ESG is good for the environment but bad for business.
Which one is it? This is the beginning of the straddle. On the one hand, most retail investors (and politicians from blue states) who buy ESG do so because they want to save the world.
They want strong policies, not just wise advice for CEOs about how to look out for their interests. But on the other hand, rating agencies know they can’t tell pension portfolio managers to ignore their fiduciary duty to investors.
It might look like there’s no way around this. But there’s a way out. What if we look at a company’s self-interest over the next 20 or 30 years? (When defending its most vague ESG rating criteria, BlackRock emphasizes the word “long term.”)
It’s okay if CEOs of companies and experts hired by rating agencies don’t know what the world will be like in 2050. But, also, think about this: Laws and rules that haven’t been made yet will be among the risks of that future world. The original U.N. document discusses “increasing pressure from civil society to improve performance, transparency, and accountability, which can lead to reputational risks if not handled properly.”
Here’s the bottom line. By saying that laws and rules that will be in place tomorrow are a risk to a company’s reputation today, ESG raters say they know how our democracy will decide on all these issues in the future.
CEOs follow ESG guidelines despite not agreeing with the ESG raters about the long-term value of their companies, but to avoid reputational risk. In this way, the ratings are self-reinforcing in a strange way. They don’t need a reason.
When CEOs of companies say that adopting ESG standards is in the long-term interests of shareholders, they are telling the truth. But, of course, shareholders lose when there is bad press. But, as Ramaswamy points out, if you follow that thinking, ESG is not much more than “a protection racket.”
Let’s move on to the next problem with a definition. Let’s say we agree with this project as a whole. We want to determine the company’s risks over the next few decades. This includes risks that come from public policy. So how do we even start something so big? How do we know what the world’s risks will be in 2050? And how do we know which risks investors have already priced in and which they haven’t?
You can’t, is the answer? These choices are made at random. These choices are made at random. According to the people who rate companies, Philip Morris (PMI) is not at risk from regulation because it sells 700 billion cigarettes annually.
MSCI has given Coca-Cola a AAA rating because the people who do the ratings think that, while methane emissions are a new health risk, obesity and type 2 diabetes are not.
And since we’re talking about methane, let’s talk about McDonald’s, which puts out a lot of greenhouse gases. The MSCI rating for McDonald’s was recently raised to BBB due to the company no longer worrying about climate change. However, some utilities that emit much less are graded much more harshly. S&P removed Tesla (TSLA) from its broad ESG index (SPXESUP) in May because of problems in the workplace. This was done even though the company was the world leader in getting drivers to stop using carbon-based fuel. Exxon (XOM) stays on the index, though. Hmm? How do the people who rate compare bad bosses to warmer earth? You can guess just as well as I can.
That’s something else. Why do big energy companies stay on so many ESG indexes if carbon emissions are the biggest problem? The raters like to compare firms to others in the same industry.
So if you’re Exxon and you’re better than Chevron, you get to stay in (CVX). This needs to be clarified. Risk is a risk. So what if that means the whole industry goes down? Why don’t raters have more courage? Simple. They want to keep most companies from all sectors in the ESG index so that their return is similar to that of the whole market. They only go after the last ones standing, probably to put “social pressure” on the industry by making it more competitive.
Even when teams of experts work hard, they often come to very different conclusions about how dangerous something is. So the rating agencies start with the concerns listed in the original U.N. report: environmental, social, and corporate governance issues.
But the ways they measure risks for each of these issues are very different. One study of six rating agencies found that they used 709 various measures of risk across 64 different categories. All six agencies only used 10 of these metrics.
Not surprisingly, the fact that there is no standard method means that ESG scores are very different depending on who makes them. Credit risk ratings from other agencies agree 99% of the time, but ESG ratings agree just over 50% of the time. S&P Global gave Credit Suisse a terrible 15% score for corporate governance in January. This was a long way behind competitors like JPMorgan and Goldman Sachs. MSCI gave it a rating of A, which is about the same as the other two banks. Refinitiv was the least harsh, giving Credit Suisse an 81% score for governance.
Firms like Credit Suisse, which get a wide range of scores from different agencies, may be told to only talk about the best when they talk to investors or the general public.
Some companies may have fewer choices. And companies that want to be in the top-rated ESG ETFs may have to figure out how to do well on the MSCI index, which is used by most “green” funds now.
Lastly, let’s ignore all the problems with how these ESG ratings are calculated in terms of ideas and how they work in real life. Let’s say we could come up with a good, consistent score. What good would it do for society? That’s hard to answer. It gives big companies a big reason to eliminate “problem” operations.
Energy giants are selling off dirty refineries in the Middle East and Africa. Now, the Iraqi and Nigerian governments are in charge of these refineries. This doesn’t make the world much better. And some companies that have lost value because of the ESG stigma may decide to stay there as long as they don’t have any big plans for new capital expenditures. Many investors will be happy to buy them because the returns will be higher.
The best way to resolve this mess would be to get rid of ESG. The whole thing. Not only the “S” and “G,” but also the “E.” Businesses aim to make money for their investors in the long run. Usually, this mission serves the public interest.
When it doesn’t, the government (federal, state, or local, depending on the issue) is there to act in the public’s best interest. If, for example, you want companies to cut carbon emissions to help the people (to get rid of what economists call “negative externalities”), then do everything you can to pass a carbon tax. That’s clear, reasonable, open, and democratic. Everyone can talk about the issue, and then everyone can vote.
ESG, on the other hand, is indirect, doesn’t make sense, is hard to understand, and isn’t democratic at its core. It also messes up our government. Do we want to see different groups of blue and red states fighting over whose pension funds go to whose idea of how the future should be run?
It’s insane. Individual investors are free to think about what they want about where the world is going. And if you think we should be running things differently, you can try to change how we do things now. But if that doesn’t work, don’t force other people to invest the way you want them to.
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