A (3:50)

And that's about when the term ESG even came about. John, who coined that term and what brought this issue to a head?

C (3:59)

I don't know actually who coined the term, but I do know that it is attributed to an effort at the United Nations. The UN Global Compact created the United Nations Principles for Responsible Investing, which I believe was created in about 2006. And associated with that effort, the concept of categorizing corporate behaviors into things that impact the environment, into things that impact social outcomes, human outcomes, and into corporate governance issues. Categorizing it into those three areas was created and the term ESG was coined.

A (4:46)

It's kind of amazing because I think the United nations has a reputation of being important, but maybe not agenda setting in that sense.

C (4:57)

Originally, this was driven by client demand, religious institutions, some philanthropic organizations, some individuals wanted to express their values in their investment portfolios. And they created the original concepts of around socially responsible investing. But that was small and that was very idiosyncratic. It became a movement in the 1990s and early 2000s, and I think the United nations was a factor in transitioning it into something that brought together investors and investment managers from all over the world with an agenda.

B (5:51)

You know, John, I was a little surprised I was going to have you as my phone a friend person for ESG trivia. In terms of who coined the ESG terminology, certainly the case that I think the UN had a big role in starting this for sure. But maybe, as you're going to allude to, there was certainly precedent prior to that for companies thinking about this information, prior even to that point. The balanced scorecard was something.

A (6:17)

We should just explain what the balanced scorecard is. I'm trying to remember the dates for it off the top of my head.

B (6:22)

1992, I think, was when the first version of it came out and what.

A (6:26)

Was groundbreaking about it.

B (6:28)

The big thing that was groundbreaking about the balanced scorecard is really this idea to move beyond thinking about financial statements, which everybody had thought about since the 1920s. Right. That was kind of the gold standard for how to evaluate a company and its performance.

C (6:43)

And.

B (6:43)

And the balanced scorecard's big insight, I think, was to get companies internally to think about, well, what if you don't just focus on financial measures? There are other things that are going to affect your performance, and maybe they won't affect them today, but they're going to affect them in the short term, midterm, long term, building in those other criteria, those other dimensions, and explicitly linking that to your strategy, to how your company's going to operate, what kind of big decisions it's going to make. That's really what the biggest inside of the balanced scorecard was meant to do. And at the time, right now, it doesn't seem particularly revolutionary. It seems kind of obvious. We've been stuck in the ESG movement for a while, and thinking about linking these things to corporate strategy seems pretty obvious. At the time, it was a pretty big whoa kind of moment. And again, it wasn't just the idea of going beyond financial statements. It was the systematic structure of how to think of broad categories and how to assess the categories and then link them all the way through strategy, to evaluation, to decision making, to change what the company. That was the big insight, I think, of the balance scorecard.

A (7:45)

What did it actually do for firm operations and communication? How did it change reporting and how companies were run?

C (7:53)

What did it do for companies in terms of how they think about their reporting and how they organize things? I think is something that happened company by company, because not everybody took up the balanced scorecard at the same time.

A (8:07)

Or esg.

C (8:08)

Yeah, or esg. And one of the things that is still happening is that the kind of corporate community is developing standards, developing kind of common language around these issues so that data and information can be created that is useful. One of the things that has not happened yet is for the regulators around the world to come together with clear, useful regulatory frameworks for sharing that information. That's something that has been slow to develop and is necessary to really formalize this and make it something as useful as financial accounting.

A (8:56)

It's really interesting to hear about all of these forces kind of coming together to bring ESG into, to the forefront and also make it a global phenomenon. Sticking with standards and metrics here, though, that John brought up, what traditions of reporting did ESG kind of like, you know, get in the flow with to become such an accepted practice?

