Are ESG Ratings a Scam?

Are ESG ratings a scam image of Tesla

Are ESG ratings a scam? That’s how Elon Musk responded after Tesla was removed from the S&P 500 ESG Index in 2022. After all, why would S&P remove a trail-blazing electric car company from an index that rates companies on environmental, social and governance issues?

 

S&P’s reason is that Tesla fell behind its automotive peers in overall ESG performance. In her “Indexology Blog,” S&P ESG Indeces lead, Margaret Dorn, cited: a lack of a published low carbon strategy and code of business conduct; two events of suspected racial discrimination and poor working conditions at Tesla’s Fremont factory; and concerns about the safety of Tesla’s autopilot technology.

 

Note, S&P didn’t remove Tesla because of these concerns per se, but because of Tesla’s “current and potential future exposure to risks stemming from its involvement in a controversial incident.” Put simply, Tesla was removed because S&P judged it has a greater risk of scandals relative to some of its car industry peers.

 

In the same exercise, the S&P 500 ESG Index also removed Meta (Facebook, Instagram) from its ESG Index. It is not a major polluter either of course, so presumably it faced the axe because of its exposure to corporate scandals involving user privacy and data, and the risks of regulators coming down hard on the company.

 

The ESG Ratings Logic
Governance ESG

In the finance industry, the S&P’s ESG ratings logic isn’t necessarily a scam. In fact, its logic is common place. Asset managers have legal fiduciary responsibilities to protect investors from excessive risk exposure. Exposure to corporate scandals and long-term structural risks, such as climate change, can affect companies’ valuations and stock prices.

 

For this reason, conducting ESG risk analysis alongside traditional financial risk analysis is becoming the norm. Indeed, the CFA Institute offers a certification in ESG Investing that teaches financial professionals to understand and manage ESG risks to investors’ portfolios.

Hedge funds also incorporate corporate scandals in their strategies. The tactical difference is their software programs monitor for potential corporate scandals and companies to “short.”

 

 

ESG ratings usually score ESG risk management not impact

 

The existing ESG ratings systems are produced by analytical teams offering different qualitative judgements about how well companies manage material ESG risks. Asset managers can derive some value from this. Rather than going to the expense of hiring their own teams and developing their own ESG indicators and data, they can subscribe to use the qualitative judgements and data of many providers to understand how well a company manages ESG risks.

 

The S&P 500 ESG Index covers all sectors of the market. This is justifiable since financial regulators tend to emphasize the importance of investors maintaining a diversified portfolio. Within each sector, the S&P ranks companies on their ESG performance according to a group of indicators defined by S&P. Margaret Dorn mentioned that S&P derives some of the data they need to make judgements from the presence or absence of certain public documents and perception surveys carried about by S&P. Companies with the top scores in each sector make it into the Index. That is how Exxon Mobil made it into the S&P 500 ESG Index, relative to its fossil fuel peers, and Tesla didn’t make it in, relative to its automotive peers. It is a method known as “best in class” by ESG ratings insiders.

 

Bloomberg Businessweek carried out an in-depth investigation into MSCI, the leading ESG ratings company. The investigation also found that MSCI rates companies based on judgements about their ESG risk exposure, not their ESG impact.

 

Similarly, if you take the very informative Morningstar ESG Foundations Course, you will learn how Morningstar and its subsidiary, Sustainalytics, assess and rate companies’ material ESG risk exposures and the quality of their risk management.

 

 

ESG ratings aren’t a science

 

Despite their utility for some asset managers, ESG ratings don’t have a long academic tradition behind them. Business schools have only become interested in the topic within the last decade, and most large companies only started to report ESG data in the same period.

 

There is very little historical data to tell us which indicators matter most for measuring ESG performance and there is no academic method for turning ESG raw data into judgements about ESG ratings. We also have to rely on the data that companies voluntarily disclose and data based on perceptions.

 

That is why currently, ESG ratings from different providers don’t statistically correlate with one another. There is lots of space for human bias and error. I think this lack of agreed transparent and scientific method has made ESG ratings vulnerable to the accusation, including from Elon Musk, that individuals could “weaponize” ESG to accomplish overtly “leftist” political agendas.

 

 

ESG ratings can be used for “greenwashing”

 

Where ESG ratings providers are most vulnerable to accusations of scams, is that they are constructed with poorly understood methods. I’ve written before about the counter-intuitive nature of many ESG ratings systems. Whereas investors and consumers believe that ESG ratings systems rank companies by their beneficial effects, in fact they almost all rate ESG risks to company profits.

 

So when ESG ratings systems are used to design investment products, they can be misleading to everyday investors and consumers. Asset managers can present investments as more environmentally sustainable, socially responsible and ethical than they are when using the language of ESG ratings systems.

 

In the worst case scenario, ESG is used to deliberately mislead investors. In May 2022, German police raided the offices of DWS and Deutsche Bank over misleading claims to investors about ESG factors. The raid comes after the 2022 launch of the EU’s Taxonomy of Environmentally Sustainable Activities, which defines economic activities that can be properly described as sustainable to investors and consumers. Through the Taxonomy, EU regulators set a clear standard. They expect companies to report on their environmental impact and sustainability, and for investors to be able to easily access this data, which permits them to make decisions about the sustainability of their investments.

 

As European standards become stricter, the use of the ESG label is declining. The EU has experienced a decline in funds labelled as ESG, not because European investors are less interested, but because the standard for what constitutes ESG has become stricter in Europe.

 

Perhaps the German raid is a sign of a larger clampdown coming on misleading ESG claims from European and North American regulators and law enforcement. After all, the ESG investing industry is worth trillions of dollars. If, in fact, much of this money is not invested in sustainable and socially responsible activity, this will eventually amount to a giant scandal and further loss of public faith in the finance sector.

 

 

So was Elon Musk right or wrong about ESG ratings?

 

So are ESG ratings a scam? It depends what you want from ESG ratings. If you are concerned about managing ESG risks in a portfolio, you might find interesting information and analysis when you compare ESG ratings systems. If your concern is environmental sustainability, social responsibility and good corporate governance, you could do well to look at the raw company data to make up your own mind about whether a company is achieving the ESG impacts that you value.

 

Certainly, investors and consumers have the right to know what exactly is involved in the products on offer and what is behind ESG ratings system. It is a poorly understood area, and the risks of being scammed are there, as we see from active investigations by regulators.

 

Canada, EU, UK and USA regulators are all in the process of defining some level of regulations around company environmental disclosures, and some have active enforcement operations underway against companies using ESG greenwashing techniques. Perhaps further regulations will follow, to protect investors, and to promote public faith in ESG and the financial sector.

 

If you would like to learn more about ESG, check out our ESG for Beginners, videos and FAQ and become an insider in no time.

 

 
Tags :
Environment,ESG and Sustainability Standards,ESG Basics,ESG Ratings,ESG Strategies,Governance,Greenwashing,Social Risks
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