The Big ESG Debate: What Are the Critics Saying And How We Respond

Introduction

Sustainable finance has brought profound shifts to the financial markets. Environmental, Social, and Governance (ESG) assets – defined as assets deemed by investors to have strong ESG-related characteristics – are expected to reach $41 trillion by the end of 2022, or one-third of total assets under management.1 The momentum that ESG has generated is clear through the enormity of funds, investment strategies, and policies that have erupted in the last fifteen years. One measure of this growth is the number of signatories to the Principles of Responsible Investment (PRI), a financial network upholding six principles related to sustainable and responsible investment approaches.2 In 2021, PRI signatories increased 26% YoY and total assets managed by PRI signatories surpassed $120 trillion.3 

Figure 1: Growth Trends of PRI Signatories and Assets Under Management. Source: PRI.

However, the ESG mainstream has not been met without critics. In fact, with fears that the “virtue economy bubble” may burst, ongoing investigations on ESG fund managers, and growing complaints on what qualifies as ESG, it seems justifications for ESG’s efficacy and value to its stakeholders is needed more now than ever.4

The following article will explore the criticisms at the heart of the ESG debate. First it will examine the conflict of interest between the “E”, “S” and “G” factors and the extent to which the three pillars of ESG support or oppose each other. Next, it will explore the limitations of ESG scoring and taxonomy and recent examples of greenwashing. Lastly, the article will review why certain critics claim ESG investing inherently challenges fiduciary duties. Alongside the presentations of these criticisms, we will provide our own perspectives to the ESG debate.

ESG Conflicts

The Economist’s “ESG should be boiled down to one simple measure: emissions” article sparked a debate over the efficacy of combining environmental, social, and governance issues under one ESG investment method.5 The question is simple: if sustainable finance is truly driven by a means to combat climate change, then are composite ESG scores the most effective way to identify the companies at the forefront of climate action efforts?6 A case study highlighting this dilemma is the recent delisting of Tesla’s stock from the S&P 500 ESG Index. While Tesla is an undoubted leader in climate technology and innovation, accumulating accusations of racist conduct, discrimination, and inhumane working conditions they have led to troubling concerns over its governance and internal operations.7 The stock’s delisting sent a message that an outperformance in the “E” pillar of ESG does not compensate for shortcomings in its “S” and “G” activities. Yet, the S&P 500 ESG index’s top 10 holdings include (See Figure 2) Apple, Microsoft, Amazon, and even Exxon Mobil.


Figure 2: S&P 500 ESG Index Top 10 Holdings as of November 6th, 2022 Source: S&P 500

In other words, compositing “E” “S” and “G” criteria create conditions for companies that should not be mistaken for climate change leaders to benefit from flawed ESG screening tests. ESG critics argue therefore that distinguishing environmental, social, and governance leads to more effective responsible investing.

Our response

The most concerning issue with ESG scoring is the fact that there is an inherent bias towards large corporations who have the resources and the power to participate in nonfinancial disclosure activity, which in turn have a significant impact on a firm’s ESG score. This is a common phenomenon as large corporations have inherently higher scores than smaller ones. More financial resources must therefore be provided to support mid-cap firms in order to make them competitive on a transparency level. Furthermore, while at times E, S, and G may oppose each other like in the case of Tesla, they also highlight the importance of supporting companies that are not only outwardly focused on green or social initiatives but also conducting themselves in a transparent and ethical way in their activities. Therefore, despite the fact that the scoring system is in need of a correction, the three pillars of sustainability, E, S and G do go hand-in-hand.

ESG Transparency

Closely related to the recent criticisms on grouping E, S, and G criteria under one composite score, other critics have started casting doubt on the methodology behind ESG ratings and taxonomy. ESG ratings carry a significant weight in the responsible investing universe and are pivotal in ESG portfolio construction. However, the correlation amongst top ESG scoring providers (e.g, Sustainalytics, MSCI) is on average 56%.8 Compare that with the fact that US credit rating providers S&P and Moody’s correlate 99%.9 In other words, there is a concerning lack of standardization amongst ESG scoring providers which may hinder investors from effectively identifying the top-performing ESG companies. To make matters more challenging, many investors rely on proprietary methods for ESG scoring and integration. The general lack of regulations surrounding ESG portfolio construction have perhaps enabled cases like Deutsche Bank (DB) and its subsidiary DWS group’s investigation.10 DB and DWS are under fire for “greenwashing” or misleading their investors by inaccurately marketing their activities as sustainable.11 While the investigation is ongoing, the raiding of DB’s Frankfurt office has sent critics demanding further ESG transparency and standardization.