B (9:18)

Yeah, it's a great question. Just alluding back to what John said, it's the next evolution that's clearly so critical right now is for us to get to a point where we have standardization much more broadly than where we are. We're moving in that direction, but it is going slowly. But you know what's kind of funny about this is that at least from a kind of genteel accountant's perspective, we've seen this movie many times before and even. I'll just give two examples. If you go back to the 1920s, the roaring twenties and the stock market was great and people had flush with cash, and then it all came crashing down in 1929, 1930, the Great Depression hit. Right at that time, there was no structure for financial reporting. It really didn't exist. It was the Great Depression that led to the creation of the securities and Exchange Commission in the United States and to lead to standardized financial reporting as we know about it right now. In the 1920s, companies could pretty much report what they wanted to. And so you had this big shock that led to the creation of some type of standardized reporting. But there was a process there. Second example even occurred just 20ish or so years ago. It used to be the case that Germany had its own set of financial reporting standards, Japan had its own, the United States, Brazil, all over the world. Every country basically had ownership of its own standards. And, and the problem was you had apples to oranges, to lemons to pears to grapes comparisons because countries viewed things differently and standards were not the same. Okay, so that's a problem, particularly if you link that with the rise of global capitalization. So now if you're trying to think of how do I make an investment in Russian oil company versus Total, in France versus British Petroleum versus Exxon, you're actually going to compare the companies because the reporting wasn't the same. That gave rise in the early 2000s to what's called IFRS, International Financial Reporting Standards. And, and that was another massive change that happened in reaction to a demand for information. And so what we're seeing, I think with esg, is just this pattern that replays we're kind of in the fourth or fifth inning of the game. I think to use the baseball analogy, but we've seen the games before, we've played these games before, and I think we're on a pathway that will get to a similar outcome.

C (11:30)

I love the reference to financial accounting in that history because it brings to my mind the corporate behaviors that are not captured in financial accounting, sometimes called externalities. And one of the ways that I understand ESG is an effort to understand and quantify the externalities that a given company exerts on society broadly. Polluting the river or discharging carbon into the environment, which creates global warming, climate change. Those are not things that companies have traditionally been charged for. They can do those things. Those things create outcomes and costs that are borne by society broadly. And the company doesn't have to deal with those in its financial accounting, can report its earnings without regard to the externalities that it creates for the rest of the world. And one of the things that is happening that companies might not like is an effort to create standards for calculating their externalities, which could, in the long term, lead to them being charged for those.

A (12:50)

So ESG brings all of these pressures together, creates a new way for companies to report it, solves problems in some ways. Is it, I don't know, is it just kind of a natural evolution to that problem, or is it more of a quantum leap? Like, to what extent is ESG reporting today different than maybe reporting traditions in the past?

C (13:16)

Well, if we focus in on one particular area, it's potentially a quantum leap and creates a lot of challenges. When you raise the price of energy, you potentially impair economic growth and economic development. Everything we do essentially converts energy into other goods and services and ultimately profits, and has a huge impact on societal development and outcomes. If you start to raise the cost of energy, it impacts the economy very, very broadly. And as I mentioned, we have not been charging ourselves broadly for carbon emissions, which are currently a big part of our energy system. So if we begin to cost this in, it's a quantum leap. It has very big implications for the energy system, for geopolitics, for asset values, and many, many things.

B (14:24)

Just to even add to that, it is a quantum leap, because this might one of the first times that there's a coordination that needs to occur across regimes. Right. When we think about carbon emissions that happen in East Asia, where a lot of the manufacturing occurs, that has direct implications across the world. And so it's not just that it has to occur within a regime, it has to occur across regimes. And so the quantum leap potential here is that finally we've got a circumstance where it's going to happen with a lot of frictions. But you're starting to get to the point that countries collectively understand the need, that they need to cooperate, they need to work together both on the reporting side and then hopefully the reporting leads to some type of actionable side as well.

C (15:09)

And I think the concept of bringing all the critical players together on this is enormously challenging because not everybody is going to act in the world's interests. Some of the players in the global economy and the global energy system might act in their own self interest without regard to the impact on the rest of the planet. So this is where it gets very tricky.

A (15:39)

The metrics, the reporting, the standards are tricky too, right? With this enormous challenge in front of us, are we in a better place in being able to tackle that challenge just based off of the information we get from ESG as opposed to 20 years ago when we didn't have it?

