A look into recent investment trends reveals a move among socially-conscious investors to screen potential ventures by environmental, social, and governance (ESG) criteria. While these investors may be well-intentioned, the ESG criteria are misleading due to faulty algorithms, and they do not represent what the public generally believes sustainable investing to be. Instead, conscious investors should seek alternative investment methods to ensure that their sustainability efforts are not made in vain.
First, What is ESG?
The ESG movement encourages corporations to heed environmental, social, and corporate governance responsibilities, as well as obligations toward their shareholders. This growing interest has produced a demand for data on companies’ ESG practices.
ESG indices have, consequently, emerged as a method of ranking companies on their performance regarding the central tenets of ESG. Though varying indices exist, many of them are produced by monopolizing credit rating agencies. One such company, Morgan Stanley Capital International (MSCI), has a 40% market share within the ESG data provision market. More so, most data used by ESG indices are either unregulated or self-reported by each company.
Problem 1: A Monopoly
ESG investments have garnered a total value greater than $35 trillion, and this figure has increased by 15% over the past two years. The problem is that the majority of sustainable investment funds use data provided by firms like MSCI, meaning that the algorithms used at these firms virtually dictate the flow of trillions of dollars of capital.
Problem 2: Public Misunderstandings
Although ESG is a familiar name to most, the general public doesn’t know much about it. A 2020 poll found that only 30% of investors are familiar with ESG investing, but 70% say that it’s important to align their investments with personal values. This combination of enthusiasm and ignorance leaves the public open to appealing — yet misleading — investment opportunities presented by the ESG movement.
Though limited polling exists on the general public’s understanding of ESG, the idea that ESG investing facilitates environmental and societal progress is often left unquestioned.
However, ESG indices at firms like MSCI among others, are not measuring companies’ commitment to protecting society nor the planet.
In fact, according to MSCI, they are measuring “a company’s resilience to financially material environmental, societal, and governance risks.” Concealed by environmentally-conscious rhetoric such as “Doing Our Part,” MSCI admits that its ratings are not measures of “corporate goodness,” nor are they “focused on climate or rejuvenating the planet.” In other words, ESG indices are the opposite of what many would expect. They evaluate the resilience a company may have to risk from the environment, as opposed to the risks the company poses toward the environment.
Problem 3: Algorithmic Inaccuracy
Lastly, ESG indices are plagued with algorithmic inaccuracies and biases that limit their effectiveness:
From a sample of 155 MSCI rating upgrades, half were the result of changes to the MSCI algorithm — not any changes in company behavior. This inconsistency can create the illusion of progress when, in fact, there is none.
For instance, McDonald’s’ rating was increased from a score of BB to BBB because MSCI had reduced the significance of carbon emissions to ESG ratings down to 0% (despite McDonald’s producing more emissions than Norway). MSCI also rewarded McDonald’s for installing recycling stations at select locations in France and the UK. These changes were implemented in cooperation with government policy, so their value as evidence of McDonald’s taking sustainable initiative is questionable at best.
A study by NYU Stern found that there is a statistically significant positive correlation between the quantity of ESG data available on a company as well as its ESG rating. This suggests that the mere provision of data can lead to rating inflation, even if the reliability of that data is dubious.
As previously mentioned, a gap exists between what indices prioritize in their ratings and what the public wants from ESG. While 53% of respondents to a 2021 Bloomberg Businessweek poll said that they wished to prioritize environmental factors in ratings, only one rating of 155 MSCI upgrades resulted from changes to environmental policy.
The credit rating-like appearance of ESG Index ratings (e.g., scores of Triple A, Triple B, etc.) gives these rating firms an illusion of objectivity. Most ESG ratings are not only based on unregulated data, but also made through subjective decision-making and analysis that changes from firm to firm.
An overall combination of an industry monopoly, misunderstandings among the public, and algorithmic inaccuracies makes ESG investing a poor choice for the socially-conscious investor. Following such indices can result in unsustainable companies receiving investments because of both inaccuracies and biases built into the ranking algorithms.
Instead of relying on firms providing biased research, investors should explore the primary data for themselves. If ESG still seems too convenient of a tool to pass up, at least monitor the regular changes that firms are making to their algorithms. Conscious investors already have an interest in seeking alternatives to conventional investing pathways. Now it is time to seek regulated alternatives to the alternative.