Defining Sustainability, ESG and CSR

Photo: Inese Dosē, Geneva airport

What is “sustainability”

“Sustainability” is one of today’s most over-used words, turning it into a buzzword with blurry meaning. Its multi-dimensional nature does not help either. Let’s make its concept come to light through actual examples.

You have the saying - "there’s plenty of fish in the sea". Its meaning has little to do with fish nowadays. The phrase originated many centuries ago. Waters were then brimming with endless amount of fish. The notion of exhausting the fish supply was unimaginable. Yet, exploding demographics and ill-targeted fishery subsidies pushed fish demand worldwide. Matching supply became possible with ever growing fishing fleets and increasingly productive gear, exacerbated by illegal fishing and bycatch (disposal of lethally injured non-target species, sometimes larger than the catch, sharks for instance). The result? The sobering reality of 90% of worldwide marine fish stocks being already exploited and in some cased depleted. The impact? As fish accounts for 15% of animal protein consumed worldwide yearly, food security, human health and general well-being are affected. Economic situation and the livelihood of the 820 million humans relying on fishing and aquaculture are compromised. Marine ecosystems are destabilised as removing important species from an ecosystem could lead to unexpected shifts in populations (the famous food chain).

Let’s take our trawler to the Easter Island in the South Pacific, between Chile and Polynesia. It is famous for the thousand enigmatic monumental head statues, moai, that dot its barren landscape. The island was covered with palm trees before the 17th century, yet it is treeless today. Besotted with their moai, the islanders became obsessed with the quest to build and mount them, cutting off all the palm trees to transport them around the island. When Europeans discovered the island on Easter in 1722, not a single tree was left. The effect? The ecosystem was substantially compromised. The islanders lacked the important resource to roll the statues, had no firewood, could not build canoes for fishing, and birds could not roost. The closest coastal areas were quickly overfished, birds disappeared, the soil became unfit for growing food. Lack of food supplies triggered wars, cannibalism, and exodus from the island. In his bestseller, "Collapse: How Societies Choose to Fail or Succeed," US geographer Jared Diamond writes:

Without trees, the soil was not protected against erosion. They couldn't go out to sea to harpoon tuna, so Easter Island society collapsed.

Uncontrolled consumption of resources hits economies, alters lives, and can lead to extinction. Resources that seem endless are NOT. In 1987, the United Nations Brundtland Commission formulated a definition for sustainability as “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”

This suggests the necessity for optimisation and maximisation of the output from utilised resources and assets. It implies the review and transformation of business models and processes to become more efficient, minimise wasted time and energy, decrease reliance on external resources whenever possible, and cut waste and pollution.

For instance, energy-wise, sustainable manufacturing is about reducing energy use, waste, and water consumption. Business-model-wise: using less polluting or biodegradable materials, whilst maintaining the desired performance. Business-processes-wise: efficient manufacturing processes requiring less energy-intensive machinery and production methods that generate less waste.

The good news associated with this transformation is that it is driven by efficiency and self-sufficiency, which, in the long-term, saves costs on resources. It lowers operational costs. Clients, publicly committed to cutting negative environmental impact in the supply chain, will favour you. Investors are keener on green investments, driving capital to you. Sustainability-based transformation is not a fad. It has the potential to boost your profits.

The less good news is that each step of this transformation requires investments, investments in money, in resources, and in people, the oft forgotten element of the triad. Successful transformation is initiated by top management but is implemented by middle management. You need to align your workforce around your sustainability targets. That is the opposite of greenwashing where CEOs jet to Davos, make a few Greta-friendly statements on CNN, and return home leaving their company unchanged. A sustainability drive is sustainable only to the extent that your organisation shares the target. This is a reason why Sustainability is often associated with Governance.

