Ethical investing gained the spotlight back in the 60’s during the civil rights movement and the boycotting of companies that either supported or were involved with the Vietnam War. People felt the push to align their investments and support companies that shared their personal ethics. Since 2005, we have seen the rise in popularity of ethical investing in the form of ESGs, this time with a broader focus which includes environmental, social, and governance factors, aimed to measure the sustainability of a company. There’s a certain “woke” element to ESGs driven by millennial investors around the world, but do these factors really encapsulate the morality of a company? Does it really help investors align with the companies that hold their same values?
ESGs are scored on factors like how a company effects the natural environment around it, if the company is meeting “green” legislation, how the company treats its employees and customers, if it supports the surrounding community, as well as the company’s diversity, its decision-making procedures, and its policies. In whole, an ESG score looks to grade a company on its direct and indirect effect it has on the wellbeing of others. On the surface, this seems like a great way to summarize how well a company may align with your personal ideals and beliefs. But, there are over 150 providers of ESG scores, with no regulated standard on how to grade a company. How do we know where a company’s ethics truly lie if each of these different providers use a different ideology to grade on? There are many unquantifiable factors involved, how are we to know what goes into the making of a company’s ESG rating?
MSCI, the largest provider of ESG ratings, posted on their website, “ESG ratings focus in on what’s significant to a company’s bottom line and compare it with its peer group.” And “we look at the company’s exposure to industry-specific risks, based on its business activities, size of its operations, and where it operates.”
There are many examples of companies receiving an upgraded score, even when they made no changes just because the ESG provider changed the focus or the way it weighted the score. For example, one fast food restaurant, whose emissions are greater than the whole country of Portugal, received an upgraded score. MSCI changed their grading focus by changing the rating of emissions from 5% to nothing, replacing it instead with an added environmental initiative. This “initiative” was the result of legislation mandating the restaurant to install recycling bins in select locations in Europe. In this situation, it looks like this company is making efforts to minimize its carbon footprint, but in reality its only maintaining the bare minimum requirements and receiving a higher score because of it. This makes it very difficult to analyze what a company’s ethical standing truly is. This is made even more difficult because companies aren’t required to track their ESG performance, allowing them to greenwash their companies and give a false impression.
In an interview done by Bloomberg, MSCI’s CEO was asked if he thinks investors have any idea that the entire system is based on the impact of the world on the company and not the impact of the company on the world, he responded no, he doesn’t think they have any idea. He even went on to say he thinks even investment managers who are putting these funds together don’t grasp it.
Another downside to ESG investing is its limits in diversification. You will have a much smaller pool of stocks to choose from which exposes you to the risks of those unique sectors. Portfolio managers may try to offset the higher risks by adding non-ESG or lower scoring ESG stocks. Many “green” investors may be surprised to find fossil fuel companies included in their ethical ESG mutual funds.
When investing, do your own research. Find the companies that align with your personal ideals.