Environmental, social and governance (ESG) issues are increasingly seen by investment companies and shareholders as a window into the future. For many, the term “ESG” brings to mind environmental issues like climate change and resource scarcity. These form an element of ESG, but the term means much more. It covers social issues like a company’s labor practices, talent management, product safety and data security. It covers governance matters like board diversity, executive pay and business ethics.
You're probably asking yourself, "How does this affect me?" We are entering a new stage of understanding of the linkage between investment performance and social impact. Previous approaches, such as socially responsible investing and environmental, social, and governance screening, have obscured the opportunities for higher growth, profitability, and competitive advantage that come from treating social and environmental issues as integral to a company’s core strategic positioning.
Consider the companies, identified on Fortune magazine’s annual Change The World list, that are delivering profit-driven social impact. Many of them do not achieve the top ESG rankings in their industries, nor do they have any significant presence of SRI funds in their share registry. Yet public companies on the Fortune list from 2015 through 2017 outperformed the MSCI World Stock Index by an average of 3.9 percent in the year following publication.
This has become a widespread problem for companies that chase the publicity that comes with Environmental, Social, and Governance (ESG) guidelines. The mantra for justifying this behavior is "companies that do well must also do good!" which has now been flipped into the maxim "companies must do well for doing good." It's tempting to accept something as true simply because it sounds nice, but there's no evidence to support this maxim.
In fact, the truth is the exact opposite. A recent study from the National Association of Manufacturers has asked the question — do ESG shareholder resolutions create or destroy value?
The answer is a definitive: "They destroy."
While the study suggests that participation in shareholder resolutions that force ESG guidelines does not significantly impact company returns, it notes that such resolutions are far from harmless, averring that such activism diverts resources toward goals besides shareholder returns and harms corporate governance.
A company's purpose is not to challenge social norms or service liberal guilt; it's to provide value to customers and shareholders.
For example, a company may rate well below its peers according to one ratings agency while simultaneously out performing them according to another. This is exactly the case for Bank of America, which was rated "below average" by RepRisk, but "well above average" by Sustainalytics.
Even more puzzling, they both cited many of the same factors in justifying their ratings. While just a single example, this inconsistency is indicative of the fundamental problem at the heart of the ratings process: currently ESG ratings are inherently subjective.
In addition to inconsistent methodologies, an analysis found that ratings agencies don't control for externalities as tightly as they should. For example, they use the same fixed scoring criteria for companies in different countries, despite the fact that they are subject to varying regulatory and disclosure regimes. As a result, American companies are at an immediate disadvantage to their European counterparts who are subject to more stringent disclosure requirements.
This is precisely the reason why Sustainalytics rates Germany's BMW as one of the best performers, in the 93rd percentile on its ESG rating, while placing Tesla in the 38th percentile. BMW, which made headlines for anti-competitive and illegal marketing practices, scored higher than an electric vehicle, energy storage, and solar panel manufacturing company whose core mission is to lower CO2 emissions.
In fact, Tesla also scored below another German company, Volkswagen, which has been embroiled in an emissions-control scandal for more than three years.
Yet this is precisely what occurs when publicly owned companies put ESG causes above the needs of their shareholders. And it's particularly galling for pension managers to do this with other people's money without first securing their approval. What's more, retail investors have no real power to push back — and may not even realize that companies use their resources in this way.
While deficiencies in the process don't render ESG investment meaningless, they do indicate that the agencies' influential findings must be viewed through a critical lens. It is imperative that investors understand what these ratings are: largely subjective and prone to serious methodological problems. They are not infallible, scientific measures of companies "doing good."
Given the widespread conflicts of interest, varying guidance, and opaque business practices inherent within the proxy advisory industry (the subject of ACCF's last report), it becomes clear that there are systematic failings within many unregulated parts of the financial services industry. Too much of the capital that Wall Street is deploying towards ESG investments is based on inconsistent, subjective, and faulty guidance raising serious questions about whether it is having the desired effect.
Greater oversight and reform of the ratings system must be seriously considered. Universal standards for ratings should be required in order to provide a level and transparent playing field for companies and investors alike. And agencies need to disclose how they reach their decisions, and their success rate in actually protecting investors from large-scale risks.
All investors need consistent and reliable guidance. A meaningful reform of the ESG rating agencies system would provide an important step toward ensuring they receive it.
Using ESG causes to chase publicity is a shameful abuse of someone else's money. A hedge-fund manager's effort to win plaudits at retirees' expense is just another example of arrogant Wall Street millionaires taking advantage of Main Street.
Fighting human trafficking, minimizing environmental impact, and so forth are all good causes. Our world is better off for the people who engage in them. But that engagement is better left in the hands of think tanks, governments, nonprofits, churches. Corporate America's job is to create value for its shareholders. If that value is set aside, those organizations will have fewer resources to carry out their mission.