ESG Doesn’t Measure Corporations’ Impact on the World
ESG, which stands for environmental, social and governance, is quite possibly the most celebrated, attacked and misunderstood tool for asset managers in the last decade. What ESG does and does not do are important distinctions that every investor needs to know.
ESG data typically measures how a company is managing the material, environmental, social, and governance risk factors facing a company. Using ESG data or integrating ESG data into your selection process provides an additional way to measure and manage risk in various market cycles, which may lead to enhanced performance. This is why even the big firms have adopted it – it’s another tool in the toolbox to make investment decisions.
However, using ESG data to choose companies does not mean that your investments will protect the environment or communities. In a Bloomberg report, the authors state “MSCI, the largest ESG rating company, doesn’t even try to measure the impact of a corporation on the world. It’s all about whether the world might mess with the bottom line.”
Take their explanation of a company – such as a textile manufacturer – that uses a large amount of water in its processes. Most investors assume that a high environmental or ESG score means that the company is managing its reliance on water by implementing new processes that use less water. But that is not always the case and can create confusion about the company’s actions and reasoning.
If one company changes it process to conserve water, but the other buys water rights from nearby communities, both reduce their “water risk” and MSCI – and many other ESG data providers – do not distinguish between the approaches. But the real-world consequences are vastly different with one company working to minimize their reliance while the other will get access to water before the community if there is a drought.
How Did this Get Turned Upside Down?
As the demand for responsible products grew and Wall Street saw the opportunity to capitalize on it, it was implied that using ESG data would protect the environment and produce social benefits.
“BlackRock and other investment salesmen use these ESG ratings, as they’re called, to justify a “sustainable” label on stock and bond funds.” In the field and in the media, ESG is used interchangeably with “sustainable” or “responsible.” This misrepresentation has confused thousands and is why investors need to be concerned about greenwashing.
Forty years ago, when the socially and environmentally responsible investing field started, the approach was focused on what the company produced and if that was harmful to society and if so, it “screened” out. The initial exclusions were on alcohol, gambling and tobacco, and soon were expanded to other external industries including firearms and fossil fuels. However, ESG ratings that looked inward, or at risks to the company primarily and preferentially above society, became the norm over time.
Now, “ESG ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders,” according to the Bloomberg article.
Mainstream firms declared “ESG” as the modern approach and tried to describe screening or ratings that measured a corporation’s impact on communities or the environment as outdated. The ubiquitous pictures of rolling hills, windfarms and serene water that often accompanies ads for ESG products implied that investors were helping save the world.
Too many people have been misled into believing they are investing in companies that protect the environment when they are not. It’s time for asset managers to be transparent about why and how they use ESG — and there are some signs that it is changing. At a recent national socially responsible investing conference, for the first time, every presenter made it a point to state that they were using ESG information in hopes of reducing risk and enhancing performance. There were no promises of saving forests by using ESG.
Asset managers need to be clear in their communications, refrain from misleading marketing, and sales teams need to stop overpromising.
Only then will investors get the honest descriptions they deserve.
–Leslie Samuelrich, President, Green Century