With environmental devastation and social injustices straining the planet, a more robust environmental, social, and governance (ESG) rating system is required to ensure investors get the positive impact they pay for.
Despite the second wave of the pandemic and post-election mayhem, nothing would have changed, and Philip Morris’ inclusion in the ESG club might have gotten more attention. There are 700 billion cigarettes sold by the company every year. Is it good at product safety, greenhouse gas emissions, diversity of the board, and other ESG factors? How did it get into the Dow Jones Sustainability Index (DJSI) North America?
The reason is straightforward. As corporate citizenship standards are so low, ESG investing, arguably the hottest trend in investing today can destabilize society and the planet in ways that would not have been possible if it didn’t exist.
The issue’s core is how ESG ratings, such as those provided by MSCI and Sustainalytics, are calculated. MSCI and Sustainalytics provide ESG ratings like those described in this article. Most ratings don’t take ESG factors into account when determining corporate responsibility. As a result of ESG factors, they evaluate whether a company’s economic value is at risk. Instead, they assess the extent to which a company’s economic value is jeopardized due to ESG factors. For example, a company may be a significant source of emissions but still receive a good ESG score if the rating firm views the pollutive behavior as well-managed or non-threatening to the company’s financial value. MSCI, one of the leading rating agencies, gives Exxon and BP an average (“BBB”) aggregate score, despite their existential threats. It’s also possible that’s why Phillip Morris made the DJSI. Rating agencies may view the company’s commitment to a “smoke-free” future as a reduction in regulatory risk, despite the company’s next generation of products still being addictive and harmful.
The second issue is how rating agencies assign weights to each ESG factor. Each company is rated based on various ESG factors, and a composite score is calculated by aggregating the scores. A strong ESG performer may
- receive a triple-A composite score, whereas an ESG laggard may receive a triple-C score. These scores are the foundation for how ESG indexes and ESG funds build their portfolios. This may appear to be a legitimate strategy, but it is not. Inconsistent access to ESG information and human judgment lead to significant variation in rating. A company can still have excellent other metrics despite a low composite score.
Consider the brands Pepsi and Coca-Cola. The major rating agencies give both companies high ESG ratings. They are also frequently among the most significant holdings of ESG funds, owing to their high rankings on metrics such as corporate governance and greenhouse gas emissions. Nonetheless, they primarily produce, market, and sell addictive products that contribute to diabetes, obesity, and premature death. As well as funding extensive research to avoid attention from their products’ health consequences, Pepsi and Coca-Cola use their clout to avoid taxes and regulations. Due to the high cost of diabetes in the United States, these companies may undermine their economic contribution by causing human and financial harm.
Technology companies like Alphabet, Amazon, and Facebook are also among the top holdings for ESG funds. They frequently receive high ESG ratings because their greenhouse gas emissions are predictable. However, only some people would consider them to be good corporate citizens. Amazon has poor labor practices and uses predatory pricing. In addition to their business models, Facebook and Alphabet promote dangerous hate speech and misinformation on the internet. Their products appear to contribute to a rise in mental health problems among young people. Academics, policymakers, business leaders, and attorneys general have all labeled all three companies as monopolies that threaten the existence of a free-market system. If a company’s core business model causes so much harm, it should be challenging to cover it up with “good behavior” on other parameters.
A large body of research has found a positive correlation between ESG performance and financial performance using ESG rating data in recent years. Their broad conclusion is that investing in ESG factors will result in higher profits and better returns for investors. However, there are several problems with this. The first is that positive links are typically minor and highly dependent on how profits are measured and over what period. The second point to make is that correlation does not imply causation. Aswath Damodaran points out in a recent blog post the ESG mantle is just as likely to make firms successful as it is to adopt the ESG mantle. Third, and most importantly, the positive correlation is primarily due to the abovementioned ESG rating system, which has shallow performance standards. Technology companies have been outperforming the market for years, which has driven most ESG funds to overweight technology companies. Finally, amplifying business models driven by algorithms is often harmful to society and could account for much of their revenue growth.
As we move towards a critical juncture in our understanding of environmental devastation and inequality, investors will increasingly want their portfolios to reflect those concerns. Blackrock and Vanguard, two large financial institutions, have launched ESG funds based on environmental, social, and governance indices. By 2020, these funds are expected to receive nearly ten times more than they did in 2018. ESG funds have been able to charge higher management fees due to their novelty. The rapid shift in capital flows illustrates the power of business, according to proponents of “conscious capitalism.” A profitable movement aimed at driving money to harmful actors and lowering their capital costs is being celebrated by Wall Street’s top executives and CEOs.
Having an entirely new rating system to quantify the true impact of corporate behavior on environmental, social, and economic factors is essential—one that calculates the costs of a company’s “market failures.” The failure of a market involves:
- Monopoly or monopsony, in which a seller or buyer has limited competition or outsized power.
- Negative externalities, in which a third party is directly affected.
- Environmental damage, including depleted forests, polluted oceans, and the clogging of our atmosphere by emissions.
Performing poorly on a single factor with high societal or environmental costs would not lead to a high aggregate score under such a system.
For example, despite being well-governed and environmentally responsible, a company that produces harmful food products would receive a low rating.
Market failures are so common today that most corporations rated in this manner would almost certainly receive low ESG scores, significantly reducing the number of ESG investment opportunities. As a result, the entire system and the lucrative management fees charged by investment firms capitalizing on ESG investing for “conscious capitalism” could come to a halt.
That may be what we require. CEOs have pursued “growth at any cost” strategies for far too long to maximize shareholder value. Despite ongoing disasters and injustices, they are portrayed favorably through an ESG rating system that obscures the nature of their corporate citizenship. To be true ESG leaders, they will have to pay their employees more, create less addictive products, and increase their costs to protect the environment. In other words, they may have to make a profit sacrifice. Being true to ESG will take a lot of work.
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