the global system for evaluating corporate ethical credentials makes no sense

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As the war in Ukraine rages on, finance professionals on Wall Street and across Europe have recently sparked outrage by suggesting that investing in arms manufacturers should be treated as an ethical investment. In the fight against tyranny, they argued that such investment “preserves world peace and stability” and upholds “the values ​​of liberal democracies”. As such, it belongs to the increasingly lucrative investment category known as ESG or Environmental, Social and Governance.

ESG is considered a kitemark for socially responsible investing. If you tick a box indicating that you want your pension or savings to be invested ethically, whoever takes care of your money will put it in ESG funds, i.e. funds that only hold ESG rated companies.

Unfortunately, the label isn’t currently worth the paper it’s written on — and not just because of the defense contractor controversy. My recent research shows that this completely undermines the potential of ESG as a force for good. As we will see, however, regulators are at least taking steps in the right direction.

How ESG Works

ESG investing evokes the ideas of companies dedicated to a fairer and more sustainable world. You imagine them reducing carbon emissions and water consumption, creating good jobs with equal pay and opportunities, or ensuring they are well managed and accountable to shareholders, employees and customers.

From a standstill a decade ago, Bloomberg estimates that US$41 trillion (£31 trillion) of financial assets under management will carry the ESG label by the end of 2022. This figure is expected to reach US$53 trillion by 2025, or one-third of all assets under management globally – an incredible statistic. Yet the closer you look at what ESG means, the harder it is to get clear answers.

Companies are rated on their ESG performance by a multitude of rating agencies, the most important of which are MSCI and Refinitiv, both based in New York, and Sustainalytics, based in Amsterdam. These agencies produce opaque scores using different methodologies. Scores combine hundreds of entries that hide often inconsistent and incomplete data provided by the assessed company. There is no industry standardization and no regulation of ratings.

Equally troubling is how fund managers assemble the ESG funds they offer to financial advisers and hobbyists as investment opportunities. Any fund can be ESG labeled as long as the fund manager has taken ESG factors into account, but some funds are much more ethical than others.

There are broadly three types of funds. Those likely to be the most ethical aim for sustainable investing or reducing carbon emissions. Then there are those that exclude entire sectors like tobacco or the aforementioned arms manufacturers. You know you’re definitely not exposed to everything that’s excluded, but the logic behind what’s included can be harder to discern.

The third category is that of funds that have been renamed ESG. According to investment research firm Morningstar (which owns Sustainalytics), 536 funds across Europe were renamed this way in 2021, double the number that were similarly renamed in 2020, so we’re talking about much of the industry. Many funds have higher fees than non-ESG funds, suggesting this is an allure of relabelling.

What do the scores mean

There is also a fundamental problem with what ESG scores mean. For example, recent research found that dozens of big banks, including Wells Fargo, Citi and Morgan Stanley, achieved higher ESG scores despite increasing their lending and investment in fossil fuel companies.

This has been possible because rating agencies are only concerned with assessing environmental, social and governance risks external to a company’s ability to generate cash flow and earnings in the future (which the is called “materiality”). They are not concerned – contrary to what most people probably assume – by the risks the company poses to the environment or society. So when the rating agencies raised the ESG scores of these big banks, they were simply saying that the environmental and social risks to earnings were lower than before.

If arms manufacturers were to be considered ESG, you could apply a similar logic: the war in Ukraine has reduced the chances of these companies being hit by a period of peace in which they don’t sell a lot of equipment, so their ESG score should undoubtedly increase. The only reason this is not happening is because the defense sector is excluded from ESG funds for not being considered ethical in itself. Sectoral exclusions are arguably the only ethical judgment in this entire endeavor.

Investments in fossil fuels are not incompatible with higher ESG scores.
Ivory Red

ESG rating agencies have also used artificial intelligence and machine learning to make scoring even more pointless. They scour the internet for companies’ ESG disclosure statements and public opinion about the company’s activities on social media, and feed that data into algorithms that often boost the companies’ ESG scores.

The problem is that ESG disclosures are usually just marketing materials. Unlike companies’ financial reports, there is no legal obligation for them to be provided by certified public accountants. Companies can select positive facts and ignore anything they don’t want us to see. All of the US$41 trillion of ESG-rated stocks are colored in this way. My research calls this the “ESG echo effect.” This means that the more a company markets its ESG information, the better its ESG ratings.

Hope for the future

So what do regulators do? New EU rules introduced in 2018 make ESG reporting more meaningful by requiring large listed companies to report annually on a range of metrics alongside their financial reports. They must not only weigh the external risks to their profits and cash flow, but also how their activities threaten the environment and society (including both types of risk is known as “dual materiality”). From April 6, large companies listed in the UK must meet similar requirements (but only for climate issues at first).

The US has also just released proposals requiring corporate ESG disclosures, but only for climate-related risks and there is no dual materiality requirement. The Chinese appear to have taken a similar approach in new rules introduced in February.

The EU also introduced rules in 2021 requiring fund managers to define and label ESG funds specifically for the first time. This is a massive change that gives investors much more clarity on what they are investing their money in. Meanwhile, the EU and China have published proposals for international standards to define green investments and direct investments towards sustainable projects in six industrial sectors, with a focus on mitigating the climate crisis.

Overall, progress is promising, but it remains uneven. Many parts of the world have yet to accept requiring companies to perform a dual materiality analysis. Around the world, small and medium-sized companies need disclosure requirements, but with a lighter reporting requirement than large companies (just like for financial reports). Disclosures must be carried out by certified public accountants – even in the EU this remains voluntary. And ESG rating agencies need to be regulated: they have so far been largely ignored by regulators.

The fact is, there is a huge business opportunity in sustainable businesses. But for ESG to live up to its potential, we are still a long way from making sense of it.

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