really complicated questionnaires and send them to the companies and see what the companies send back. Then we’ll take all these different variables, sometimes hundreds of variables, and compile them into an index or a score. Then we’ll sell that to the investor.

Let’s think about that process. What do they tell us? They tell us the good news. What do they not tell us? The bad news. We’ve got all this data that’s biased towards smiling faces and green spaces. One of our new faculty recruits, Leandro Pongeluppe, has a paper that shows that over time, the percentage of pixels in sustainability reports that are the color green is increasing dramatically. We’re getting a lot of fluff and happy faces in these sustainability reports, but we’re getting less and less useful data. That’s the old way of measuring ESG.

People have recognized that’s a problem, so they’re trying to come up with better ways of measuring it, looking at what stakeholders say about a company. Do they say good things or bad things? Looking at government regulatory filings. Are they being sued? Are they being investigated? Looking at satellites and looking at the emissions coming out of the smokestacks of companies. Doing environmental monitoring. Scraping the web and looking at the wage distribution of the workers. There’s a whole host of new data providers that are trying to really get objective information on what companies are doing, but there’s still the question you hinted at: How much weight do you put on one versus another, and how sophisticated is that? And the further question is, when will those harms or benefits be realized by shareholders, not stakeholders? Everyone has a different answer. When you look at Microsoft, you might find one company put it in the 80th percentile, the next company put it in the 20th percentile. That’s a real problem that’s holding us back from progress in making the business case for ESG factors.

Klein: As I’ve read some of your work on ESG, what comes through to me is you are saying that there is a large gap between ESG practices today and the potential. Let’s talk more about that, and let’s start with some of the metrics and the research. Maybe it’s worth underscoring that measuring ESG is really hard. From a simple measurement standpoint, it’s a very multidimensional space. That means you can have a lot of noise as you try to aggregate this into a single score or even a few scores. The underlying data to base these ratings on is often unavailable or is going to differ wildly for different firms.

Nonetheless, there have been reports that investing in highly rated ESG companies or highly rated ESG funds is financially beneficial. Talk with us about that and what we should and shouldn’t take away from existing research.

Henisz: There is a large volume of academic research that purports to find a positive correlation between some measure of ESG or sustainability performance and stock price. There are a lot of problems with that research. If we could find that correlation, and if all the investors could find it, I think we’d solve a lot of problems like climate change and racial justice a lot faster than we’re able to. One issue is the difference between correlations and causation. Does ESG performance lead to financial performance or are highly performing firms strong on financial performance and ESG. Unfortunately, it’s a bit of both.

Another problem is that most of those studies use a dataset developed by a company called KLD that’s now provided for free from MSCI. It was one of the first efforts to measure if a company is good or bad, but it wasn’t designed to measure whether it was a business case. It was just a list of “goods” and “bads.” The first academic paper that looked at this dataset said, “Let’s subtract the bads from the goods and come up with a net score of companies,” without any attention to whether there was a business case on those goods or bads, or how to weigh the goods and bads. That dataset is very infrequently used in the investor community, but it is used in over 80% of the academic studies that purport to look at the financial returns to sustainability. Academics should just stop using it. It’s not helpful. And reviewers should stop demanding that academics use it. That’s part of the problem.

Klein: That’s so interesting, because I’ve read studies with KLD, and they look pretty good to me.

Henisz: It’s a very carefully designed dataset, and the founders of it deserve an enormous amount of credit for being the first out there. But it was designed to speak to values-based investors who wanted to know about goods and bads and wanted to assess a company. Do they do gambling? Do they do landmines? Do they do fossil fuels? It does what it says it does. But that’s not what ESG investing is about, and that’s not what we should be looking for if we’re looking for the business case. So, I want to couch my criticism. The data is actually quite good at what it was meant to do, but that’s not what we should be measuring today.

I think the challenge is we don’t have good enough data. And I think there really is an opportunity in the ESG space, like there was when we started investing in emerging markets, to have a sustained period that outperforms the market because we’re starting to understand these relationships. We’re starting to see these opportunities, the same way we started to see the opportunities of emerging markets in the ’80s and ’90s.

Klein:  Let’s talk about what better research is more appropriate for exploring the business case, and what you believe that research has shown or will show as the field advances.

