The World May Be Better Off Without ESG Investing
With environmental devastation and social injustices pushing the planet to the breaking point, a stronger environmental, social, and governance (ESG) ratings system is needed to ensure investors get the positive impact they're paying for.
At the core of the problem is how ESG ratings, offered by ratings firms such as MSCI and Sustainalytics, are computed. Contrary to what many investors think, most ratings don't have anything to do with actual corporate responsibility as it relates to ESG factors. Instead, what they measure is the degree to which a company’s economic value is at risk due to ESG factors.
The second problem involves how ratings firms assign weights to each ESG factor. A strong ESG performer might get a triple-A composite score, while an ESG laggard might be assigned a triple-C score. These scores form the basis for how ESG indexes and ESG funds construct their portfolios. This may seem like a legitimate approach, but it’s not. It is subject to human judgment and inconsistent access to ESG information, making for tremendous variability across raters. But more detrimentally, it permits companies to achieve high composite scores even if they cause significant harm to one or more stakeholders but do well on all other parameters.
For “conscious capitalism” enthusiasts, the rapid shift in capital flows is evidence that business can indeed be a force for good. But the system as it stands gives a pass to a large number of harmful actors, driving large fund flows to them and lowering their cost of capital, while CEOs and Wall Street executives celebrate a lucrative movement that they hope will improve their public image.