B (15:56)

You know, part of this is there's an evolution that happens and you have to get comfort with the evolution, how quickly the evolution can occur. And this relates back to some things that we've seen previously. When we use the examples of the shareholder reporting that occurred in the 20s or the global financial reporting, what typically happened in these previous big change cycles that we had previously, you had some demand coming from somebody. It could be investors, could be from governments, and they're looking for new types of information. You need data to make decisions and they're lacking data. And so it's driven by the demand for some new data. And then what happens is that companies start responding, typically individually, and they'll provide one version of here's some data we think will be useful. The problem is that you get a lot of variation. So company A reports it one way, company B reports it a different way, and little by little things start to coalesce and companies start learning from each other, industries start reporting a little bit more aligned with each other and you get a little bit of best practice evolving. That's typically the point when the regulators step in and say, okay, now we can see that there's some viable patterns here and we're going to institute something and put a stamp on it. And so one of the things we've learned, certainly from academic research, regulation, for good or for bad, it's typically reactive, not proactive. And that's not to belittle it. It's just the reality. Economic circumstances can just evolve so dynamically. It's really not realistic sometimes to expect regulators to anticipate how things are going to evolve. They have to sit and watch and learn from it before they can put structure on it. And I think that's kind of where we are with esg. I think a lot of people would want it to evolve quicker than it is, but the evolution, it's starting to come.

A (17:41)

So if part of this process is kind of feeling out what's working and getting over the frictions and basically looking for what's successful and doing more of it. John, I'm curious, what are some of the biggest and most successful developments in ESG that we can point to today?

C (17:58)

I want to go back to the energy system and answer your question kind of with that focus, because if we took all of the work associated with creating ESG standards and metrics and data and said, and let's prioritize the most important thing and do that one thing really well, I would vote for doing it on carbon and methane, because, as I say, this is going to directly impact resource allocation related to the global energy system, which is enormously important. So one of the areas where I think we have been focusing and where there's a lot of effort is calculating carbon emissions company to company, country to country, and getting a decent data set there. And that's where most of the effort should be. And frankly, where most of the effort has gone into. However, it's still voluntary mostly, and there has not been global agreement on how to create the numbers and how to develop the ecosystem of clear, accurate, reliable data. Nonetheless, it's the area where we've had both the most success and probably the most controversy.

A (19:25)

Eddie, one area of your research is looking at SEC filings, right? These corporate information reports that are standardized that we've mentioned. When you look at it over time, like, what trends or changes have you found with esg, what do those filings show for this evolution that you're talking about?

B (19:43)

Yeah, yeah, right. And to link it to John's previous comment. So once you get into the domain of the sec, you're moving from voluntary space into mandatory space, right? The SEC sets the rules, and companies have to play by those rules. They don't get a choice about that.

A (19:57)

And it's public like they're fired with the sec. But this is available to all investors and anybody. To look at.

B (20:03)

That's correct. Exactly. And so one of the things that we've been doing was trying to understand these ESG risks and how they're reported within these 10K filings, because it's a pretty important mechanism. The 10K is an annual filing in the United States, and it's supposed to basically provide an overview of the company and everything that it's doing in terms of its strategy, risks, operations, et cetera. And one thing that we've noticed is that over time the companies are reporting more and more information regarding their ESG risks. The information is getting more granular. So there is a trend of companies providing more information. Is it standardized? We're getting there. Little by little we're getting there. But the other thing that we notice, maybe that's perhaps a little bit more interesting, is that we're seeing we use this fancy term called a spillover. And all it means is that companies are learning from each other. They start adopting what others are reporting because everyone's trying to figure out what's the best way to approach this. Even that is elevating now from voluntary disclosures into what's being filed within the 10k filings too. And I'd say that's a good sign. That's what gets us from the fourth and fifth inning of the baseball game to the sixth and seventh inning of the baseball game. That's the kind of progress that we want to see more of.

A (21:17)

So if we're in the sixth or seventh inning now, I'm curious, like how the game has progressed. Like we've talked about all the history leading up to today. Is the game getting more exciting? Are we kind of grinding out through some messy middle innings here? Where are we?

