ESG is taking a hammering. While ever increasing volumes of capital flow into its sunny embrace, there has been a simultaneous upwelling of critique over the methods used, particularly where concerns climate change. In recent months, the offices of two major European banks have been physically raided, Morningstar has culled over a thousand of its ‘sustainable’ funds, and the previously lagging SEC has proposed a new ruling to clamp down on greenwashing. The media storm following Tesla’s removal from a major ESG index was perhaps the final straw for many. Commentators ranging from economists to academics, and asset managers to environmentalists, are arguing that the flaws in ESG methodologies are leading to the misallocation of capital that is intended to tackle climate change.

In this article, we would like to introduce the concept of ESG 3.0 as the necessary, and perhaps natural, resolution to this criticism. Rather than joining the chorus of blind ESG bashing, we believe that huge positives have come from the movement, and propose that we allow the idea to develop into its next, more impactful, iteration rather than throwing the whole thing out. We identify here two broad delineations in the ESG movement, centred around differing intentions for the impact of capital. This has been a diverse movement, so these delineations are far from perfect, but we believe they demonstrate the key moments of thought and its progression. We then propose a third, ESG 3.0, which we hope will change the way the financial sector engages with climate change. Note: our focus here is very much on the E of ESG, but the same principles could be applied by other institutions for the S and perhaps even the G.

• The origins of the ESG movement can be traced back to the socially responsible investing (SRI) movement. This revolved around the principle of ‘do no harm’. For proponents of SRI, this exclusion was all about avoiding association with industries that compromised their principles. This philosophy can be termed ESG 1.0. Here, the activity of capital was seen as superfluous to real economy impact. In other words, there was no intention to influence the companies through investment decisions, simply to cut their association.  

• ESG 2.0, on the other hand, came with a growing awareness of the material implications of poor social or environmental performance. Exclusions were, and are - for ESG 2.0 still dominates today - driven by risk, whether physical, financial or reputational.  The period has been characterised by the growth of a major industry made up of ratings providers, specialist teams and marketing departments. Under this paradigm, allocations are driven by calculations of risk, based generally on backwards looking metrics and/or opaque scorecards. Capital is at best correlated with impact. In other words, decisions that are taken to reduce exposure to, say, emissions intensive companies, are driven by a desire to reduce the risk entailed with high emissions, be that transition or liability risk, but may happen to create positive real-world impact as well. Many decisions of course won’t. The greatest danger here is that decisions taken to mitigate risk are repackaged as being taken to have positive impact. MSCI’s ratings have been heavily criticised for this.

• Under the emerging paradigm of ESG 3.0, by contrast, capital actively seeks to cause impact, rather than just be correlated with it. This has always been iClima’s philosophy, and we are proud to lead on this endeavour. ESG 3.0 is built around finding solutions, underpinned by forward looking metrics.

While ESG indices working within the paradigm of ESG 2.0, as many of today’s leading offerings are, often favour mainstream companies with intrinsically small environmental footprints such as healthcare or tech players, ESG 3.0 requires seeking out companies for whom providing environmental solutions is a revenue generating item. Rather than social media or pharmaceuticals, indices thus end up with solar panels, meat alternatives, sustainable forestry or electric vehicles.

To assess what solutions move us away from BAU, a new tool kit and metrics are needed. This focus on causation is delivered through forward looking metrics that allow for determination of a company’s potential positive impact. At iClima, we pioneer the use of Potential Avoided Emissions (PAE) for listed companies. The metric, developed by Mission Innovation in the wake of the 2015 Paris Agreement, allows for a quantification of the potential emissions saved by the use of a product or service versus its business-as-usual alternative. This allows us to weigh up two companies and the benefits of an investment in each. More detail on the concept can be found here, and our comprehensive methodology here. In addition to PAE, we hope to soon employ the concepts of the Time Value of Carbon (TVoC) and Carbon Return on Investment (CRoI) once data availability improves. An outline of each of these can be found here.

We are not the first to propose changes to ESG, nor, we doubt, will we be the last. We have, however, been working on the idea of ESG 3.0 for over two years, albeit without using the term explicitly, and have immense conviction that this is the way forward. We must seek to maximise the impact of well-intentioned capital by investing in solutions, not greenwashing reality by clinging to minor improvements.

If you have questions, comments or ideas, we would love to hear from you. While we a for-profit enterprise, we are aware of the immense need for collaboration in this space. Without collaboration, we will never scale up the necessary solutions in the time available. If we don’t, then no one wins.

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