The idea of motivating public companies to “do good” through ESG mandates has gained momentum over the past decade. ESG attempts to advance social and environmental causes by using investment as a lever. The United Nations Principles for Responsible Investment project, for example, calls on signatories to “incorporate ESG issues into investment analysis and decision-making processes.”
But ESG is not what it purports to be. ESG is a flawed concept that mainly relies on aspirational “happy talk” for marketing purposes. ESG actually makes problems worse by diverting resources and attention from initiatives that could have a positive effect.
This article will examine what ESG actually does and how it is sold. In a future article, we’ll delve into the origins of ESG and the economics of so-called “impact investing.”
The first question to ask when considering ESG is, what problem is it trying to solve? The inquiry reveals three big misconceptions at work. Let’s look at each in turn.
ESG investing does not add capital to change initiatives. The first misconception is that investing according to ESG guidelines adds capital to causes like the environment or social change. That is simply false, says the Harvard Business Review.
To illustrate, of the estimated $3.5 trillion needed annually to address climate change, ESG investing adds nothing to the total, according to the author. “Unfortunately, [the] trillions [needed for climate change] are not the same trillions that are presently invested in assets managed according to many forms of ESG investing[.]” ESG investments are “dedicated to ensuring a return for shareholders, not delivering positive planetary impact.”
ESG ratings do not measure progress. A related misconception is that ESG ratings measure positive social or environmental impacts. But that isn’t true either, according to Bloomberg. 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” – are you, as a company, exposed to the risks of climate change? (Rather than what a company can do to reduce climate change.)
ESG funds are not catalysts for change. A final misconception is that ESG investing can be a catalyst for change by rewarding companies that “do good.” However, “[m]ost economists agree that it is virtually impossible for a socially motivated investor to increase the beneficial outputs of a publicly traded corporation by purchasing its stock,” according to an article in the Stanford Social Innovation Review.
And since most ESG investing is done on the secondary market, i.e., by buying stock from other investors or through indexed funds, the connection between investment and impact is even more attenuated.
Another problem is the absence of clear ESG standards. “Over the past decade, multiple organizations both IGO and NGO, have become involved in the development of ESG, however their publications typically produce general principles, rather than actual hard guidance,” according to the University of Chicago Business Law Review. The result is that ESG ratings are often meaningless “happy talk” or “greenwashing” with little substance.
Lack of guidance from U.S. regulators. In 2021 the U.S. Securities and Exchange Commission (SEC) called on the Division of Corporate Finance (DCF) to create guidelines for ESG investment disclosures, but only as they relate to environmental issues, per the University of Chicago. According to the authors, “The final action offered no guidance as to ESG factors or definitions…. It only required advisors and funds to declare how they determined their ESG ratings.”
At best, the SEC and DCF have offered vague guidance for the contents of a few prospectus disclaimers, to be tucked away in footnotes and printed in tiny, eye-straining fonts.
Lack of guidance from European regulators. The same lack of guidance prevails in Europe, origin of ESG mandates. Germany, Europe’s largest economy and a leader in ESG, put its efforts to develop clear ESG guidelines on indefinite hold after the invasion of Ukraine, citing “market instability.”
Similarly, the European Parliament’s Corporate Sustainability Reporting Directive of 2022 merely calls for ESG reports to be “understandable, verifiable, comparable, and . . . represented in a faithful manner.”
European ESG efforts, like those in the U.S., lack substance and clear standards. ESG guidance is left to fund managers and others with a financial interest in the outcome of their work.
Unregulated “happy talk” on ESG. In the U.S., ESG guidance largely falls to a little-known company called MSCI, Inc. “No single company is more critical to Wall Street’s new profit engine than MSCI, which dominates a foundational yet unregulated piece of the business: producing ratings on corporate ‘environmental, social, and governance’ practices,” writes Bloomberg.
The result is confusion in the marketplace, which is good for sales but little else, the Harvard Business Review reports. “Marketing materials of ESG funds make lofty statements about social or environmental aspirations, but the fine print reveals that the real goal is to assure shareholder profits,” the author writes.
Even MSCI agrees. Its CEO, Henry Fernandez, is reported to believe that “ESG doublespeak has confused most individuals, many institutional investors, and even some portfolio managers.”
There is much more to say about ESG with the first countries already pulling out of the Clean New Deal. For now, it is enough to conclude that ESG does not tackle the issues trumpeted in investment marketing materials, nor was it ever intended to. People who want to support positive change should invest into people initiatives rather than obscure / miasmic global programs.
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