Nobel Laureate Milton Friedman, in his famous essay titled The Social Responsibility of Business is to Increase its Profits which was published in the New York Times magazine in 1970, famously wrote, “There is one and only one social responsibility of business--to use its resources and engage in activities designed to increase its profits ...”
Compare this with the Statement on the Purpose of a Corporation adopted by 181 CEOs of America’s largest companies in 2019. The statement declared, “… companies should deliver long-term value to all of their stakeholders—customers, employees, suppliers, the communities in which they operate, and shareholders.”
After the Covid-19 pandemic, calls for “stakeholder capitalism” further picked up the pace. Gone are the days when economic profits alone determined a firm’s success. The for-profit entities are being held responsible not only for the bottom line but also for the activities through which they create shareholder value and the value they create for other stakeholders. As a result, it is no longer surprising to see them getting mired in controversies or even attacked by their shareholders over broad-ranging social issues. This has led shareholders and the wider investor community to take stock of businesses beyond traditional metrics.
Measure Accurately and Improve
The method to measure economic profits has been established and standardised for long. However, measuring stakeholders’ value creation is still in its infancy. And, what cannot be measured cannot be improved, managed or controlled. Therefore, combined with changing social dynamics and the issue’s salience, many rating agencies and data providers started providing ESG ratings for companies.
At the most basic level, ESG ratings aid investors in comprehensively evaluating a firm by analysing it across its three major dimensions: environmental, social and governance actions and impact. While ESG, in spirit, is a step in the right direction, it has been wrestling to drive a commensurate impact worldwide. There are significant roadblocks impairing its overall uptake and effectiveness: the lack of standardised disclosures by corporates and inconsistent measurement criteria employed by the ESG rating providers (ERPs).
Disclosure: The First Roadblock
Our research at the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business, suggests that less than four per cent of the total publicly listed Indian firms have been assigned ESG ratings between 2014 and 2021. We arrived at this figure by consolidating three different ERPs, i.e., WRDS Sustainalytics, Thomson Reuters and CRISIL. The reason for the low coverage of companies by ERPs is that ERPs rely on publicly available data to make assessments. However, most companies—especially the medium and small-sized ones—do not track their ESG activities, let alone disclose them publicly. Even companies that make complete disclosures do not follow any standard procedure, making their interpretation subjective and comparisons across companies challenging.
Measurement: The Second Roadblock
While comparisons across companies are difficult due to a lack of standardised disclosures, how information for the same company is compiled, measured and converted into an aggregate score differs quite a bit from ERP to ERP. A study conducted by researchers from MIT, published in the Review of Finance, reported steep inconsistencies in the ESG ratings assigned to a business by different agencies (Berg, Koelbel, & Rigobon, 2022). In many cases, firms are assigned highly inconsistent ratings by different ERPs owing to differences in methodology, scope or weights (importance) assigned to attributes. The divergent estimates about the same underlying entity add to the confusion and defeat the very purpose of these ratings.
Sample: Another Concern
The number of firms assigned an ESG rating in India (by the three ERPs cumulatively) is a minuscule per cent of all listed firms (four per cent). Further, because we cannot compare the ratings across ERPs, research must be done using the data from just one ERP, reducing the number of companies that can be studied even further. Additionally, the number of years of data available for each ERP varies. In such a scenario, the reliability and generalisation of research become questionable.
ESG ratings and their effectiveness are subject to substantial political debate in the West. The opposition has openly attacked ESG for its overly ambitious vision but deeply flawed implementation. Some critics have even questioned the morality of ESG by calling it a fabricated tool to legitimise greenwashing. However, in our opinion, although ESG is undoubtedly far from perfect, it remains one of the most potent ways to reimagine businesses in a society fraught with grand challenges.
In line with the old saying “do not throw the baby out with the bathwater,” we expect that in the Indian context, SEBI’s mandate for BSE Top 1000 companies to report their ESG activities as part of the Business Responsibility and Sustainability Reporting (BRSR) shall alleviate some of these concerns. However, it is time companies understood the spirit of ESG, and even those companies that do not fall under the purview of BRSR voluntarily disclosed the steps taken toward a more sustainable future. Let us actively work towards addressing the pitfalls, bringing more standardisation to disclosures and objectivity to measurement.
The authors are from the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business, India. Views are personal.