In light of its impact and the complexity of transition, the sustainability agenda is often skewed towards the environmental aspect. Yet, there are other dimensions. In 1994, author and global authority on corporate responsibility and sustainable development John Elkington coined a term: the “triple bottom line” (“TBL” or “3BL”) - an accounting framework to measure social, environmental, and financial results as bottom lines. The term "People, Planet, Profit" also coined by Elkington is often used to describe the TBL, which are considered the three pillars of sustainability. 3Ps appeared for the first time in Shell's initial sustainability report in 1997. Elkington expands the definition of sustainability more concretely:

Sustainability is the principle of ensuring that our actions today do not limit the range of economic, social and environmental options open to future generations.

In his book “Cannibals with Forks: Triple Bottom Line of 21st Century”, Elkington envisaged that in the coming decades not only government entities, but also global financial markets will insist on companies delivering against the triple bottom line. Today we see this vision becoming a reality with regulators legally enforcing sustainability reporting. Commercial banks and asset managers are monitored and scrutinised in turn by their stakeholders and regulators to report. It creates a domino effect that drives transparency and delivery against all dimensions of sustainability demanded by various sets of stakeholders – regulators, financial institutions, clients, and society. Stakeholder capitalism is a reality.

What is ESG

The acronym ESG was coined in 2005 by United Nations Environment Programme Initiative, in the landmark Freshfields Report that argued:

Integrating ESG considerations into an investment analysis so as to more reliably predict financial performance.

Paul Clements-Hunts, the report lead writer, initially proposed the acronym GES, since Governance is the most important pillar, followed by Environmental and Social. But branding is important. ESG was selected as it sounded “catchier”.

Environmental, Social, and Governance are the three pillars in the framework. Companies are expected to measure and report on those three dimensions. The framework’s main goal is to capture all the non-financial risks and opportunities inherent to business’ operations and demonstrate the progress towards environmental and social goals in addition to highlighting shareholder value.

In April 2021, the European Commission approved the Sustainable Finance Package, shaping the reporting, which meant that nearly 50,000 EU companies in the EU would have to report on the defined scope. In addition, a growing number of investors are incorporating ESG criteria into their investment decision-making. Following the framework becomes important to secure capital, both debt and equity. Clients are increasingly navigating by ESG scoring when selecting their suppliers – companies’ commitments extend to their entire supply chains. This is a corporate ecosystem revolution.

What exactly falls under these pillars? The Environmental is the most complex to report. It requires the business to report data on emitted greenhouse gases, water and ground pollution emission, information on sources of the materials, whether virgin or recycled materials are used in production processes and how the business ensures that, from cradle to grave, the resources are used in the most optimised manner. Businesses need to demonstrate their intentions on stewardship of the resources. Under the Social pillar, businesses must report how they manage and develop their workforce, and on product liabilities as to their safety and quality. The reporting applies to the company’s own operation but also to its supply chain. Under the Governance pillar, businesses elaborate on shareholders rights, board diversity, top executive compensation how their KPIs are aligned to sustainability performance, anti-competitive practices, and corruption.

What are an ESG score and the ESG rating agencies? In financial markets, a credit score indicates the (perceived) ability to repay the debt. A bond rating communicates the ability to meet the financial commitments and to avoid default. Equally, an ESG risk score is designed to communicate the performance on ESG issues and related risks. It is calculated against defined metrics and is expressed on a number scale or letter ranking. Scope and methodologies significantly vary among rating agencies. Most agencies assess risk and performance on the basis of publicly available data (CSR and sustainability reports). The most popular rating providers are MSCI ESG Ratings, Sustainalytics’ ESG Risk Ratings, Bloomberg ESG Disclosures Scores, FTSE Russell’s ESG Ratings, ISS Ratings and Rankings, S&P Global ESG Score, Moody’s ESG Solutions Group, and CDP Climate, Water and Forest Scores.

The difference between sustainability and ESG

In my conversations across various levels of businesses, I have been often asked about the difference between sustainability and ESG, since they stand for very similar goals.

