Can You Trust ESG Scores?

What could be more central to ESG investing than ESG scores? As concern for the state of the world grows, investors consider Environmental (E), Social (S), and Governance (G) factors in their decisions with increasing urgency. The acronym ESG is sometimes used as shorthand for socially conscious investing. Critics say the scoring system behind ESG, however, lacks consistency and has motives that are not socially conscious. Are the critics right? Can we trust ESG labels? Or are “socially responsible” investments a sham?

Consider the premise of the scores. Generally, they serve to measure non-financial aspects of a company. In 2006, not long after ESG’s first appearance, the United Nations Principles for Responsible Investment (UNPRI) was founded with its first principle being to “incorporate ESG issues into investment analysis and decision-making processes,” which brought the idea front and center. Anyone who became a signatory would have to square this with existing missions to maximize shareholder value. In 2006 and today, this is most easily accomplished by using ESG to assess business risks to a company, as opposed to an ethics-driven approach that assesses the damage a business causes (or reverses) in the outside world. Do investors want a business risk-driven approach? Are some trying to invest ethically? The vague definition of ESG makes it hard for the casual investor to spot the difference across the market.

Do scores mislead investors?

The Global Sustainable Investment Alliance defines sustainable investment inclusively as “an investment approach that considers environmental, social and governance (ESG) factors in portfolio selection and management.” Making up 35.9% of total assets under management in 2020, it is hard to argue every one of these investors turned to ESG out of concern for business risks. ESG ratings are not a problem when they help investors find suitable investments. But when unregulated scores are marketed to mislead investors, presenting as ethics-driven when they are really business risk-driven, the practice becomes what many call greenwashing.

ESG scores come from ESG ratings agencies. No US government agency currently regulates or oversees the administration of their ratings. Still, MSCI, Sustainalytics, and other ratings agencies give investors and fund managers a quick and easy way to know which companies score well. Scoring systems are generally explained on the rating agency’s website. Despite this, firms’ marketing can paint a different picture.

MSCI’s marketing gives the impression that MSCI helps enable “better decisions for a better world.” MSCI’s chief executive, according to Bloomberg reporters, concedes that “ordinary investors piling into such funds have no idea that his ratings, and ESG overall, gauge the risk the world poses to a company, not the other way around.” He told the reporters “I would even say many portfolio managers don’t totally grasp that,” noting that they have a fiduciary duty to their clients.

Some ratings genuinely aim to highlight companies that have a positive impact. These can be useful to the socially conscious investor. Humankind Investments takes this approach by using research to calculate the net value that companies add to humanity. This research forms the basis for the Humankind Rankings. Investors should understand that ESG scores can have different goals and certain ESG scores do not necessarily measure companies’ positive impact. Knowing this, they can be wary of marketing and read the fine print to avoid being misled.

Are ESG ratings inconsistent?

ESG ratings vary. Without much regulation or standardization, one agency’s ratings are bound to be different from those of the next. There is a lack of guidance on which issues take precedence: the environment, social justice, animal rights, Christian values, or something else. The biggest agencies put financial materiality first, while niche agencies might choose a particular issue or take a holistic approach to corporate goodness. With many ratings systems, it is harder to find those that help investors make a positive impact. It would be simpler for there to be one accurate rating system. Still, a varied field means smaller firms that truly focus on positive impact can make their mark alongside big agencies.

Do ESG ratings promote bad companies?

ESG critics point to the hypocrisy of elevating companies that have negative effects. Companies might score well but do not fit their vision of “sustainable.” It is true that polluting, discriminating, price gauging, or causing addiction harms people. However, companies may be rated well overall thanks to the impact they have in other areas. The industry lacks a consensus on what issues should be weighted more heavily than others.

Following a simple cost-benefit analysis, ratings agencies would not be wrong to give a company a good rating for developing drugs that save millions of lives, even if they don’t use clean electricity at their facility. There is no such thing as a perfect company. That said, some issues have a markedly lower impact on humanity than others but are weighted the same in some ESG scoring systems. This can make ratings misleading. Imagine a company with no board diversity and a terrible impact on the environment. If it wanted to improve its overall score, it could bring in executives from minority groups and, without other tangible changes, gain many points on some ESG scales. A system where every category holds the same weight allows the company to cover major problems in one area with favorable scores in another, less impactful area. That is why research is important to understand the true impact of each category. Doing so might help scores correlate with positive impact.

Is ESG counterintuitive?

We’ve covered one way ESG is counterintuitive: that the most common ratings care most about business risks. Do they still align with the positive-impact goals of the socially conscious investor? Regarding emissions, in most cases, a low emitter will score well in environmental (E) metrics. But a company with high emissions? Under frameworks such as MSCI’s, the company might be at risk of losing out on profits in the case of stricter climate regulation. For the company to keep its ESG score high, it is in its best interest to lobby for politicians who oppose stricter climate regulation. Success for this company’s rating is installing a legislator who allows for high emissions with few consequences, so the company can continue to pollute and generate profits. It is possible for ratings systems to influence behavior in a way that adds to the problems investors might have hoped to improve.

