Contemporary activism has spawned an array of sustainable investment opportunities and interest in companies deemed to have impeccable ESG compliance has never been higher. The million-dollar question is whether investors and companies alike are genuinely concerned about ethically-oriented practices and not just feeling good through virtue signalling? It is after all unvirtuous to hop on the bandwagon merely because it is valorised as meritorious.
In the third quarter of 2020, responsible investment funds attracted a net inflow of £7.1 billion, almost four times higher than the preceding year. Realising that sustainable investing and returns are not necessarily mutually exclusive, investors around the globe are increasingly tapping into assets that seek to impact climate change, inequality and other world problems. As the popularity of ESG investing grows, so do its critics, with the most prominent counter narrative being the framework for evaluating ESG ratings is inherently subjective and esoteric.
A quick look at the observations and examples that elicited the clamorous antithesis is germane.
Yardstick of Ratings
In a 2019 joint study conducted by academics at the Massachusetts Institute of Technology and the University of Zurich, it was found that ESG ratings from different providers varied substantially, with the correlation amongst the providers averaging at 0.54. This suggests a moderate similarity in the ratings that lacks consistency, thus hampering efforts from various stakeholders to materially contribute to an environmentally sustainable and socially just economy.
There are more than 150 ESG rating systems employed by companies worldwide, making performance metrics hardly comparable. As former US Securities and Exchange Commission chairman Jay Clayton pointed out, the problem lies in the ‘over-inclusion’ of assessment criteria that aggregate data on topics as eclectic as human rights and waste management into a single score. As such, it is not surprising for companies including Exxon Mobil and British American Tobacco professing to have passed their ESG screenings with flying colours.
ESG Rating Providers
Investors usually turn to ESG scores issued by agencies when conducting due diligence on a prospective company. A study by the CFA Institute last month revealed that 73% of investment professionals in the UK did just that. Concomitantly, conglomerates such as MSCI and S&P have injected more capital into their ESG ratings business in a bid to cement their position as trusted providers. S&P has snapped up one of its rivals, IHS Markit, for $44 billion and MSCI could soon follow suit through a merger with FactSet.
But ESG rating providers have drawn flak for failing to spot governance and social failures. MSCI felt the heat after it reportedly gave fast-fashion retailer Boohoo an AA score in spite of allegations of labour violations against the company’s supply chain. It was also responsible for scoring Wirecard, which collapsed last year after its external auditor refused to sign off on the 2019 accounts due to fraudulent practices. Solvay, a Belgian chemicals multinational, was the recipient of an overall triple-A rating on ESG compliance from MSCI despite ranking below the industry average for toxic emissions and waste because it scored highly on other issues such as carbon emission and chemical safety.
These jarring instances have undermined the credibility of the ESG concept and leave many wondering if it is overhyped and oversold. It is impossible to have an overt and honest discussion about ESG if it gyrates upon weak to non-existent evidence of promised outcomes. It has been suggested that scrutinising the supply chain of a business and its interactions with customers might offer a more reliable reading. The emergence of a new wave of digitally-driven ESG data would ameliorate such scrutiny as it leverages on satellite imagery and blockchain-verified tracking to provide more accurate and relevant information to the stakeholders.
Now more than ever, investors must trust but verify. A recent study by Barclays shows most investors are not aware that investments ESG-labelled investments are virtually indistinguishable from those which are not in terms of portfolio composition or returns. Only fees differ and, unsurprisingly, are considerably higher for ESG-labelled funds with an average of almost 0.75% as opposed to less than 0.50% for non-ESG-labelled funds. When people feel good about partaking in investment initiatives that supposedly serve a good cause, they are lackadaisical about where their money is going. This has provided a fertile breeding ground for mendacious companies to propagate their red herring fallacies. Self-education would serve half-baked investors well in the long run.
It is common knowledge that independent non-executive directors (INEDS) are empowered to provide check and balance throughout the decision-making processes deliberated amongst the upper echelons of a company. By virtue of their pantheon, INEDs are expected to uphold the inherent Hippocratic Oath – to bring independent judgement on strategy, performance, resources and standards of conduct. The voting against the re-election of six INEDs of Top Glove Corporation, the world’s largest rubber glove maker by BlackRock Inc, over its handling of migrant workers’ health and safety earlier this month, is a wake-up call to all INEDs that their fiduciary duty is not something that can or should be taken for granted.
There is also a pivotal role for regulatory authorities to play. In South Korea, its financial watchdogs have obligated listed firms to disclose their ESG data from 2025 onwards. This policy framework does not stop there. The Korea Exchange, the operator of Seoul’s bourse, has set up a team dedicated to reviewing and reporting on companies’ ESG practices while an advisory committee with external experts has since been formed to provide consultation on the same. With such changes, stakeholders can begin to expect more prudence and homogeneity in disclosure from the impacted companies.
Making ESG Ratings Meaningful Again
As sustainable investments continue to mushroom, companies seeing dollar signs will endeavour to greenwash and gaslight unsuspecting investors and the wider public that fair is foul, and foul is fair. Many could be forgiven for thinking that ESG has lost its soul in the bargain. Exposing companies with questionable ESG ratings that hardly correspond to their practices is the first step towards salvation and redemption. As Carson Block, founder of Muddy Waters Research aptly puts it: “We want to pull their pants down in public and say ‘nothing green here’”.