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Is it time to rethink what ESG investing means?

Adele Peters - May 25,2022
Fast Company


When Tesla was booted off the S&P 500 ESG Index —an index that ranks companies based on environmental, social, and governance data—Elon Musk responded by tweeting that ESG was a “scam,” and pointing out that Exxon, one of the most polluting companies in the world, was ranked in the top 10 best companies in the index.

In a blog post, the S&P explained that Tesla was cut in part because, despite making electric cars, it didn’t have a low-carbon strategy. They cited Tesla’s lack of codes of business conduct, along with reports of discrimination and dangerous working conditions at its California factory, as well as its handling of a National Highway Traffic Safety Administration investigation. (The EV company was also listed on the Toxic 100 Air Polluters, ranking last year for pollution from its battery factories, fined in Germany for not meeting laws requiring it to recycle used batteries; and earlier this year, fined by the EPA for violating the Clean Air Act with hazardous pollution from its California factory.)

It’s clear that Tesla has flaws. But if other ESG funds continue to hold Tesla, while S&P’s ESG index includes an oil company, and the Dow Jones Sustainability Index includes the tobacco giant Philip Morris, what does ESG investing really say about corporate responsibility overall? The first thing to understand is what ESG investing means: Most ESG ratings aren’t actually looking at the impact a company has on the environment or society. Instead, it’s a way that investors are evaluating the financial risk companies face because of environmental or social issues. And as ESG investing keeps growing—with assets that could reach $41 trillion by the end of 2022—it’s worth questioning if it’s measuring the right things.

“There’s a sort of obscure language that ESG raters use to talk about this stuff,” says Thomas Lyon, director of the Erb Institute for Global Sustainable Enterprise at the University of Michigan’s Ross School of Business. “They like to talk about ‘materiality,’ which means, is this particular thing going to have a material impact on our bottom line? It’s not asking the question, ‘Will it have a material impact on the planet, or on people?’ It’s all about the bottom line.” For example, MSCI, one of the largest companies that rates companies for ESG, says on its website that its ratings are “not a general measure of corporate ‘goodness'” or even “a synonym for sustainable investing”; instead they “provide a window into one facet of risk to financial performance.”

The concept of ESG investing grew out of socially responsible investing, a strategy that investors use to make more ethical choices; but the ESG approach focused on profits. In 2005, a UN report argued that investors needed to consider how companies were handling environmental, social, and governance risk more broadly because it had financial implications; companies that are managed more responsibly, the theory went, will ultimately make more money. (Many studies have, in fact, now shown a positive correlation between ESG and financial performance.)

Multiple rating systems now exist to score companies on long lists of factors, from recycling strategies to human rights. But some of the choices can seem arbitrary. For example, the S&P index screens out companies that extract oil sands, but not oil companies generally. It also screens out tobacco companies, though the Dow Jones Sustainability Index does not. The S&P index is designed to reflect the same industries included in the S&P 500 in general, so it includes fossil fuel companies—despite the fact that analysts have warned that those companies face financial risks because of climate change.

Each of the firms producing ESG ratings uses different criteria, and they aren’t transparent about the details of their methodology. A company’s rank might be very different from one list to the next. “The thing that’s pernicious is that each of the raters wants to keep their secret sauce—you know, ‘I’ve got the magic method that will help you make a lot of money, and I can’t tell you what it all is, but trust me, it will make you more money than the other guy’s secret sauce,'” Lyon says. “And because they have the incentive to keep their methodology secret, there’s unlikely to be a full convergence in these ratings over time.”

Because most indices aren’t measuring the actual impact that companies are having, their scores might go up even as performance worsens. Even though McDonald’s emissions went up 16% between 2015 and 2020, “McDonald’s is getting ESG upgrades,” says Hans Taparia, a clinical assistant professor at NYU Stern School of Business. “That’s because those emissions . . . are not considered a risk for the company. Right now, everything’s being judged on financial risk to companies, which is extremely disingenuous.”

Also, the scores often don’t include criteria like corporate political activity. Exxon, for example, spent millions lobbying to slow down climate action by spreading disinformation, including op-eds arguing that climate science was “unsettled” and decrying the “media hype” about climate change. Among other things, Exxon funded the Competitive Enterprise Institute, an organization that ran an ad that promoted CO2, saying, “You call it pollution. We call it life.” Lyon says, “Exxon has a terrible track record in its political engagement. But most of these ESG raters don’t pay any attention to that.”

While a smaller subset of ESG funds exclude fossil fuel companies, and according to Lyon, the ESG world is beginning to talk more about ranking companies based on impact along with financial risk, there are also trends moving in the other direction. The Global Reporting Initiative, an organization that helps companies report their impact on climate change, human rights, and other issues, may be replaced by a broader effort between the World Economic Forum and large accounting firms aimed at standardizing sustainability reporting, with a result that may look more like ESG ratings do today.

“What they’re doing is zeroing in on just the handful of things that investors care about the most, and that are easiest to measure,” Lyon says. “If the GRI standards get pushed aside, and we focus only on what investors care about, then we’re missing that broader picture of what do we actually need to protect the planet.” The same is likely true in terms of missing the broader impacts on people.

The ESG space should evolve to track whether companies are reducing negative impacts on the world, Taparia argues. And for now, rather than relying on outside ESG ratings, it may make sense for investors to compare corporate ESG performance themselves. “They should make their own judgments, and do their own research,” he says.