ESG is Broken — But Can it be Fixed?

Environmental, social, and governance (ESG) ratings were supposed to provide ethically-conscious investors with criteria to measure non-financial factors like carbon footprint and diversity, equity, and inclusion efforts when evaluating potential business investments. As a tool for raising corporate accountability, the criteria were initially adopted enthusiastically by fund managers and investors. According to Business Times, by the end of December 2021, “$28 trillion in global assets were reported to be managed under ESG principles.” McKinsey reports over 90% of S&P 500 companies now publish ESG reports.

But despite — or perhaps as a result of — their widespread adoption, the tides began to turn on ESG in 2022. “In the first quarter, all large-cap US stock funds fell an average of 5.6 per cent on an asset-weighted basis,” reports Business Times. “The ESG funds in the group did worse, falling almost 7 per cent.” At the same time, questions began to be asked about whether ESG measures were valid or, indeed, had any meaning at all.

To understand the origins of the backlash, let’s dive into the fundamental issues underpinning ESG investing — and assess the possible solutions.

ESG - what went wrong?

From a lack of uniform standards to accusations of fraud, there are several reasons ESG has come under scrutiny in 2022. Let’s take a closer look at some of the most problematic — and interconnected — issues.

1. A lack of standardization

Despite its aspirational goals, in practice ESG lacks uniform standards and is up to a wide range of interpretation — and implementation. According to The Economist , “The ESG rating agencies are the veritable acme of inconsistency. A study of six of them found that they used 709 different metrics across 64 categories. Only ten categories were common to all—and they do not include such basics as greenhouse-gas emissions.”

The state of stock indexing fares no better. The Economist reports that in May 2022, “S&P Dow Jones Indices kicked Tesla out of the ESG version of its S&P 500 index, while keeping oil giants like ExxonMobil in.”

Such confusion and contradiction have most certainly gone a long way to undermining faith in ESG ratings.

2. Greenwashing*

*Disinformation disseminated by an organization so as to present an environmentally responsible public image.

In June 2022, the Grantham Research Institute on Climate Change and the Environment and the Centre for Climate Change released a report on global climate change litigation that found the number of climate change related cases had doubled since 2015. The report identified “Climate-related greenwashing litigation” — the act of holding companies legally accountable for climate misinformation — as a rising factor in this uptick.

High-profile accusations of greenwashing have been leveled at major companies like KLM and CocaCola, but in May 2022, when Deutsche Bank subsidiary DWS was raided over “allegations of misleading investors about ‘green’ investments,” the potential for greenwashing of ESG ratings came under widespread public scrutiny. The Economist identifies 2022 as “a year in which ESG has turned from an investment craze attracting trillions of dollars on promises to make the world a better place into a source of eye-rolling cynicism.”

3. The “inherent hypocrisy” of ESG ratings

Just as ESG’s questionable standards have opened the door to greenwashing, so have accusations of greenwashing revealed the hypocrisy undermining ESG investing’s apparent good intentions.

“The torrent of greenwashing surrounding ESG investing proves that the industry can’t rely on self-governance,” reflects fintech consultancy 11 FS. “Instead of positive action, ESG investing has caused an epidemic of virtue signaling and window dressing.”

At the heart of this hypocrisy is the inconvenient fact that ESG measures, as The Economist puts it, “the risks that climate change pose to a company, rather than the threat the company poses to the climate.” If ESG is to rise above the accusations of greenwashing and virtue signaling, it must not only hold corporations to account but also incentivize a culture of actionable change.

4. Is ESG compatible with 'shareholder value'?

A more fundamental question has also been raised about whether adherence to ESG principles goes counter to a corporation's obligation to maximize value for its shareholders and other stakeholders. This is discussed in a recent post on the Harvard Law School Forum on Corporate Governance. The author concludes that it does not, but the subject raises interesting questions about the role of business in society.

Working towards a future of ESG sustainability

The challenges ESG must overcome are immense but not insurmountable. Here are some of the best solutions for restoring credibility to ESG investing:

• Regulatory reform — In the wake of so many high-profile accusations of greenwashing, countries are beginning to address concerns over ESG standards with widespread regulatory reforms. The Financial Times reports the U.K.’s Financial Conduct Authority has recently cracked down on greenwashing “with proposed restrictions on investment managers using terms such as ‘green’ and ‘ESG’ in fund marketing and a new set of consumer-friendly labels for sustainable investments.” According to Reuters, China has also begun standardizing guidelines for ESG initiatives.
• Focus on one measure: emissions — The Economist believes the simplest way to solve ESG’s “dizzying array of objectives” is to focus on the environmental component of ESG. Specifically, emissions. “Investors and regulators are already pushing to make disclosure by firms of their emissions more uniform and universal. The more standardized they are, the easier it will be to assess which companies are large carbon culprits—and which are doing most to reduce emissions.”
• Don’t just mitigate harm, prioritize regeneration — Considering ESG’s questionable reputation, the Institute of PR wonders “whether sustainability can ever be truly ‘sustainable’ if what it means is merely controlling our human urge to consume nature’s resources.” But if ESG can find a way to prioritize restorative efforts — such as carbon sequestration and regenerative agriculture — it might one day facilitate true accountability, if not a measurable improvement.

Though ESG’s reputation has been tarnished by recent allegations of greenwashing and hollow virtue-signaling, a positive outcome is still on the table. The experts at McKinsey believe the underlying idea of ESG “has not peaked; indeed, the imperative for companies to earn their social license appears to be rising.” If countries continue prioritizing regulatory reform, and ESG better defines its standards — or narrows its focus entirely — then perhaps credibility can be restored to ESG investing and may bring closer the corporate change that the measures were created to promote.