May 21, 2024

Measuring what matters: Developing Effective Metrics for ESG Performance Evaluation

In recent years, Environmental, Social, and Governance (ESG) criteria have gained significant traction as essential metrics for evaluating a company’s sustainability and societal impact. However, the subjectivity inherent in measuring these factors poses challenges in developing effective metrics that accurately reflect a company’s ESG performance. Here I explore the subjectivity of ESG metrics, highlighting how different criteria may vary in relevance across sectors and geographies and the consequent implications for best practices.

ESG metrics encompass a wide range of factors, from carbon emissions and resource conservation to labor practices and board diversity. While these criteria are universally important, their relevance can vary depending on the company’s industry, size, geographic location, nature of work, materials involved, cultural or political context, among others. For example, water and forest conservation may be of utmost importance to Fast-Moving Consumer Goods (FMCG) companies reliant on agricultural supply chains, whereas they might hold less significance for consulting firms primarily engaged in knowledge-based services.

Similarly, the significance of social factors like labour practices and human rights can differ significantly across industries. A manufacturing company operating in developing countries mayface greater scrutiny regarding labor conditions compared to a technology firm primarily engaged in research and development. Thus, the relative importance of different ESG criteria must be considered within the context of a company’s operations and industry dynamics. This variation makes it very hard to standardise a set of ESG metrics that are mandated for all companies, and hence also for investors to evaluate in a standardised manner. While materiality mapping and sector-based disclosures aid the problem to an extent, there is still inherent subjectivity and context-dependence within many metrics.

Moreover, best practices for addressing ESG criteria can vary based on the nature of a company’s operations. Take, for example, the case of emissions reduction strategies. A cement company, inherently reliant on high-energy processes, may face limited avenues for directly reducing emissions. In such cases, offsetting emissions through investments in renewable energy or carbon capture technologies may represent the most viable approach to achieving sustainability goals. Therefore, a cement company that successfully offsets 100% of its emissions could be considered as performing well against ESG metrics.

Conversely, a company operating in the transportation sector, such as Uber, has ample opportunities to reduce emissions through innovations in vehicle technology, route optimization, and alternative fuels. In this scenario, simply offsetting emissions may not be sufficient to demonstrate genuine sustainability efforts. Instead, best practices would entail implementing measures to reduce emissions directly, such as transitioning to electric vehicles or promoting ridesharing to decrease vehicle miles traveled. Even within the same sector of transport, there are differences based on whether it is long-haul or short-haul transportation, and passenger or cargo transport- while most passenger transport can be transitioned to electric vehicles, long-haul transportation is still majorly reliant on diesel in the absence of alternate fuels that can provide the same performance. Another issue when evaluating companies on standardised best practices is that if a company has gone above and beyond to create a best practice that is most suited to the context, it may not be recognised; and in many cases is penalised instead. An unfortunate example of a similar case is where a large MNC was extremely thorough in its estimation of scope 3 emissions and disclosed categories that were beyond best practice, it impacted them negatively as their emissions seemed larger than most other companies that did not delve deep enough to disclose to this level.

To evaluate companies fairly on whether they are doing the best they can on ESG, highly trained resources are required to manually sift through the public disclosures of companies, a painstaking and largely infeasible effort at scale.

Furthermore, the effectiveness of ESG metrics hinges on their ability to capture both quantitative data and qualitative impacts. While quantitative measures like carbon footprint and energy consumption provide tangible metrics for evaluation, qualitative factors such as community engagement and stakeholder relations are equally critical in assessing a company’s overall sustainability performance. Therefore, a holistic approach to ESG measurement should incorporate both quantitative and qualitative indicators to provide a comprehensive assessment.

In conclusion, measuring what matters in ESG performance evaluation requires careful consideration of the subjectivity inherent in determining the relevance of different criteria across industries and geographies. Effective metrics should reflect the specific challenges and opportunities faced by companies within their respective sectors while also accounting for both quantitative and qualitative impacts. By developing nuanced approaches to ESG measurement, stakeholders can gain a more accurate understanding of a company’s sustainability efforts and drive meaningful progress towards a more equitable and resilient future.

Author

Ria Narayanan