Chloe Kauffman and Mason Robinson
October 31, 2022
In recent years, a growing cohort of individual investors have been considering and participating in efforts to tie their asset portfolios to their political or social values, a practice known as ‘socially responsible investing’ (SRI). While SRI can be—and has been—employed in a multitude of ways, including refraining from investing in companies that manufacture and sell addictive substances, some have sought to achieve social investment in recent years through investing in firms with high ESG ratings. ESG—first conceptualized in a 2004 “joint initiative” invitation from the United Nations to 50 major financial institutions—grades publicly traded companies on the basis of their environmental, social, and governance policies/performance. Specifically, these categories entail performances on corporate climate initiatives, pollution, board transparency, employee diversity, and labor practices, amongst other criteria.
In strict terms of the amount of capital under management, ESG investments have set consecutive records in recent years. Global ESG assets under management (AUMs) surpassed $35 trillion in 2020 (up nearly 15 percent from the end of 2018, up 33 percent from the end of 2016) to become a third of total global AUMs and, by some estimates, are expected to exceed $50 trillion by the year 2025. 94 percent of these firms are concentrated in Europe and the United States, with the United States holding 13%. Despite the perceived popularity of using ESGs to obtain SRI, there are reasons to be highly cautious of ESG ratings when determining socially responsible investment strategies.
While having investment holdings in highly rated ESG firms may show concern for sustainability, a high ESG rating is not associated with a strong investment holding. A joint study by professors from the London School of Economics and the Columbia Business school found no evidence of ESG investment funds outperforming non-ESG investment funds, showing that ESG ratings are unreliable regarding increasing investment returns. They also found that ESG funds have violated more labor and environmental laws than non-ESG firms. ESG-based investing does not provide any additional benefits compared to non-ESG based investing, on both the basis of the ESG-graded value or the monetary value of an investment.
In 2021, The Securities and Exchange Commission (SEC) created the Climate and ESG Taskforce to “proactively identify ESG-related misconduct” because of the unreliability of ESG ratings and misconduct in correctly allocating ratings. The SEC dedicated an entire task force to catch misconduct, illustrating the severity of the harm ESG ratings can cause. Professor Theo Vermaelen cited that ESG funds mislead potential investors by promoting things like: “Investors in the fund will (1) reduce global warming and (2) do this without giving up returns.” The primary issue is that often, a company’s ESG rating is not synonymous with its actual climate actions, nor does it guarantee positive investment returns. A model created by professors Lubos Pastor, Robert F. Stambaugh, and Lucian A. Taylor predicted that ESG assets, or green assets, “underperform” non-ESG assets “over a sufficiently long period”. An ESG score does not even guarantee that a company follows the guidelines outlined, as it only allocates a weighted scale to companies, at the discretion of the firm allocating the score to the companies.
Additionally, the ESG ratings themselves are not reliable. Many firms receive high environmental and social ratings despite having negative human rights/labor records or having questionable environmental impacts. A key example is the SK Group and the collapse of the dam they built in Laos. Before the catastrophe, the parent company, SK Inc., had an ESG score of BBB from the firm MSCI. Following the collapse that displaced thousands of people and killed at least 70, the parent company received no change to its score. Instead, three months following the disaster, the score was increased to A by MSCI. Now the parent firm has a score of AA, relative to the highest MSCI score of AAA.
ESG investing has become a fad investing approach for a growing number of individuals who wish to tie their social values with their portfolios. While ESG ratings offer an accessible metric to achieve this, their shortcomings—reduced investment returns and misleading results/marketing—should prompt serious concern from investors wishing to have a sustainable portfolio. At best, ESG ratings are merely another form of mass marketing used by firms to attract investors and should be treated as such.