B (21:34)

I think it is about to get very, very exciting. And that's exciting as a double edged sword, isn't it? Right, so there's good things and maybe not so good things to it. John's point before about thinking about carbon, carbon emissions and the energy system I think is so absolutely spot on because the implications and impact of that for so many different domains of society are really incredible. And we were just seeing the front edges of what that can mean. And you think about the cumulative impact of all these different environmental items, most of which is I think, fairly compellingly linked to carbon, carbon emissions. Those are the economic shocks that are going to make for a very exciting end of the game for good or for bad. The reporting side of it, hopefully is that that's going to be the impetus to push companies, governments, NGOs and just a much more collective working together to try to come up with good reporting because this is an accountant's bias. But in the end, I'm not quite sure how you make a decision on how to allocate resources, how to correctly price insur, where to put buildings and real estate infrastructure. If you don't have the right information to cost it.

A (22:50)

Yeah. John, where would we be if there were no ESG today?

C (22:55)

You know, before we had ESG and before we were really focused on climate change, we had something in the United States called acid rain, particularly problematic in the Northeast. And this was basically power generation in some factories. You had a lot of pollution coming out of their smokestacks. And when it rained, that pollution came out of the sky and got on people's cars and ruined the finish of the cars, and it became known as acid rain. And we wanted to fix that. We did it by pricing those emissions. Once we put a price on those emissions and we traded that price on those emissions, there was a clear price point that entrepreneurs and innovators could work against. They knew how much money they could make if they could solve that problem. And companies knew what the economic consequences were of not solving the problems. And so the market had a pricing mechanism, a price discovery process, and money got put to work to create scrubbers and different mechanisms to reduce that pollution significantly, and we got rid of the problem. That was way before the term ESG or all of this was really operative. As Eddie said, we're about to get into some very exciting times. And I think one of the outcomes of those exciting times will be to figure out, will the market be able to solve this problem with the energy system, or are we going to have to have some really significant system change that is essentially run by the government? How is this actually going to play out? Because we do need to solve the problem.

A (24:40)

A final question for both of you, and this is maybe to kind of end here on the history. What's the biggest misconception about how we got to ESG that people have that you want to clear up?

B (24:55)

I think the biggest misconception relates to capitalism. It's that capitalism is somehow inherently flawed. That ESG is just one other manifestation of a flawed system. And my own perspective, it's admittedly biased, but I feel like we have a lot of evidence to show that in the past, when we've had major challenges in society. Capitalism, when it's done right, and you do need rules in the game, you do need structure and all these other points that we mentioned before. But when it's done right, it's very good at coming up at very creative solutions to very thorny problems. It truly is. Perfect example that we have of that is the pandemic. Where would we be had Pfizer not come up right and these drug companies not come up with a solution? A vaccine for that pandemic. And so if we can get some alignment with incentivizing, not just big corporations, incidentally, because a lot of the innovation doesn't happen with the big corporations. A lot of it happens with the entrepreneurs, with the small players, and they're the ones that come up with creative ideas. What the corporations allow us to do is to scale things in a very, very quick and rapid way. So my hope is that there's a little bit more positive perspective on the potential for capitalism. It's not perfect, it's not a panacea, but it can be a very, very big mobilizer to getting to good solutions. That's what I hope is what we get from this.

A (26:20)

John, what about you?

C (26:21)

I agree with that concept. I think the biggest misconception today about ESG is that it is some kind of a political. It's been co opted and they've called it woke. It really is an effort to improve how capitalism works, strengthen the system so that the market can in fact have a more accurate and clear set of data to use in the current incentive system.

A (26:51)

Eddie and John, thank you so much for talking about this.

B (26:54)

It was a pleasure. Very, very honored to be here. Thank you so much.

C (26:57)

Thank you.

A (27:03)

That's Eddie Riedel, the John F. Smith Jr. Professor in accounting at Questrom, and John Stroyer, the former chair and CEO of Calvert Research and Management. Next week we continue our series with a conversation on how ESG is being used today. What does ESG look like in practice? That's next week. To get that episode and more, please follow the show on Apple Podcasts, Spotify or wherever you listen. Thanks for listening to Is Business Broken? I'm Kurt Nikesh.