Home / Opinion / Views /  Watch out for special interests in today’s ESG gold rush

While Environmental, Social and Governance (ESG) investing has taken finance by a storm, opinion is sharply divided over whether it represents the wisdom of crowds or the madness of a mob. Previously, this column had provided extensive evidence against the ability of ESG investing to bring about desirable social change and empirical findings supporting its inability to generate superior risk-adjusted returns. Notwithstanding its social utility, the ESG bandwagon has wide ranging ramifications for investors.

One, it has spawned a multi-billion dollar pack of ESG rating providers who seem to have distinguished themselves by their utter inability to agree on what makes a company superior on ESG parameters. For example, every greenhead environmentalist aspires to drive a Tesla for its purported impact on reducing carbon emissions. However, the S&P disagrees. It dropped Tesla from the S&P 500 ESG index ostensibly for its lack of a low-carbon strategy. This is even more galling when one considers the fact that Exxon, hardly an exemplar of environmentally responsible corporate behaviour, is still part of S&Ps ESG index. Similarly, in India the MSCI rates ITC ‘AA’ on ESG. S&P concurs and rates ITC above average. However, according to Sustainalytics (another ESG ranking provider), ITC barely makes it to its median rankings on ESG. Practically speaking, a fund manager investing in ESG plays is not actually investing based on ESG, but on the interpretation of a rating agency she has chosen to use. An analysis done by The Wall Street Journal showed that while there was an 80% correlation between the ratings of different agencies for credit ratings, this correlation was only 30% for ESG ratings. This means that on average ESG rating agencies disagree on the rating of a firm 70 times out of 100. Berg, Kolbel and Rigobon (‘Aggregate Confusion: The Divergence of ESG Ratings’, 2022) confirm these low correlations for six ESG rating agencies and also document a ‘rater effect’, where a rater allows her overall view of the firm to bias ratings in specific ESG categories. Even more worryingly, Berg, Fabisik and Sautner (‘Is History Repeating Itself? The (Un)Predictable Past of ESG Ratings’) find that one ESG rating agency changed historical ESG ratings of firms with retrospective effect without explanation. The ESG rating provider Refinitiv upgraded 13% of the sample and downgraded 87% of it retroactively on ESG ratings. This means that many who thought they were investing in stocks with high ESG scores a few years ago now suddenly realize that they had actually invested in stocks with low ESG scores.

ESG data is so unreliable and difficult to interpret that researchers found, perversely, that greater disclosure on ESG by firms led to greater disagreement about its rating among rating agencies. This begs the question, how are investors supposed to invest in environmentally and socially responsible companies when no one can agree on what constitutes environmentally and socially conscious behaviour by companies?

The second fallout of the wave of ESG investing is the exploitation of investors who want to do well by doing good by corporations and the financial services industry. While “greenwashing", which means raising funds on an ESG mandate but not deploying them accordingly, has gained prominence after a scandal at Deutsche Bank, it remains widespread and often undetected. For example, ‘green bonds’, the proceeds of which are supposed to be used for climate-friendly projects, issued by the UK government have a tiny provision which allows half the proceeds to be used for spending the year before they were issued, ostensibly for non-green purposes.

Fund managers have also jumped on to the ESG bandwagon, sensing an easy opportunity perhaps to fleece more fees out of well-meaning customers. Many ESG mutual funds (including Indian ESG funds) hold more or less the same stocks as non-ESG funds, yet have expense ratios that are many orders of magnitude higher. Research shows that investors invest in ESG funds driven by social preferences and for social signalling. They value sustainability and see it as a predictor of future out-performance. While funds are able to generate significant investor inflows by branding themselves as sustainable/ESG and charge higher fees, they tend to generate lower returns and do not outperform non-ESG funds (‘Do investors value sustainability’ and ‘Why do investors hold socially responsible Mutual Funds?’, Journal of Finance). Not only do they charge higher fees, they often do not adhere to their ESG mandate either. Kim and Yoon (‘Analyzing Active Fund Managers Commitment to ESG’) show that US mutual funds that sign the United Nations Principles for Responsible Investment use this fact to attract large inflows but show no improvement in fund-level ESG scores and do not outperform. Raghunandan and Rajgopal show that ESG funds actually hold firms with worse compliance records for labour and environmental laws and higher carbon emissions. So profound is the allure of ESG that firms use ESG announcements to shield themselves from criticism when they are underperforming financially (‘Stakeholder Value: A convenient excuse for underperforming managers’)

In sum, while investing to improve the world is a laudable goal, it should not be conflated with investing to generate returns. Trying to do well by doing good in the financial markets neither does well for investors, nor does ‘good’ for society, and only enriches the financial services industry.

Diva Jain is a director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics. Her Twitter handle is @DivaJain2

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