Environmental, social and corporate governance (ESG) investing – an increasingly popular trend in finance – is facing mounting scrutiny from both the public and regulators. It attempts to improve capitalism while dealing with the threats posed by climate change, thus focusing on both environmental and social goals to evaluate a company’s value. However, as an investment practice, it risks setting conflicting goals for firms, therefore distracting both the public and private sector from the important task of mitigating the climate disaster. With public interest in ESG investing skyrocketing, it is worth taking a closer look at this practice.
What is ESG Investing?
Environmental social and corporate governance (ESG) is an alternative approach to evaluating the extent to which a corporation works on behalf of social or environmental goals, as well as its commercial performance. The term ESG dates back to 2004 and it is oftentimes expressed through a numerical score. By evaluating a corporation or a fund in this way, proponents of ESGs hope to raise the cost of capital for polluting firms and encourage socially and environmentally friendly corporate behaviour.
With many governments gridlocked into inaction on climate change, some people feel that it is the firms’ responsibility to step up their game. By evaluating companies not just by their financial performance but also by their commitment to broader movements, proponents and policy-makers hope for alignment with the Sustainable Development Goals (SDGs) or the diversity, equity, and inclusion movement.
An example of ESG evaluation in a corporate environment might be a credit card company that invests in “data for good” programs – in which data is used to track the accessibility of financial institutions, or an oil and gas company that provides opportunities for investment in clean energy. The idea is that these investments in social or environmental goods will offset the concerns that investors may have and simultaneously raise the cost of polluting behaviour. Indeed, while the intentions behind ESG investing are good, this risks leading to greenwashing, a practice of companies that use marketing to convince the public that their products and business operations are environmentally friendly. And it may well be that the lack of a coherent and agreed-upon definition has encouraged those views.
Why Is ESG Investing Growing so Quickly?
A number of factors have pushed ESGs into the spotlight. With an estimated one-third of managed assets invested in ESGs – believed to be valued at around US$35 trillion – it is important to understand the reasons behind this astronomical growth. With climate change becoming an increasing threat to the world, more people have shown interest in wanting to align their financial commitments with their concerns about global warming and global injustice, particularly young people.
Seeing democratic and governmental institutions gridlocked into inaction, particularly with regard to legislation aiming to tackle climate change, people are turning to the private sector to solve larger societal problems. In fact, recent polling has suggested that a majority of people worldwide believe that companies should be responsible for paying for the growing cost of climate mitigation. Besides the public’s interest in ESG investing, the asset management industry is also increasingly attracted by it, since selling products that are billed as “environmentally friendly” or “green” is often a way to charge consumers higher prices.
Despite the seemingly good intentions laid out in the definition, ESG suffers from a number of fundamental problems. First, in attempting to simultaneously tackle such a wide array of objectives from the environment and social governance to diversity, equity, and inclusion, this still provides a poor guide for both investors and firms. Inevitable trade-offs are going to be made as competing objectives determine the ESG status.
The Economist recently laid out the prime example of Elon Musk and Tesla. As the CEO of Tesla, Musk is popularising electric vehicles (EVs) and, in theory, is helping to tackle the climate crisis. But what about the cost of lithium mining to the environment which supplies Musk’s EVs or Tesla’s corporate governance nightmare? While Telsa Inc. has since been dropped from the S&P ESG Index, this still warrants attention. Similarly, British American Tobacco was rated as the third-highest ESG performer, despite the obvious concerns around tobacco. Answering complex climate questions, such as how to facilitate just transitions or reach wind farm capacity without damaging the local ecology, quickly highlights competing goals in securing emissions mitigation. It is unfair and unrealistic to each of the goals put forward by ESG investing to suggest that conflicts don’t exist.
The second major flaw with ESG is how the ratings are calculated. The Organisation for Economic Co-operation and Development (OECD) and other regulatory bodies have questioned whether the ratings or numerical scores attached to companies are sufficiently transparent. ESG ratings consider all three pillars in scoring, but many companies may excel in one or two but perform poorly in another – all while maintaining a high rating.
Of increasing interest to the public and regulators is how the “E” in ESG is considered. Instead of measuring the impact that a company has on the Earth and society, ESG ratings measure the risk the world poses to a company’s profits. For example, in 2019, McDonald’s was responsible for producing an estimated 54 million tons of CO2 in emissions. However, in 2019, its ESG rating was upgraded after analysts determined that climate change did not pose a significant risk to the company’s profits.
These inconsistencies are reflected in recent research about ESGs. In a study conducted by the University of Columbia and the London School of Economics, they found that companies included within an ESG portfolio actually had worse compliance records for both labor and environmental regulations than those that were not included. They also did not find a significant change in the environmental or social behaviour of a company upon addition to an ESG fund. Other studies found that issues such as equitable pay for female employees tended to outrank climate considerations, once again highlighting the conflict in the definition of such fund.
What Can Be Done to Improve ESGs?
The increasing skepticism from both individual investors and regulatory bodies, coupled with turmoil in financial markets, have resulted in a decrease in money flow as well as slower economic returns for global ESG funds. Climate activists have also been calling for a rethink amid accusations of greenwashing.
The first point of action is increased regulation of the financial asset management space. At the end of 2019, the European Union outlined its Green Deal commitments. In March 2022, the US also introduced a climate disclosure rule proposal through the Securities and Exchange Commission (SEC) which opens the door for broad, federally mandated corporate ESG data disclosure. Taken together, these regulatory frameworks would clarify the expectations for disclosure for the companies and allow for more consistent, clearer, and high-quality reports for investors.
Many financial experts and ESG-skeptics have suggested the separation of the three letters: “E”, “S”, and “G”. The fewer targets that firms have, the better the guidebook and regulatory framework and the greater the chance of firms actually hitting those targets.
Perhaps it is easiest to simply focus on the “E” – the environment. But as has been discovered in the case of “green funds” or even “green NFTs”, it is clear that measuring the impact on the environment is still too broad. Perhaps the easiest and most significant way of measuring this is to consider emissions. There have already been calls for increased standardisation of a firm’s emissions disclosures. The more standardised, the easier it will be to make comparisons across firms and industries. This will make it clearer for the public as to where to invest their money and for regulatory bodies to track who is doing the most to reduce emissions.
A growing number of consumers, particularly young consumers, are choosing to invest in cleaner funds, even if there are increased up-front costs. Making it easier for those potential investors to understand a) which funds are actually environmentally friendly and b) what actually makes a difference in mitigating emissions will be significant in financing climate action.
Given the way they are currently structured, ESGs make a compelling argument for tougher government action and stricter regulation. It seems more clear than ever that transparent and consistent information lead by elected officials will do more to save the planet than catchy private sector abbreviations – ESG – and unregulated markets.
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