Impact Voices | May 31, 2022

Three ways to reboot ESG for social value

Brad Swanson
Guest Author

Brad Swanson

ESG investing – short for Environment, Social and Governance – now accounts for about $15 trillion of assets under management in the USA, almost a third of the total. But it has sold its soul along its rise to fame.

Many investors think that an ESG score is a measure of a company’s adherence to socially positive practices. In reality, rating agencies typically gauge ESG risk in relation to a company’s profitability only – not its impact on the larger community.

The clearest example of this anomaly is a company like Altria, maker of Marlboro cigarettes, the leading cigarette brand in the USA, with a 43% market share. Given that cigarettes kill an estimated 8 million people annually, including half a million Americans, one would think that Altria, which derives 98% of its $26 billion revenues from tobacco, would have an ESG rating of, say, zero.

But actually Altria’s ESG score is “medium,” according to Sustainalytics, a market leader in ESG ratings. This is because Sustainalytics, like MSCI and other leading ESG rating agencies, assesses ESG risk solely from an internal perspective – the danger to a company’s bottom line from ESG issues. Since Altria doesn’t face much financial risk from selling cigarettes, the fact that Altria’s products can kill its customers doesn’t count for much in its ESG ratings.

Similarly, MSCI uses financial criteria only to evaluate the “material risks” and “material opportunities” that underlie its ESG ratings of 8,500 companies. In this topsy-turvy view, practices with negative consequences for society, like emitting pollutants, are not “risks” unless they incur additional cost, while positive social practices, like gender pay equity or truth in marketing are not “opportunities” unless they lead to higher revenues.

This logic explains how ExxonMobil can land on ESG indexes while Tesla gets booted. 

Time for a Reset

Defining ESG in profitability terms means that ESG ratings correlate well with financial success. That enables fund managers to promise investors that ESG funds will deliver returns that rival mainstream funds.

In fact, many large ESG equity funds simply duplicate much of the composition and weight of a broad market index to ensure that “tracking error” of returns against the benchmark is slight. For example, eight of the 10 largest constituents in the ESG Aware exchange-traded fund, managed by BlackRock, are also in the top ten companies in the MSCI USA index, a broad measure of total stock market performance.

ESG today is nothing more than the handmaiden of shareholder value, the notion that the only social responsibility of business is to increase its profits. This theory, popularized 50 years ago by libertarian economist Milton Friedman, has been used ever since to excuse any damage that corporations do to the environment and their communities.

To regain relevance as a measure of social good for investors, regulators, rating agencies and the broader sustainable investment community, ESG needs a reboot. 

First, ESG must take into account the impact of a company’s actions, whether intended or not, on the world in which it lives. Good corporate citizens should be recognized and bad actors exposed.

This means that companies whose business models harm consumers and the environment cannot be awarded high ESG ratings, no matter how well they manage risks in their operations. Similarly, companies that pay no taxes are simply passing on these common costs to the rest of us. 

As the famed Supreme Court justice Oliver Wendell Holmes said, “Taxes are what we pay for a civilized society.” Avoiding them should be called out in ESG ratings.

Second, the narrow focus of ESG on profitability must be broadened. Good and bad social practices must be assessed for what they are, regardless of their impact on the bottom line. Positive social practices cannot always be monetized. Doing well by doing good – the axiom that drives ESG ratings – is not absolute. In the real world, sometimes doing good entails a net financial cost. To the extent that tradeoff exists, ESG should capture it and make it transparent to investors.

Third, ESG raters must simplify and standardize their criteria so that investors can understand the rankings and hold companies accountable.

Currently, ESG scoring systems are needlessly complicated. Worse, they are hopelessly inconsistent, with different rating agencies giving the same companies widely disparate scores. Company credit ratings have a 90% correlation among different agencies. ESG scores?  Only 32%.  

Standardizing data provided by corporations, as the Securities and Exchange Commission aims to do with its proposed climate risk disclosures, is a step forward, but disclosures are only one source of input for rating agencies, which have a proprietary interest in keeping their inner workings hidden.

ESG rating agencies will keep peddling the false equivalence between ESG and profitability until their customers – investors – rise up and demand a reboot. For now, as net funds continue to flow into traditionally structured ESG products, the raters have no financial incentive to change their model.

But hope is on the horizon. Investor dissatisfaction with the internal contradictions of ESG is building, and raters are listening.  ESG 2.0 is no longer an impossible dream: a rating that scores stakeholder  value independently of its effect on the bottom line.

By refocusing on social value, not shareholder value, ESG 2.0 would provide a distinct input for investors to use alongside other factors – some financial, some not — in making investment decisions. Instead of being a byword for shareholder value, ESG could become a powerful force to drive substantial social progress through purposeful investment. 

Brad Swanson is a partner at Developing World Markets, a socially responsible fund manager, and adjunct professor of finance at George Mason University’s School of Business.