If you own a stock, chances are good that you’ve heard the term ESG. It stands for Environmental, Social and Governance, and is a way of appreciating corporate leaders who take sustainability – including climate change – and social responsibility seriously, and punish those who do not.
Less than two decades after a United Nations report drew attention to the concept, ESG investment has grown into a US$35 trillion industry. Wealth managers who oversee one-third of total US assets under management said they used the ESG criteria in 2020, and that global assets managed in portfolios labeled “ESG” are expected to reach $53 trillion by 2025.
These investments have gained momentum partly because they satisfy the growing desire of investors to make a positive impact on society. By quantifying a company’s actions and results on environmental, social and governance issues, ESG measures provide a way for investors to make informed business decisions.
However, investor confidence in ESG funds may be eroded. As scholars in the fields of supply chain management and sustainable operations, we see a major flaw in how rating agencies, such as Bloomberg, MSCI and Sustainlytics, are measuring companies’ ESG risk: the performance of their supply chains.
The problem with ignoring supply chains
Almost every company’s operations are supported by a global supply chain that includes workers, information and resources. In order to accurately measure a company’s ESG risks, its end-to-end supply chain operations must be considered.
Our recent investigation of ESG measures shows that most ESG rating agencies do not measure companies’ ESG performance through the lens of the global supply chains that support their operations.
For example, Bloomberg’s ESG measure lists “supply chain” as an item under the “S” (social) column. By this measure, supply chains are treated separately from other items, such as carbon emissions, climate change impacts, pollutants and human rights. This means that all those items, if not included in the vague “supply chain” metric, reflect each company’s own operations, but not their supply chain partners.
Even when companies aggregate the performance of their suppliers, “selective reporting” can arise because there is no unified reporting standard. A recent study found that companies under-report environmentally responsible suppliers and hide “bad” suppliers, effectively “greenwashing” their supply chains.
Carbon emissions are another example. Several companies, such as Timberland, have claimed major successes in reducing emissions from their own operations. Yet emissions from their supply chain partners and customers, known as “Scope 3 emissions,” could remain high. ESG rating agencies have not been able to adequately include Scope 3 emissions due to a lack of data: only 19% of companies in the manufacturing industry and 22% of companies in the service industry disclose this data.
Broadly speaking, without accounting for a company’s entire supply chain, ESG measures fail to reflect the global supply chain network that today’s companies large and small alike depend on for their day-to-day operations. Huh.
Amazon and third-party-supplier issues
For example, Amazon is one of the largest and preferred holdings of ESG funds. As a company larger than Walmart in terms of annual sales, Amazon has reported emissions from shipping that are only one-seventh that of Walmart. But when researchers from two advocacy groups reviewed public data on imports, they found that only 15% of Amazon’s sea shipments could be tracked.
Furthermore, Amazon’s figure does not reflect emissions generated by many of its third-party sellers and their suppliers who operate outside the US. This difference matters: While Walmart’s supply chain relies on a centralized buying strategy, Amazon The U.S.’s supply chain is highly decentralized – a large percentage of its revenue comes from third-party suppliers, about 40% of whom sell directly from China, which further complicates emissions tracking and reporting.
Another important ESG metric relates to consumer protection. Amazon prides itself as “the most customer-focused company on earth.” However, when its customers have been injured by products sold by third-party sellers on its platform, Amazon has argued that it should not be held liable for the damages, as it is trying to match buyers and sellers “online”. Serves as a “Marketplace”. Amazon’s foreign third-party sellers are often not subject to US jurisdiction so cannot be held accountable.
Yet the major ESG rating agencies do not reflect the supply chain implications on customer safety when measuring Amazon supply chain performance.
For example, in 2020, MSCI, the largest ESG rating agency, upgraded Amazon’s ESG rating from BB to BBB, reflecting its strengths in areas such as corporate governance and data security, despite its consumer liability risk.
This gap is also a matter of concern for the ratings of companies like 3M, ExxonMobil and Tesla.
Other countries are adding pressure
There is currently no unified reporting standard, so different companies may choose to report certain ESG performance measures to boost their sustainability and social ratings.
To improve sustainability, the next step for ESG rating agencies will be to redesign their practices to take into account environmentally harmful and unethical operations throughout the global supply chain. ESG rating agencies, for example, may create incentives for companies to collect and disclose the activities of their supply chain partners, such as Scope 3 emissions.
In June 2021, the German parliament passed the Supply Chain Due Diligence Act, which will take effect in 2023. Under this new law, large companies based in Germany will be responsible for social and environmental issues arising from their global supply chain networks.
This includes a ban on child labor and forced labor, and a focus on occupational health and safety throughout the supply chain. Those who violate the law face fines of up to 2% of their annual revenue.
The EU’s new Sustainable Finance Disclosure Regulation, which took effect in March 2021, adds to the pressure in a different way. The funds are needed to describe how they integrate ESG characteristics into their investment decisions. Bloomberg reported that this has prompted some wealth managers to drop the phrase “ESG integrated” from some of their assets.
Without similar laws in the US, we believe ESG rating agencies could fill a significant gap. To be sure, it is far more complicated to survey the ESG performance of a company’s entire supply chain. Yet by tying all ESG dimensions into the end-to-end operations of a company’s supply chain, rating agencies can push corporate leaders to be responsible for actions in their supply chain that would otherwise be kept in the dark.
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