Our response

Lack of consistent data prevents investors from accurately evaluating companies’ performance on environmental, social, and governance criteria and identifying serious risks, which could impede the growth of ESG investing. There has never been a more pressing need for both public and private companies to have access to trustworthy and auditable ESG data. A growing body of research continues to show that businesses with higher ESG ratings outperform their rivals, get better credit ratings, and have lower risk profiles. The ratings environment is mostly unregulated; there are dozens or perhaps hundreds of different systems from a wide range of sources. Due to this, at the recent annual UN climate change conference, COP26, an international ESG standard-setting body was introduced. The International Sustainability Standards Board (ISSB) marks a significant step towards the harmonization of ESG ratings. The ISSB’s role is to create a global standard for ESG disclosures and to help the major rating agencies become more uniform so that stakeholders can more easily assess and evaluate different companies with one another.12 Thus, there is significant evidence to show that a lack of uniformity in ESG rating systems negatively impacts investors and consumers, however, this issue has been recognized and is in the process of being addressed.

Fiduciary Duty and ESG

Fiduciaries have opposing points of view as interest in integrating environmental, social, and governance (ESG) aspects into investment procedures has expanded. According to one argument, a fiduciary obligation is “a legal duty to behave only in the interests of another party,” which traditionally means concentrating only on maximizing financial gains for that party. Therefore, a focus on anything other than the bottom line, such as ESG, would be considered a breach of responsibility unless it were thought to boost returns. That is precisely the argument made by proponents of ESG-based investing who posit positive ESG ratings contribute to long-term sustainable value and ESG risk factors have meaningful impacts on financial results. ESG risk factors could therefore be viewed as a useful input by a plan fiduciary. This dispute can be observed in the case of Blackrock. They claim that their participation in ESG initiatives is entirely consistent with their fiduciary obligations and CEO Laurence Fink has described ESG initiatives as advancing the interest of a company’s stakeholders. Whether one supRubeports the ESG agenda or not, it is obvious that it is not driven only by the desire to maximize investor profits.13 The sole interest rule requires investment fiduciaries to act to maximize financial returns, not to promote social or political objectives.

Our response 

While of course fiduciary duty is central to the financial sector and services, there is not enough evidence to suggest that ESG investing strategies and fiduciary duties are mutually exclusive. In fact, peer-reviewed academic papers have even suggested that companies with strong ESG profiles also have stronger operational and financial performances. One study found that higher ESG performing companies had statistically lower risk than companies with low ESG ratings.14 Another study found a positive correlation between governance scores and company stock price.15 When examining post-IPO stock performance and risk, another study found that voluntary ESG disclosure activity was positively correlated with reduced idiosyncratic risk.16

In addition, ESG investing places investors in a position to not only protect against downsides driven by climate change but also upsides related to financial opportunities in climate action and mitigation. There is enough evidence to suggest there will be market corrections that result from the global economy being fundamentally unsustainable, such as the ongoing energy crisis. ESG investing not only draws attention to the E, S, and G risks at the asset/sector/portfolio level, but also draws attention to the upside from positioning investments to capture the benefits of these technologies/corporations, which we can reasonably believe to occur when looking at trends in climate regulation, leadership, and policies. Companies need investors who are aware of the issues involved and what it will take to succeed if they are to fulfill the net-zero challenge. In conclusion, there is a growing body of evidence contradicting the idea that ESG and fiduciary duties are fundamentally at odds with each other. 

Conclusion

Overall, ESG measurements can be inconsistent and challenging to quantify, but they are becoming increasingly standardized as reporting standards are set by authorities. Investors of today are eager about trading money for change. According to a survey conducted by Domini Impact Investments, more than 50% of participants would be willing to give up investment performance to further their ESG objectives, (Islam, 2022).17 Therefore, despite the number of controversies about this ESG Debate, there is undeniable worldwide momentum for ESG enhancing shareholder value. Investors need to broaden their perspectives on sustainable investing because ESG is a factor in decision-making for all assets, not only those that are ESG-oriented.

Authors: Michael Katzovitz , Claudia Persico

Footnotes:

[1] “ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence,” Bloomberg, 2022. Available at: https://www.bloomberg.com/company/press/esg-may-surpass-41-trillion-assets-in-2022-but-not-without-challenges-finds-bloomberg-intelligence/.  

