The explosion of ESG investing
ESG investment funds, which claim to invest according to environmental, social and governance criteria, grew to almost US$3 trillion in 2021. With a 53% increase since 2020, this made ESG the fastest growing sector of the asset management industry.
The rapid flow of funds into ESG investments has led to many demands from investors and the financial press for reliable accounting information. There is enormous variability in valuations of stocks and indices according to ESG criteria, and even a fundamental confusion about what ESG investing is.
In response to this variation and confusion, there is a proliferation of standards aiming to account for non-financial value. Two of these initiatives are the Sustainability Accounting Standards Board (SASB) and Integrated Reporting (IR), which have recently merged into the Value Reporting Foundation.
Critical accounting literature has long recognised the limitations of social and environmental accounting. A key concern is that accounting standards fail to properly measure the complexity and diversity of social and ecological value. This might be perceived as a fundamental or epistemological disconnect between the domains of the financial and the social: these things are incommensurable. Alternatively, others find that while financial accounting might be up to the task of attaching prices to all manner of values, to do so would devastate the rate of profit, so there is a reluctance to develop comprehensive measures.
But looking beyond these limitations reveals the productive function of ESG accounting frameworks.
In a recent article for Critical Perspectives on Accounting, I argue that while SASB and Integrated Reporting fail to fully account for the social and ecological impacts of business activity, this is not crucial to their function. ESG accounting standards provide a foundation for the accumulation of ‘ethical capital’ for which a comprehensive account of social and ecological value is unnecessary.
What is ethical capital?
The term ‘ethical capital’ tends to elicit a visceral response. For some people, it suggests a beacon of hope in a post-political world desperate for social and economic transformation. For others, ethical capital is an oxymoron and a greenwashing exercise.
ESG investors themselves, like others I characterise as ethical capitalists, tend to steer clear of any discussion of ethics at all. But the massive growth of ethical capital, of which ESG investing is one branch, is predicated on its ambiguity and hidden contradictions. By uncovering the conflicts about what ethical capital comprises, I aim to expose the tensions, debates and disagreements that ethical capital’s advocates profit from concealing.
Ethical capital is a process by which ethical claims or credentials are incorporated into intangible assets such as corporate reputation and credit ratings. Where capital perceives political issues that may become risks to accumulation, it absorbs them as profit making opportunities. Typical examples include climate change, forced labour, and workplace health and safety.
The phenomenon of ethical capital as a way of making profits need not imply that capital has become more ethical (whatever that might mean). Ethical capital merely permits investors to speculate on which ethical issues they think will be the most lucrative to support or avoid. It is a mode of investing based on ethical claims, and the ethics underlying those claims are as varied as the people who assert them.
Accounting for ESG
Like any other form of capital accumulation, ESG investing relies on accounting to provide relevant, consistent and comparable information to support investment analysis. Standards like those set by SASB and IR translate ethical issues into metrics that corporations use to bolster their sustainability credentials. Where these credentials become part of an intangible asset like a brand or a credit rating, they boost stock values and returns.
Bringing together accounting for intangible assets and accounting for social and ecological values, SASB and IR create a basis on which businesses can create, measure and trade intangible ‘ethical assets’. In SASB’s approach, this involves developing a list of ‘sustainability topics’ that are relevant to particular industries and requiring firms to report on these. The process for determining which sustainability topics are relevant involves consultation with industry participants and investors, as well as media analysis and other desktop research to reveal the nature of public opinion on these issues. The issues of financial materiality is paramount.
For IR, the rationalisation process focuses on ‘six capitals’, which include the traditionally recognised financial and manufactured capital, as well as four non-financial capitals: human resources, natural, intellectual and social / relationship capital. IR then requires firms to report on how it is growing these six capitals, but privileges financial outcomes and the interests of shareholders.
Redefining ethics through the frame of financial materiality, SASB and IR are grounded by the proposition that there is no contradiction between the interests of business and the interests of everyone else. A core tenet of ethical capital is that responsible business is more profitable, but this is only true if ethics are restricted to those issues with financial implications. The rationalisation and standardisation of ethical issues through the SASB and IR frameworks renders a constrained form of market-compatible ethics legible to capital in the form of risk.
While critics of social and ecological accounting are correct to identify that ESG standards fail to properly account for social and ecological value, that they have regard only for financial interests and that they are disconnected from reality, these arguments miss a crucial point. ESG accounting does not need to be accurate nor comprehensive to support the accumulation of ethical capital. Indeed, if ESG accounting was more comprehensive, it would undermine ethical capital production, which relies on concealing the conflict between profitability and sustainability. The ambiguity of ESG accounting standards is crucial to the growth of ESG investing and the accumulation of ethical capital.