ESG (Environmental, Social, and Governance) metrics have become crucial for companies and investors over the last ten years. Realpolitik means a system of politics or principles based on practical rather than moral or ideological considerations. However, companies have historically kept a low profile about their military business and related investments. But, things are changing rapidly.
ESG is being criticized
ESG is being increasingly criticized for various reasons. At the same time, some companies are actually proud of their military business, but others haven’t been able to realize the risks in their political environment. Do we need new approaches and metrics to assess opportunities and risks? Could this be a long-term change in the investment market and how to evaluate businesses? Perhaps we should be more realistic.
The world returns to realpolitik
We can say that after Russia’s invasion of Ukraine, the world has quickly returned to realpolitik. During the last thirty years, since the end of the cold war, it has been possible to be much more ideological about politics. In business, we have seen this in the energy and military sectors. Nowadays, the focus is to guarantee enough energy for the following winter, preferably non-Russian energy, and enough reasonably priced food, and governments have started to increase their military investments significantly. As Wall Street Journal just wrote, even Venture Capitalists have started to love bombs, and there are even serious lobbying attempts to push the European Union to include defence companies in its new standardized ESG taxonomy.
There are claims that ESG helps to greenwash things, especially when you can find ESG metrics that work for your purposes. ESG itself has many issues. Significant criticism has been aimed at bundling the three things together – environmental, social, and governance issues – doesn’t make sense. At the same time, ESG criteria in investments are inadequate to fight against climate change. Elon Musk has called it a scam but has made many similar provocative claims. German prosecutors are investigating whether Deutsche Bank’s DWS has made misleading claims about their funds and how ESG has been taken into account in the investment decisions.
ESG has quite many qualitative aspects, which means that it is not very consistent. Different ESG metrics can give a very different evaluation for the same company or investment (e.g. other stock indexes provide similar results). ‘Environmental’ impact alone can mean many things.
There have been proposals to unbundle ESG and have, for example, a specific metric for emissions of an investment. Evaluation of social aspects and governance practices is quite different from the environmental impact. One could argue that ESG has always been quite an ideological metric, but it has become a significant business to measure and audit ESG, make reports and consult on ESG.
Dependent on Russian oil and gas
Germany and several other European governments have also received criticism on how their energy supply became dependent on Russian oil and gas. Germany even started ramping down its nuclear power and considered Russian gas the ‘cleaner’ energy source until renewal sources can replace it. We can ask whether ESG could be relied upon to indicate these kinds of risks and consequences.
What were the social metrics concerning the purchase of gas from Russia, which occupied Crimea in 2014? Did it matter that Russia had been aggressive for years? Was it good governance from many companies that ignored political risks with Russia? Maybe military business is not only socially harmful but something that is also needed in the world, whether you like it or not. And let’s remember that Russia is not the only country with a high political risk nowadays.
Doing business in a vacuum
Many companies have thought they could do business in a vacuum away from politics and global affairs. Many, today, are paying a high price for this, especially if they have significant business in Russia. At the same time, many other companies and investors have underestimated political and security policy risks.
Companies have also missed business opportunities when they haven’t realized fast changes occurring in the business environment. For example, COVID offered opportunities to build a more reliable local supply chain. Now, not only the demand for the military but also dual-use technology has grown rapidly. We know it is hard to predict things, but in business, it is crucial to react fast to changes and also be able to utilize weak signals. It is naïve to claim that there were no signs of risks involved with Russia raising tension between the west and more authoritarian countries and the subsequent risks with global supply chains.
This all raises a question about business and investment metrics. Companies have always used traditional financial metrics and ESG had become more important. However, this has not been enough to build a more sustainable business through the current disruption. ESG has many issues, and it is likely, that the current situation will change it. The environmental factors will also be important in future, but social and governance have probably failed for now, and political and country risk factors have been largely ignored.
Time for new metrics
Perhaps we need new metrics to evaluate opportunities and risks. Companies and investors must be better positioned to assess political risks and recognize signals from security and stability factors surrounding the company’s environment. For example, if signals indicate wars, warlike operations (grey zone), coups, dictators, embargoes or significant constitutional crises, companies and investors should not ignore them. Today there are signals like those almost everywhere, and there should be a systematic way to evaluate them.
We have had a lot of expectations for ESG, but now it looks like it is not powerful enough to stop climate change. Furthermore, ESG goals have also failed to evaluate social and governance issues, as businesses with Russia have indicated. It is essential to have metrics and a systematic evaluation for investments and businesses to improve the world. We will probably see realpolitik coming back into those metrics and assessments. We need a straightforward way to measure emissions, political risks, changes in the security environment, country risks and opportunities. They must be based on actual signals, not only on an ideological framework of how we would like to see the world.