The ESG (Environmental, social and governance) framework for investing has its origins in the 1990s when investing in socially responsible ways was coming to the forefront of financial markets and business strategies.
Financial instruments like SRI (Socially Responsible Investing) mutual funds and the CSR (Corporate Social Responsibility) business model were some of the key drivers of this change.
But it’s only in 2004 that the term ESG became popular thanks to a report titled ‘Who Cares Wins’ which was a joint venture initiative between the top financial institutions of the world and the United Nations (UN).
At surface level, the ESG framework makes complete sense. An ESG rating of an organization is based on a set of criteria that evaluate an organization’s exposure to long term environmental, social and governance risks. The idea is that some of the biggest risk factors like energy efficiency, worker safety/employee wellbeing and board independence have big implications:
- Financial implications for the organization, and;
- Real world societal and environmental implications for humanity overall in the long term.
Hence ideally, ESG ratings:
- Keep companies in check and motivate them to follow ethical practices in all aspects of their business.
- Help investors make more informed decisions and evaluate the long-term potential of the companies they’re investing in.
The key word here is ideally. The situation with ESG right now is anything but ideal.
Reading the explanation above you might think that you understand the basic premise of ESG ratings. Well, as it turns out, ESG ratings are supposed to measure the ESG Quality of an organization.
But ESG Quality itself does not have a single agreed upon definition. Which means that each firm has its own interpretation of what ESG means.
Factors to consider
So effectively, as an investor it doesn’t matter what you understand about ESG from broad explanations because in the end, it’s more likely that these ratings that are supposed to guide you to make sound investments are driven by a completely different ideology.
- One view is that ESG ratings are supposed to measure the company’s impact on its direct stakeholders like the employees, suppliers, customers, local communities, and the environment. As per this, the company can improve its ESG rating by reducing the impact it has on its stakeholders or engage in activities that neutralize the negative impact. This world view of ‘doing good’ is what most investors interpret when they think of an ESG rating.
- The other competing view is exactly the opposite. It seeks to measure the impact that societal and environmental factors have on the company. Under this framework, the company can improve its ESG rating by mitigating some predefined risk factors through strategic planning and targeted investment. The idea is that this short-term investment will have long term financial benefits. This competing view is what most rating firms adopt to evaluate ESG ratings.
And this is where things turn from complicated to deceitful.
For example, one of the largest asset management firms in the world, MSCI (Morgan Stanley Capital Investment), markets its ESG Indices and methodology as ‘better world’ investments.
But a Bloomberg BusinessWeek report found that MSCI uses the second competing framework and methodology mentioned above to publish ESG ratings. This framework has nothing to do with the misleading ‘better world’ picture that they’re trying to paint for the investors. It has everything to do with how external factors will affect the bottomline of the company.
Another example is that of Tesla. As a long-term retail investor myself, this was the breaking point of my trust in ESG overall. Tesla is widely known to be the disruptor of the automobile industry for bringing the electric car revolution to the masses and pushing other legacy car manufacturers to adopt the same route.
Surely this would fit the ESG criteria of ‘doing good things’ for the society and environment, right?
S&P Global, another juggernaut in the asset management world, removed Tesla from their S&P 500 ESG Index in 2022. While at the same time, one of the big players in the energy sector like ExxonMobil, primarily dealing with fossil fuel production was added to the index.
Other oil & gas production companies like Chevron, ConocoPhillips and Occidental are still amongst the top holdings in the index. To top it up, there’s no transparency about the intricate details of the methodology used to make this index or any evidence backing their claims.
Lastly, BlackRock, which is by any stretch of imagination the largest asset management company in the world (roughly $10 trillion), has been pushing American fossil fuel companies in its ESG portfolio to take drastic measures to reduce their carbon emissions and overall impact on the environment. They’re able to exert such pressures on their portfolio companies because they’re generally the largest shareholders in the companies.
But at the same time, they’re also one of the biggest shareholders (roughly 6.81%) in PetroChina (Chinese Oil & Gas exploration company) and there’s no evidence of them pushing for similar changes in the workings of this company. What’s the reason for this? I’ll leave this up to you to research and use your imagination. But it looks like a cocktail of hypocrisy and greenwashing.
Don’t get caught up in hype
Overall, I think it’s safe to say that retail investors should avoid getting caught up in the hype. I won’t be rushing in to invest in ESG Indexes or make investment decisions based on ESG ratings anytime soon.
As retail investors, the best we can do is to stick to the basics of long-term investing. Shortlist companies or indexes of interest or those that align with one’s values. Do in depth fundamental analysis to get a sense of the long-term potential of the investment. Prepare an investment plan that you can commit to.
Start investing and regularly monitor the performance of your portfolio companies and make any changes as and when the need arises.