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Abhishek Parajuli
Trainee Investment Manager
Baillie Gifford

As ESG investing grows, people are worried that sustainability has become a marketing gimmick. They are right. Many businesses seeking investment use ESG as window dressing to attract capital.

So, how can you tell if a company really cares about sustainability? Three tests can help identify genuine ESG firms.

Is pay linked to sustainability?

The first draws on the wisdom of Charles Munger, who said, ‘Show me the incentive, I’ll show you the outcome.’ Start by checking whether executive pay is linked to sustainability.

Bloomberg data shows that this is the case for just 26% of S&P 500 companies. When it comes to the FTSE 100, the total is less than half. In other words, everyone talks about ESG, but few put their money where their mouth is.

Also, remember that not all financial incentives are equal. Research by the London Business School and PwC found that just 19% of firms use ESG targets in their long-term incentive plans. This matters because sustainability takes time. A company that relies on annual sustainability targets is likely to be more concerned with short-term headlines than long-term change.

ESG incentives should also be company-wide. Though companies often disclose C-suite incentives, it can help to see whether teams further down the corporate ladder are encouraged to care about ESG goals.

And finally, whatever those goals are, they should be concrete. Vague aspirations don’t work.

Is there a strong voice for sustainability throughout the business?

Every company is now scrambling to hire ESG staff. At some firms, ESG employees are empowered to speak up. At others, they are kept in a bunker, only to be wheeled out for investor calls.

As such, it is worth mapping out how many reporting layers there are between sustainability folks and those setting strategy. How often do they communicate? What do they discuss? Proximity to power can ensure that ESG is always on the agenda.

The best way to test whether ESG has a voice is to see if it shapes a firm’s core products and services. The firm Coloplast is a good example of this. It makes medical bags for people who cannot have normal bowel movements. Its patients used to worry that the bags were too visible, and this caused huge social anxiety.

In response, Coloplast tapped the diversity of its customers and staff to design bandages in different skin shades. It also engineered products to fit a wider range of body sizes.

Another example is the UK-based medical device designers, Smith and Nephew, who produced artificial knees with more flex following insights from engineers familiar with the Asian custom of sitting on the floor.

These companies helped their patients while also increasing sales. Being able to take ESG from glitzy brochures to a core part of the business model is a sign that it is a genuine priority.

Is there alignment between sustainability and a company’s business model?

Firms where ESG drives both sales and profits will naturally treat this as a priority. In these companies, shareholder interests are so aligned with other stakeholders that there is little need for policing.

Metropolis, an Indian diagnostics firm, is a great example of this. It has been a trailblazer in bringing new medical tests to India. In 1985, it was the first company to introduce HIV testing to the country.

Inflation-adjusted prices for its tests have fallen over time. This makes diagnostics accessible to poorer people but also boosts profits by allowing more patients to access its services.

This virtuous loop, in which lower prices drive profits and access, benefits shareholders and society.

Companies with this kind of alignment are rare, but they do exist. Hapvida in Brazil and Warby Parker in the US are examples – you can read their sustainability reports here and here. They are the pinnacle of ESG integration.

Finding ESG champions

At a time when everyone claims to be sustainable, studying how people are paid, checking if ESG has a voice, and looking for business model alignment can help. These checks can reveal whether a firm is sustainable today and will develop its ESG profile over time.

Compared to the AI bots or mile-long checklists that are often used to assess ESG, this three-part method is intentionally simple, cutting through the thicket of statistics to focus on what matters – the real-world impact a business has.

That said, while the theory is simple, it’s not easy to put into practice. It requires bottom-up, company-specific research. You can’t just drudge data and rely on summary statistics. Instead, you have to think critically and ask tailored questions. It is difficult, time-consuming work but the pay-off for companies, investors and society can’t be understated.

This article originally appeared on the Actually blog

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