The Dark Side of ESG
Updated: Oct 7, 2022
When most people think of ESG, they think of a metric that shows if a company is doing good for the environment. In fact, that is exactly how the ESG industry is marketed. The E in ESG stands for Environmental, so it makes sense. Yet, why is it that even as ESG nears $40 trillion dollars in assets, greenhouse emissions continue to climb?
To understand why this is the case, you need to know that ESG is often misunderstood. Investors of ESG often don’t have the complete picture of the company’s ESG initiatives because there are no regulations regarding ESG. It is measured by an ESG score, which can either be evaluated by a private ESG firm, or by the investor themselves. That being said, each has their own way of measuring the final ESG score. Although the broad categories of Environmental, Social, and Governance have remained consistent, there is such a wide variety of factors used to calculate the score that exist, resulting in each private ESG firm valuing the factors differently. All of this confusion means some investors get a false impression of what their investments are actually going towards.
An example of how investors get misled is through greenwashing, a concept that has become increasingly widespread in the ESG world. Essentially, a firm can make a claim about sustainability or a sustainable initiative with no intention of following through for the purpose of boosting their ESG score. As a result, they can promote themselves as a sustainability involved firm to investors by doing the bare minimum and not actually implementing any beneficial practices. Additionally, according to Bloomberg Quicktake, companies can see an increase in their ESG score just because an ESG data providing firm decides to change how they evaluated the score. For example, McDonald’s was given a boost to their ESG score because ESG data provider MSCI decided to shift away from focusing on Mcdonald’s carbon emissions, and instead emphasize a new initiative which involved placing recycling bins in areas of France and the UK. However, it was discovered that many areas in which Mcdonald’s put up recycling bins were on the verge of implementing regulations which would have required Mcdonald’s to do so anyways.
MSCI is the leading ESG data provider by a large margin, so their ESG evaluations of companies have substantial impacts in ESG investing. In an analysis of 150 companies evaluated by MSCI, it found that the increases in score were attributed to factors such as corporate behavior, employment practices, data protection, and structure of boards. Surprisingly, only 1 of the companies saw an increase in score for a reduction in carbon emissions. As shown by the study, companies are not actually contributing to Environmental Initiatives which are promoted as a core part of ESG. This emphasizes how ESG scores are completely subjective. Investors may mistakenly assume that because a company has a high ESG score, they must be heavily involved in the environment in sustainability. However, this is often not the case.
On the positive side, regulations which can help clarify the ambiguity of ESG investing to the investor are currently being developed. In Europe, around 50,000 companies will soon be required to provide full information on the environmental and social impact they have on their surroundings. In the U.S, companies are being asked to report their greenhouse gas emissions by the Securities and Exchange Commission. As you can see, there has been an increasing demand for full ESG transparency from companies. The more information concerning ESG that companies make available to the public, the less misunderstanding there is about the true meaning of the ESG score.
Conceptually, ESG incentivizes companies to pursue initiatives for public wellbeing and engage in sustainable practices. In addition, it provides an avenue for investors to align their portfolios with personal values and support sustainable companies. However, concepts such as false ratings and greenwashing hurt the effectiveness of ESG in achieving its goals. As more and more companies are involving themselves in ESG for the financial benefit, companies motivated by profit will exploit and take advantage in a field without too many regulations. It is the responsibility of the government and major ESG data providers to understand this and minimize these obstructions. If done correctly, ESG can have a real impact on the world.