Henisz: I think this takes us back to strong fundamental analysis that people who really know an industry and really know a firm can start augmenting their models with. Are they prepared for the climate transition? Are they addressing concerns around racial justice or immigrant justice? Are they building strong relationships with the community or generating hostility with the community? Do customers feel connected to the firm, or do customers feel transactional around the firm? To the extent that they can build that type of insight into their models, they can foresee risks and opportunities that are coming down the pike, they can adjust their portfolios, they can adjust their weights appropriately, and I think they have the potential to earn higher returns. But that takes deep fundamental analysis. It’s costly. It’s time-consuming. It’s going to lead to higher fees, so they have to not only outperform the market, they have to outperform the market enough to compensate them for the fees involved. And that’s a higher hurdle that they’re still struggling to meet.

Klein: Do you clearly believe this research is important? Is it likely to show these kinds of long-term financial performance? I think in part what you’re describing is, “We need to be pretty thoughtful about the mediating processes. What is it about a way a corporation is engaging on climate issues or racial justice issues that is going to affect its financial performance?”

Henisz: Right, and it doesn’t have to be as complicated. I think there are some really powerful examples that convey the logic. Can you do it at scale? Can you do it across a thousand firms? That’s harder. But let’s take a really simple case that’s gotten a lot of press over the last year-and-a-half: climate risk and the energy transition. There are oil and gas companies that are looking ahead to a period where we’re moving away from fossil fuels, and they’re investing in a different portfolio of renewables. There are other oil and gas firms that are making bets that oil and gas are going to stay the dominant energy source for the next 25, 30, 50 years, that we’re going to have a 3-, 4-, maybe 5-degree global warming scenario. Those assumptions drive investments today, and the firms that are adapting are being better prepared for the climate transition and will earn higher returns on their invested capital. The firms that are investing in fossil fuels, I would suggest, are going to have a lot of stranded assets. They’re going to be writing off a lot of the investments they make today because people won’t want that oil and gas at the price it can generate in 10 or 20 years.

ExxonMobil, Chevron, some other firms have been the laggards, and people have called them out. And people have done the financial analysis to show that you can’t justify the spend they’re making on certain oil and gas reserves if we assume we’re going to get to a 2-degree scenario or even a 3-degree scenario. It just won’t pay back. It’s not rocket science. You can work through the numbers, and they have underperformed for some time period because of these decisions. Calling that out highlights that there’s a difference between the laggards in that industry and the leaders, and people should be investing accordingly.

Klein: I’m curious about what you think on the links between the business case and diversity, equity, and inclusion, or around living wages and decent jobs. Could you talk about that?

Henisz: I think living wage is a little more straightforward — it’s turnover. When people aren’t meeting a living wage, they’re going to leave a job for the next best alternative as fast as it comes. They’re going to view that job very transactionally. “I’m not able to feed my family. The second I can get another job that allows me to do that, I don’t care about anything else. I’m tired of cobbling together two, three, four, jobs, federal assistance, so I’m out as soon as I can get to that level.”

That turnover is a cost to the firm because they have to find new workers. They have to search for them. They have to intake them. They have to train them. They’re going to be lower productivity initially. And then they’re going to do that again six or nine months later. With a higher living wage, you reduce turnover. You increase employee loyalty. You increase productivity. And it can pay to do that.

That doesn’t mean raising everyone’s wage in every circumstance is going to pay for itself, but there are cases where it will. It always helps in the short term to cut wages, but it doesn’t necessarily help in the long term. Turnover is a clear mechanism, and to the extent that we can measure turnover, we can form that link.

With diversity, equity, and inclusion, I think the research suggests there’s going to be more creative problem-solving, more inclusion of employees who feel that they’re part of the company because they’re recognized and their identity is valued. And probably more ability to reach out to a diverse set of customers, a diverse set of stakeholders, with more support from diverse communities, better decision-making in the company, being ahead of the curve as we start addressing some of the long-standing racial biases in our country. But it’s a little harder to say, “What would I measure? What data point would I want?” I think turnover for living wage is a much simpler measurement problem. But I think the business case is there in both.