A business is deemed “sustainable” when their operation, business model, and processes, are designed to have a lower negative impact on society and environment whilst creating value for shareholders. “ESG” is deemed addressed when the company has implemented initiatives and frameworks to meet specific and quantified goals in reducing environmental and social impact, as well as improving governance. In essence, ESG is a quantifiable evaluation of a company’s sustainability ambitions and performance.

What is CSR

Twenty years ago, in 2003, when filming a television documentary on labour conditions in the chocolate industry, a Dutch journalist, Teun van de Keuken, was shocked to discover that most of the cocoa available in the global market was harvested using child labour. This apparently was common knowledge within the industry. The most shocking aspect was to realise how alarmingly common were illegal child labour and modern slavery on cocoa farms in West Africa, where most of the cocoa originates from. Teun wanted to draw attention to it through a genius idea – he turned himself to the police as an accomplice to a felony, having consumed contraband by eating a couple of chocolate bars, produced with illegal child labour! The protest did not create the desired effect drawing mass attention, whilst Dutch law enforcement got into a pickle of figuring out how to handle the unprecedented case. Teun, a.k.a. Tony, decided to take another approach and start a company Tony's Chocolonely assuming full control and transparency across the entire supply chain, personally ensuring no child labour nor slavery were involved. In West Africa he signed deals with local farmers to purchase their cocoa directly. The concept of the world’s first guaranteed slavery- and child labour-free chocolate did get a lot of attention - the first batch of 5000 chocolate bars was sold out within a day. A few years later, in 2009 the company hit €1M turnover, in 2022 – €100M (no longer a small family business), with a 21% market share in the Netherlands and expanding in the USA, Germany, Belgium, and Scandinavia. These chocolate bars are not cheap, as they include the cost for eradicating slavery. High and growing market share proves that clients vote with their wallets for chocolate without slave and child labour, even if it means paying a premium, a decency premium in some ways. Similarly, companies and private persons pay a “green premium” for clean energy. I will introduce this concept in one of my following articles.

This example draws attention to the necessity of moving away from business models based on achieving the lowest prices and squeezing operational expenses at any cost, even if it implies slavery and irreversible environmental damage. Fast fashion is a good example. Have you have seen €1 bikinis? How do they achieve it? Through mass production and cheap materials of course, but also dirt-cheap labour. And through unspoken costs of water and air pollution, horrific working conditions, akin to slavery, in Bangladesh and surrounding countries, and waste mountains in Africa. This is why looking at a company’s ecosystem and its full value-chain is so important to understand its social and environmental responsibilities. Delegating slavery to supplies is still encouraging slavery. It also applies to you as a client. Should you condone slavery chocolate bars and bikinis?

How is CSR defined? Corporate social responsibility (CSR) is a self-regulating operating model helping businesses in being socially accountable to themselves and their stakeholders in society, economic, social, and environmental aspects. It calls for operations to enhance society and the environment instead of negatively impacting them.

It is a management concept where businesses integrate social and environmental concerns into their operations and their collaboration with suppliers to achieve the balance against the 3Ps whilst addressing shareholders expectations. Profits still matter.

Let’s draw a distinction between CSR as a strategic business concept, and charity, sponsorships, and philanthropy. While the latter can significantly contribute to closing the gaps in poverty and inequality and enhance the reputation, CSR goes beyond that. It embeds the concept into a company’s strategy, business model, and daily operations, as an integral part of corporate governance.

Comparing Sustainability, ESG, and CSR

These three concepts overlap in content and share common goals as to moving towards increased consciousness across the supply chain. The below table compares all three.

Criticism of Sustainability, ESG, and CSR

The strongest criticism of Sustainability and CSR gravitates around the potential manipulation of public opinion (greenwashing). Another popular criticism is the belief that environmental and societal concerns are unrelated to the primary objective of the business, defined as making profit for the shareholders. This is often summed up as the battle between stakeholder capitalism and shareholder capitalism, promoted by Milton Friedman. For the proponents of shareholder capitalism, these concepts are seen as a hurdle to market freedom. They advocate that a company should let its suppliers operate as they see fit in the name of market freedom. The supporters of stakeholder capitalism and CSR, in particular, view the absence of a strict framework applied to companies and their supplier base as a negative.

