The World May Be Better Off Without ESG Investing

(Photo by iStock/Newbird)

Had it not been for the rise of the pandemic’s second wave or the post-election mayhem, Phillip Morris’ addition to a club of companies that are supposed to be doing well on environmental, social, and governance (ESG) factors might have gotten a bit more attention. After all, the company sells 700 billion cigarettes a year. How could it have joined the Dow Jones Sustainability Index (DJSI) North America, one of hundreds of recently created market indexes that track firms purporting to rate well on product safety, greenhouse gas emissions, board diversity, and other ESG factors?

The reason is simple. The bar for what constitutes a good corporate citizen is abysmally low and may have made ESG investing, arguably the hottest trend in investing today, a greater force for destabilizing society and the planet than if it didn’t exist at all.

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. For example, a company could be a significant source of emissions but still get a decent ESG score, if the ratings firm sees the pollutive behavior as being managed well or as non-threatening to the company’s financial value. This could explain why Exxon and BP, which pose existential threats to the planet, get an average ("BBB") aggregate score from MSCI, one of the leading rating companies. It could also be why Phillip Morris made it onto the DJSI. The company recently committed itself to a “smoke-free” future, which ratings agencies might perceive as reducing regulatory risk even though its next generation of products remain addictive and harmful.

The second problem involves how ratings firms assign weights to each ESG factor. To compute a company’s ESG score, ratings firms score every company on a variety of ESG factors and assign weights to each of these factors, aggregating the results into a composite ESG score. 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.

Take the case of Pepsi and Coca Cola. Both companies get high ESG scores from the biggest ratings firms. They are also typically amongst the largest holdings for ESG funds, largely because they rank high on parameters such as corporate governance and greenhouse gas emissions. However, their core businesses involve the manufacturing and marketing of addictive products that are a major cause of diabetes, obesity, and early mortality. Pepsi and Coke leverage their power to prevent taxes and regulation on their businesses and fund large amounts of research to divert attention away from the health impact of their products. With the cost of diabetes now over $300 billion annually in the United States alone, the human and economic harm caused by these companies may outweigh their economic contribution.

Technology companies such as Alphabet, Amazon, and Facebook also tend to be among the largest holdings for ESG funds. They often get high ESG ratings because they are predictably low producers of greenhouse gas emissions. But few would consider them to be good corporate citizens. Amazon has deplorable labor practices and engages in predatory pricing. The business models of Facebook and Alphabet involve algorithms that have made dangerous hate speech and misinformation ubiquitous across the internet, and the companies' products have been tied to an increase in mental health issues in young people. All three firms have been labeled by academics, policymakers, business leaders, and attorneys general as monopolies that threaten the existence of a well-functioning free-market system. If a company’s core business model does so much harm, the cover-up through “good behavior” on other parameters shouldn’t be so easy.

Compounding the problem, a large volume of research has been published in recent years using ESG ratings data to demonstrate a positive relationship between ESG performance and financial performance. Their broad conclusion is that companies that invest in ESG factors will generate higher profits and better returns for investors. But there are several issues with this. The first is that the positive links tend to be small and very sensitive to how profits are measured and over what period. The second is that correlation doesn’t mean causation. As Aswath Damodaran points out in his recent blog post on the subject, it is “just as likely that successful firms adopt the ESG mantle as it is that adopting the ESG mantle makes firms successful.” Third, and most importantly, the positive correlation is largely based on an ESG ratings system described above, which has a very low bar for good scores. In fact, technology companies, which most ESG funds are overweight in, have outperformed the market for years. But there is an argument to be made that much of their revenue growth is a result of the amplification of business models driven by algorithms that are often pernicious to society. 

Confronted with the reality that environmental devastation and inequality are reaching palpable breaking points, investors worried about these issues are increasingly keen to have their portfolios reflect their concerns. To capitalize on this trend, large financial institutions such as Blackrock and Vanguard have launched hundreds of ESG funds, managing trillions of dollars, that mirror ESG indexes or invest in companies with good ESG ratings. Dollar flows into these funds constituted nearly 25 percent of total net flows into mutual funds in 2020, and were nearly 10 times greater than in 2018. For financial institutions, ESG funds have been lucrative—the novelty of them has permitted higher management fees. 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. 

To rectify the problems and quantify the true impact of business behavior on ESG factors, an entirely new ratings system is required—one that measures the economic, human, and environmental costs of “market failures” caused by corporations. Market failures include: monopoly or monopsony, where a seller or a buyer, respectively, has limited competition or outsized power; negative externalities, where a third party is directly harmed by the business; or environmental damage, such as decimated forests, polluted oceans, or our emissions-clogged atmosphere.

Under such a system, a company would not get a high aggregate score if it performed poorly on a single factor with significant societal or environmental costs. For example, a company that produced food products that assaulted human health would get a low score even if it was governed well and environmentally responsible. 

Market failures are so pervasive today that most corporations rated in this manner would likely receive low ESG scores, greatly reducing the number of ESG investment opportunities. The whole system—and the lucrative management fees that investment firms capitalizing on ESG investing charge for "conscious capitalism"—could grind to a halt.

Maybe that's just what we need. For far too long, CEOs have followed a “growth at all costs” mindset to maximize shareholder value. Despite ongoing catastrophes and injustices, they are being cast in a positive light through an ESG ratings system that obfuscates the nature of their corporate citizenship. To be true ESG leaders, they will have to pay workers more, make products that are less addictive, and increase their costs to protect the environment. In other words, they might have to sacrifice on profit. Being true to ESG will not come so easy.

Read more stories by Hans Taparia.