[2] “About the PRI.”

[3] “ibid

[4] “ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence.” 

[5] Harris, “ESG should be boiled down to one simple measure: emissions.”

[6] ibid

[7] Ewing, Gandel, “Sustainability Index Drops Tesla, Prompting Insult from Musk.”

[8] Berg, Köbel, and Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings.”

[9] Pérez et al., “Does ESG really matter—and why?”

[10] DW, “Germany: Deutsche Bank raided in ‘greenwashing’ probe”

[11] ibid

[12] Bloomberg Law, “Lack of Uniformity in ESG Ratings System Poses Risks, Opportunities”

[13] Rubenfeld and Barr, “ESG Can’t Square With Fiduciary Duty”

[14] Dunn, Fitzgibbons, and Pomorski, “Assessing Risk through Environmental, Social and Governance Exposures”

[15] Bruder et al., “Integration of ESG in Asset Allocation”

[16] Reber, Gold, and Gold “ESG Disclosure and Idiosyncratic Risk in Initial Public Offerings”

[17] Islam and Habib, “How impact investing firms are responding to sustain and grow social economy enterprises in light of the COVID-19 pandemic”

References:

Berg, F., Kölbel, J., Rigobon, R. 2019. “Aggregate Confusion: The Divergence of ESG Ratings.” Forthcoming Review of Finance. Available at: http://dx.doi.org/10.2139/ssrn.3438533

Bloomberg. 2022. “ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence.” Bloomberg. Available at: https://www.bloomberg.com/company/press/esg-may-surpass-41-trillion-assets-in-2022-but-not-without-challenges-finds-bloomberg-intelligence/.  

Bruder, B., Cheikh, Y., Deixonne, F., & Zheng, B. (2019).” Integration of ESG in asset allocation.” Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3473874

Deutsche Welle. 2022. “Germany: Deutsche Bank raided in ‘greenwashing’ probe.”Deutsche Welle.  Available at: https://www.dw.com/en/germany-deutsche-bank-raided-in-greenwashing-probe/a-61986810

Dunn, J., Fitzgibbons, S., Pomorski, L., & Director, M. (2017). “Assessing Risk Through Environmental, Social and Governance Exposures.” AQR. Available at: https://www.aqr.com/Insights/Research/Journal-Article/Assessing-Risk-through-Environmental-Social-and-Governance-Exposures

Ewing, J., Gandel, S. 2022. “Sustainability Index Drops Tesla, Prompting Insult from Musk.” The New York Times. Available at: https://www.nytimes.com/2022/05/18/business/tesla-esg-index-musk.html.

Harris, Mark. 2022. “ESG should be boiled down to one simple measure: emissions” The Economist. Available at: https://www.economist.com/leaders/2022/07/21/esg-should-be-boiled-down-to-one-simple-measure-emissions.

Islam and Habib. 2022. “How impact investing firms are responding to sustain and grow social economy enterprises in light of the COVID-19 pandemic.” Available at:  https://www.sciencedirect.com/science/article/pii/S2352673422000452

McDaniel, P., Rosen, P., Chibafa, J., Hancocks, T. (2022) Lack of Uniformity in ESG Ratings System Poses Risks, Opportunities. Bloomberg. Available at: https://news.bloomberglaw.com/esg/lack-of-uniformity-in-esg-ratings-system-poses-risks-opportunities

Pérez, L. V., Hunt, D. V., Hamid, S., Nuttall., R., Biniek, Krysta. 2022. “Does ESG really matter–and why?” McKinsey Quarterly. Available at: https://www.mckinsey.de/capabilities/sustainability/our-insights/does-esg-really-matter-and-why

(2022). “Enhance our global footprint.” Principles of Responsible Investment. Available at: https://www.unpri.org/annual-report-2021/how-we-work/building-our-effectiveness/enhance-our-global-footprint

Reber, B., Gold, A., & Gold, S. (2022). “ESG Disclosure and Idiosyncratic Risk in Initial Public Offerings.” Journal of Business Ethics, 179(3), 867–886. Available at: https://doi.org/10.1007/s10551-021-04847-8

“S&P 500 ESG Index.” November 6th, 2022. S&P Dow Jones Indices. Available at: https://www.spglobal.com/spdji/en/indices/esg/sp-500-esg-index/#data

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