What is the tradeoff of investing ESG?

Just as there is variation in ESG scoring, there is also variation in how ESG portfolios are crafted. Some put their faith in well-known ratings systems. Some are truly committed to measuring and investing for positive impact. Demand for sustainable products prompts some managers to raise fees, but others want to offer impact investments at a low cost to investors. Some ESG funds contain similar holdings as standard large-cap index funds. It is hard to name any one trade-off to investing in an ESG fund because of the variations within the field.

The future of ESG ratings

When people learn that a fund, advisor, or company considers ESG factors, many take this to mean that they care about company’s positive impact in E, S, and G categories, at least a little bit. A closer look reveals that big players are protecting against business risks in these areas, thus establishing a “sustainable” business model separate from an ethical approach.

People clearly have a demand for ESG investments, whether investors aim to mitigate risks or make the world a better place. The industry needs a better way to inform investors which is which, to help them align their investment activity with their goals. At Humankind, we research which issues have a stronger impact on people and which ones affect the world to a lesser degree for the purpose of making a positive impact. We believe the numbers can inform us on what issues should be top-of-mind.

For ESG investing to flourish, the segment needs to build trust among its investors. Despite an imperfect set of scoring systems, there is hope for socially conscious investors to use their investment power for good when they know scores are easily understood and based on sound research.

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A company’s Humankind Value is an estimate of how much value the company creates for humankind, is published annually, and is current as of April 29, 2022. It is based on a quantitative analysis that calculates the comprehensive economic value of a company based not only upon its financial performance metrics but also on the costs and benefits to society from conducting its business. This calculation also attempts to take into account the Humankind Value of the company’s critical supply chain partners. The components of the calculation include: (i) Investor Value, which is the estimated value to investors on the basis of multi-year profitability; (ii) Consumer Value, which is the estimated value to customers based on the offering of a product or service; (iii) Employee Value, which is the estimated value to employees based on their salaries, bonuses and benefits; and (iv) Societal Value, which is the estimated unaccounted costs and benefits to society from the operation of the company’s business.

Humankind Investments calculates a single dollar value of a company’s Humankind Value, which is intended to capture the aggregate worth of a company based upon its economic impact on humanity, defined as investors, customers, employees, and society at large. It’s important to understand that this single dollar value of Humankind Value for a company is not a precise measurement of the economic impact that companies have on humanity – rather, it represents a best faith estimate based on Humankind Investments’ internal model of how these companies behave and what the estimated impact on humanity of their behavior is. In other words, Humankind Investments has created a simplified mathematical representation of the real world, and are using that to derive this single dollar value for a company.

Published on March 23, 2023.

References

Bloomberg Quicktake: Originals. ESG Ratings Are Not What They Seem. Bloomberg. 20 December 2021. Video. <https://www.youtube.com/watch?v=f_rrS-_giP8>.

Fang, Lee. Green-Colored Glasses. 27 June 2022. 5 October 2022. <https://theintercept.com/2022/06/27/esg-funds-corporate-responsibility-dei/>.

Global Sustainable Investment Alliance. "Global Sustainable Investment Review 2020." 2021. <http://www.gsi-alliance.org/wp-content/uploads/2021/08/GSIR-20201.pdf>.

MSCI. Powering Better Investment Decisions. 2022. MSCI. December 2022. <https://www.msci.com/zh/who-we-are/corporate-responsibility/powering-better-investment-decisions>.

—. "The MSCI Principles of Sustainable Investing." 2019. MSCI.com. November 2022. <https://www.msci.com/our-solutions/esg-investing/principles-of-sustainable-investing>.

PRI Association. About the PRI. n.d. November 2022. <https://www.unpri.org/about-us/about-the-pri>.

Simpson, Can, Akshat Rathi and Saijel Kishan. The ESG Mirage. 10 December 2021. Bloomberg. October 2022. <https://www.bloomberg.com/graphics/2021-what-is-esg-investing-msci-ratings-focus-on-corporate-bottom-line/?sref=nHQs8PiA>.

Wolfe, Kurt. "Who Regulates the ESG Ratings Industry?" Bloomberg Law (2022). Website. <https://news.bloomberglaw.com/esg/who-regulates-the-esg-ratings-industry>.

About the Author

Kristina Bjorksten is an Operations Analyst at Humankind Investments whose ambition is to make companies more sustainable and enhance the quality of life for humankind. She gained her industry experience at a broker-dealer and brings fresh ideas and an international lens to her role. She studied economics, earning her Master’s in European Economic Studies from the College of Europe and her Bachelor’s in Economics from UC San Diego.