ESG has attracted more criticism. The biggest criticism revolves around the absence of standardised criteria to assess whether a company or an investment are deemed sustainable. Namely, the same company will receive very contrasting results from different rating agencies. In comparison, financial ratings provided by Standard and Poor’s, Moody’s, and Fitch Ratings tend to converge for a given company.

Profit matters. Empirical data argues that companies that focus on profit outperform companies that do not (a healthy reminder that the C-suite focuses on the goals given to it). The New York Times in its article “Misguided “Guide” to ESG” (March 13, 2023) concludes:

It’s hard enough to generate profits and returns when that is your focus, let alone when you’re trying to change the world.

Harvard Business Review, the true bible for management practices, in their article “An Inconvenient Truth About ESG Investing” (March 31, 2022) analysed the performance of numerous ESG funds and concluded:

Funds investing in companies that publicly embrace ESG sacrifice financial returns without gaining much, if anything, in terms of actually furthering ESG interests.

This criticism of ESG is becoming a popular opinion, since not aiming for an investment’s best potential performance essentially is a breach of fiduciary duty. A counter-narrative gravitates around the longer investment horizon, long-termism, which in essence is at the core of the sustainability philosophy. It calls to overlook the short-term losses for the benefit of long-term gains. It creates a dichotomy between the two horizons. But as some wise people have remarked, “for the long-term to exist, you need to survive the short-term”. The focus on the long-term might just be an expedient cover for poor business performance.

Summary and Conclusion

Sustainability is the sum of actions required to meet the needs of the present without limiting the economic, social and environmental options of future generations. It means focusing on optimising and maximising the output from utilised resources and assets, reducing waste in resources and time, and cutting pollution. When deployed smartly, it fosters efficiency.

ESG is the three pillars that companies must measure and report in. ESG aims to capture non-financial risks and opportunities and show the progress in 3Ps, while creating shareholder value. The difference between sustainability and ESG is that the latter is a quantified evaluation of a company’s sustainability ambitions and performance.

CSR is a self-regulating operating model helping businesses in being accountable to itself and its stakeholders, while delivering shareholder value. Going beyond charity, sponsorships, or philanthropy, CSR is a part of governance, business model, and operations. It is different from sustainability and ESG, by being self-regulated and achieved via culture and values.

The criticisms of the three concepts show the gaps. They point to the fact that neither are an investment panacea. They need to be improved and stabilised to provide the investment world for the answers they are looking for. But, when implemented correctly, these frameworks hold enormous value because, at their core, lies the ideas of efficient use of resources and assets, and maximisation from all your resources, processes, and assets. It can be seen as a continuation of a business most important performance indicator, ROA, Return On Assets.

Ambitious goals across all 3Ps and the design of an implementation roadmap towards achieving them, imply a rigorous evaluation of the business case of each investment and processes. When done right, it appeals to investors, clients, employees, and society at large.

In my recent interview with one of the largest Energy generators and retailers in the Baltics, Latvenergo, its CEO Mārtiņš Čakste concluded:

Used wisely, ESG and sustainability are powerful tools. They deliver performance excellence that forces you to make things right, and to think strategically five or six steps ahead. It is the next level of business operation, enforcing not only just creating value for shareholders, but doing so sustainably. It is more demanding and requires different management, culture, and decision-making approaches. Not by coincidence, the financial capital providers are ready to offer more favourable conditions if they see you operate with higher levels of governance. Doing business sustainably and profitably is more difficult, yet it pays off tremendously.”

Sources: Book “Cannibals with Forks: Triple Bottom Line of 21st Century” by John Elkington, Book “Winning Sustainability Strategies” by Benoit Leleux and Jan Van der Kaaij, McKinsey, Deloitte, Investopedia, United Nations, Harvard Business Review, The New York Times.