ESG is booming, but the industry risks becoming complacent. Fund managers are creating new products that meet markets’ needs more than those of society and the thin ‘layer’ of ESG in core investment processes is not contributing to the much-needed transformation of our economies and societies. 

The financial sector could be a powerful driver for sustainability and resilience. But to enable that, boards of pension funds, fund managers and consultants need to get out of their comfort zones. In this article, we propose five initial steps that boards can take to kick-start this process. 

Raj Thamotheram

Raj Thamotheram

Please note we say boards. If you think this can be delegated, we suggest you think again.

Our starting point is that the ESG industry has a reputation problem brewing. In the last weeks, the media has reported that:

• Members of the Principles of Responsible Investment (PRI) are as likely to vote against sustainability resolutions at corporate AGMs as are non-members.

• Climate Action 100+’s first impact report highlights that companies in high impact sectors are failing to respond to the climate crisis on the really critical criteria, for instance, re-allocating capital).

• 2021’s flagship PwC Annual Global CEO Survey shows that 60% of CEOs of listed companies have not factored climate change into their risk management activities. 

• Formal complaints have been lodged with the Climate Bonds Initiative and the Science Based Targets Initiative (the latter by an original instigator).

BlackRock’s former head of sustainable investing has made a high-profile claim that ESG is both too incremental and a distraction from what is really needed (government action).

• PRI has proposed a mild course correction to focus on impact and NBIM, a founder member, has strongly objected.

• Faced with fossil fuel lobbying on the EU’s proposed sustainability standards, including labelling methane as green, many fund managers have remained quiet and some even supported this watering down.

• Danone’s investors voted in 2019 to enshrine its social mission and then in 2021 sided with shareholder value activists to oust its CEO.

The good news? Boards that can see the ESG industry is not in a healthy state can do things to position their firms for the future.

The first thing boards need to do is think about the fundamental changes that are needed to make sustainability stick. 

Is there value in delivering a pension fund in a world which your scheme members or clients really would not want to retire into? How much ‘extra’ do you need to deliver to compensate for the impact of systemic crises? Do you want investee companies to maximise returns to shareholders or do you want them to focus on long-term value creation and if the latter, what slack are you willing to cut them with what conditions? How do you assess the scientific community’s warnings that we are crossing sustainability ‘tipping points’? A board should calibrate its real-world investment beliefs and make sure all board members own this, revising these beliefs as new data demands but not holding up action because of the lack of proof. 

Wouter Scheepens

Wouter Scheepens

Second, we propose that the position of head of ESG (widely considered to be about integrating new data) be replaced by a group head of sustainability who should be a full member of the senior management team. This role should be given to a ‘positive maverick’ who knows the organisation well and is on the way up. CEOs should alert the firm that this person has been appointed to challenge critical strategic matters and in return, CEOs should provide credible guarantees of ‘air cover’. 

This sustainability head will need a budget to employ specialists with the experience to challenge the front-office staff and ensure culture change by the key departments, like marketing, human resources or risk management. But the key should be to catalyse culture change, not create a new division to ‘do’ sustainability. This person specification is different from that of the ESG domain experts who had responsibilities which were impossible.

Third, agendas for board meetings should be turned upside down. Boards typically spend a lot of time on ‘hygiene factors’, for example (quarterly) figures, compliance and media coverage. All this is important, but the consequence often is that the big strategic discussions (about sustainability and innovation) are marginalised or postponed for the annual retreat. 

Starting with the issues that are normally dealt with after the (backward focused) essentials is a good way to put the important ahead of the urgent. Starting with sustainability, innovation and culture (change) will result in a more strategic, long-term focus for the meetings. Of course, the hygiene factors have to be taken care of as well, but this can be done adequately in the remaining time.

Part of the way forward is for boards to grapple with what creating long-term value means in a world where mounting systemic crises – including autocracy, biodiversity and inequality – threaten established business models. So, fourth, we propose the CEO and chair invite qualified experts to rattle the board’s intellectual cage. On any given issue, chances are a third of board members will be advocates for change, a third will disagree (‘business as usual’ supporters) and a third will be unsure (fence sitters). 

The chair’s role should be to hold the discussion until a productive outcome is reached. For a sustainability oriented company, the bias should be towards finding common ground between the advocates and the fence sitters, while taking into account the concerns of their ‘business as usual’ colleagues, who will provide a reality check and protect against first-mover disadvantage. Mobilising employees and taking along enough of the investors will be critical. 

Finally, given that boards are not sitting around idly today, the only way they can take on new activities is if they reduce the time on hygiene factors, by looking over the shoulder of the CEO. To do this safely, they need to ensure oversight is being done. A good way to do this – arguably at least as effective as is happening today – is for boards to empower staff to hold executives accountable. The two tools that achieve this better than anything else are an ombudsman and a whistleblower system. Both are needed because they perform different roles.

Investors, in particular, and the financial sector, in general, can either be a driver for change towards sustainability or an anchor ensuring business as usual by corporations. Businesses cannot be successful in a society that fails and the same is true for the financial sector. Moreover, externalities (such as carbon emissions, waste, social costs) will increasingly be internalised. 

Either due to legislation, expanded scopes of regulators (for example, central banks embracing sustainability), legal risk or reputation management in response to non-governmental organisations actions or media exposes. Talent will move quickly to organisations that have an authentic purpose and contribute positively to society. Investors will not be immune to these drivers. Put simply, the ESG myth has a near-term sell-by date. Responsible boards should embrace the agenda of the future to create value in a volatile world.

Raj Thamotheram is a fellow of the Nordic Institute for Financial, Technology and Sustainability and Wouter Scheepens is founding partner of Steward Redqueen, a sustainability consultancy