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Committing to ESG despite the flaws

A Refresher on ESG

Environmental, social, and corporate governance (ESG) is an approach to evaluating the extent to which a company implements social goals that go beyond the role of the corporation to maximize shareholder value.

ESG investing is a form of socially responsible investing that prioritises financial returns in parallel with their impact on the environment, its stakeholders, and the planet.

Introduction

There’s no easy way to say it; ESG investing is flawed. Capital that flows from investors intended to support ESG companies doesn’t always reach them. ESG investing demonstrates this market inefficiency and the limitations of well-intended capital.

One could argue that investors need to pay attention and ensure they know where their money goes, but that’s much easier said than done. Take one look into the ESG investments space and observe a notable lack of consistency in how institutions justify, calculate and present the decision-making around fund inclusion criteria for ESG and sustainable funds.

The recent move by the S&P 500 ESG Index to drop Tesla but include ExxonMobil has highlighted an ongoing debate over the value of ESG ratings, and the implicit presence of greenwashing (intentional or otherwise) that currently pervades many aspects of the industry, from fund managers and rating agencies down to individual companies. 

Notable Examples of Greenwashing

Greenwashing is the innocent-sounding but highly damaging practice where issuers like fund managers and companies present themselves and their products as more environmentally friendly than they are.

When combined with a distinct lack of disclosure requirements, consistent ESG data, and arbitrary methodologies, it’s easy to see why there’s so much controversy in the industry that’s only recently come to light.

S&P 500 ESG Index (S&P Global)

Following the controversial removal of Tesla with the inclusion of ExxonMobil in their ESG Index, S&P faced backlash from Elon Musk with questions raised around how they could justify the decision.

Irrespective of Musk’s opinion (that ESG is a “scam”), a valuable point was raised around how ESG ratings should be more transparent given that their selection criteria excludes companies that deal in thermal coal and oil sands but somehow includes oil and gas companies that would drag on their environmental metrics, are being included in the index.

MSCI ESG Rating System (Bloomberg)

MSCI produces ESG ratings for other institutions to label and market their financial products, a powerful tool in a competitive market. The controversy here is their environmental rating methodology does not consider the impact of the company on the world, but rather the world on the company; a complete flip on what most would expect.

Companies that yield no environmental improvements like reducing emissions can get upgraded rating year on year as long as climate change doesn’t present any risks to their bottom line (e.g. McDonald's).

Almost 60% of retail funds that have plowed into ESG funds or products are those built off inconsistent and flawed MSCI ratings and of the more than 160 ESG rating providers in the US, rating disagreements are common as none of these companies follow a standardized set of algorithms or systems like one would find in other developed industries (think banking and the credit check system; same data, same regulations, near-identical outcomes).

Committing to ESG as a Company

So with that background on the systematic flaws that have resulted in 90% of stocks in the S&P 500 ending up in ESG funds built on MSCI ratings, a question remains for companies who look to participate in this transition.

Why are you looking to implement ESG frameworks and practices?

  1. If you’re purely looking to compete on the global stage with your industry peers, be aware that greenwashing will be prevalent and may undermine your genuine efforts to transition your company into a more attractive investor offering. Regulations are on the rise (ASIC in June 2022 and SEC in May 2022) but will likely take more time to effectively police the industry in the state it is now.
  2. If you want to enact change and lead the movement, join the regulatory conversation and rally with other companies and market participants to push change. A century ago, financial reporting underwent a process to become transparent, standard, mandatory, and audited. ESG needs to undergo the same transformation and there’s ample space to be involved for all stakeholders.

Why not pursue something simpler?

  • If you want to do good, do good.

Regulation will take time, greenwashing will be prevalent, and pushing for change does require additional effort and investment.

Reframe the transition away from a means to gain additional capital and interest, and towards a decision that benefits the wider world alongside your employees, investors and stakeholders.

No matter how the industry changes, you’ll be secure in your genuine efforts towards a more ethical and sustainable future.

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