Klein:  I’d like to turn to some of the practical implications of what you’re saying, and I want to focus first on investors. Suppose an individual who’s not an investment professional comes to you and says, “This sounds great. I want to make sure that my investments are in ESG funds. You’ve mentioned that it can be kind of challenging. How do I do this well?” What’s the challenge here?

Henisz: It is a challenge because of the data problems. And just because someone has an ESG label on their fund or says they’re taking these things into account doesn’t mean they really are, and it doesn’t mean you should expect either impact financially or on climate or racial justice. There’s a lot of what’s called greenwashing out there — a lot of funds claiming that they’re addressing ESG issues, but they’re just dropping one or two fossil fuel companies or one or two arms makers out of their portfolio and saying, “Oh, look, it’s an ESG fund.”

One way to do it is to really look at the fund, look at what they’re investing in. Look at what’s called the tracking error. How much does it differ from the benchmark index? And then really try to understand what’s driving them. How are they choosing firms? That does require a lot of due diligence. That does require you to be a pretty sophisticated investor, to make sense of the way the asset managers are choosing companies.

Another way to go is to say, “You know what? Maybe the data is not there yet. Maybe I’m not ready to make this step. But at least I’d like to invest in someone who’s engaging with companies on ESG issues and voting in shareholder resolutions and proxy votes. I don’t want to shift my portfolio. I just want the S&P 500 or some big benchmark index, but I want to be with a fund that engages.”

There are funds out there like that, that have very low fees, that match the market. You’re guaranteed the returns of the S&P 500, but they’ll vote on ESG issues, which will propel all the firms to improve their ESG performance and hopefully their financial performance. The sponsor of one such ETF (exchange-traded fund) is a company called Engine No. 1, and I should disclose that I’m an advisor to them.

Klein: Let’s talk about the power of the vote, the power of more activist strategy. Say a little bit more about what that potential is, again, for people who may not be as sophisticated about what this means in practice.

Henisz: I think this is a really important conversation that we need to have more of. There’s so much anger right now around fossil fuels or other issues, and people are saying, “Let’s divest. Let’s get our pension funds, our endowments to divest. That sounds like I’m doing something. I’m divesting from fossil fuels.” Imagine we were looking at the 2022 or 2020 election, and I say, “I’m so angry about politics, I’m not going to vote. I’m just going to stay home.” A lot of people did that, but did that make things better? Did disengaging make things better?

If we call it “disengagement” instead of “divestment,” it paints a very different picture. By divesting, you’re giving up the power of the vote. You’re giving up any voice over the future of the company, so we should be much more active in our ownership. If we care about ESG issues, we should own these companies, and we should encourage the management to change their practices. That’s what an active owner does.

Study after study finds that engagement works, and divestment doesn’t work. The problem is engagement is expensive, and people are running away from high-fee funds. But if you really care about ESG issues, you should be focused on those asset managers who are engaging and voting on these issues, and giving your money to them for investment. That’s the best direction for change. Divestment doesn’t work.

Klein: For those folks who are saying, “We need to do better within our firm,” what should they be doing?

Henisz: As you do your analysis, as you look at the companies in your portfolio — whatever process you use, whether it’s value-based, whether it’s event-driven — think about how environmental, social, and governance factors affect the performance indicators, affect the variables you’re looking at. There’s likely a connection. That’s the idea. Yes, “G” (governance) factors are material. They affect the business case. How does that work for your strategy? You need to do that yourself. Don’t just expect the ESG analysts to pull some numbers out of a shelf and put them alongside you and make a decision.

There are too many companies that say, “These are the preferred stocks. Here are the expected returns.” And then, “Here’s a set of emojis, or a set of green light, yellow light, red light ESG factors. Now put them together.” How do you do that? How do you put spreadsheets together with emojis? It doesn’t work. You need to try to find a way to bring them together, and it’s got to be the investment analysts. I’d encourage them all to think about that themselves, and if they want help, look for continuing education courses that retrain existing investment analysts on what’s called ESG integration.

We just launched one here at Wharton through the Coursera platform. There are other programs at Columbia, at NYU, and the UNPRI has them. There’s a set of online learning opportunities to figure out how to connect the dots. Those tools will be incredibly valuable, and I suggest they’d be a positive net present value investment for many career tracks whether in financial, consulting, or corporate careers.