The Broken Promise of ESG Investing

[Shuchi Agrawal is a Research Fellow in the Corporate Law and Financial Regulation team at Vidhi Centre for Legal Policy]

The concept of environmental, social and governance (“ESG”) factors was first introduced into the mainstream in a 2004 United Nations report on sustainable finance. Since then, the idea has gained much popularity and has become increasingly important in the financial sphere because it signals a shift in the priorities of investors, banks, and other financial institutions. Concerns regarding climate change and social justice are becoming more relevant to the public, and have been gaining much momentum over the last few decades.

The financial sector is uniquely well-positioned to remedy ESG-based issues by providing the resources required to counter these problems. It has been estimated that limiting global warming to 1.5°C relative to preindustrial levels by 2050 will alone require an annual investment of around .5 trillion. With renewed public interest in ESG-related matters, it is understandable that entities want to finance and support sustainable businesses that align with their personal values. Due to this, there are, at present, around 240 and 500 ESG exchange traded funds in the United States (“US”) and Europe respectively. On the other hand, the concept of ESG funds is in its infancy in India and as a result there are only eleven active ESG mutual funds in the country. However, over the last few years, there has been growing distrust against ESG funds due to their opacity and the difficulty in distilling ESG quality to a score.

One of the biggest problems with ESG funds is that they rely on ESG ratings of companies while creating a portfolio and, at present, there is a lack of consensus regarding what it is that ESG ratings actually measure. ESG ratings can roughly be categorized as ‘impact based’ or ‘risk based.’ Impact-based ESG ratings measure the impact of a company on environmental, social and governance issues. On the other hand, risk-based ESG ratings are based on the potential impact of the world on the company and its shareholders. Consequently, risk based ESG ratings are only concerned with how a company’s exposure to climate, social and governance risks can affect its bottom line

However, this rather important distinction is often not highlighted and this leads to misunderstandings that have far-reaching implications for the financial markets, companies, regulators as well as retail investors. The general understanding of ESG ratings tends to be impact-based even though several ESG rating providers (“ERPs”) employ the risk-based approach. As a result of this misconception, many investors mistakenly support and invest in ESG funds believing that they are financing and contributing towards solving ESG-related problems. The considerably higher fees associated with ESG funds also serves to lure asset managers to promote these funds, and the idea of impact-based ESG ratings acts as persuasive marketing with respect to activist investors.

In addition, there is an acute lack of consistency across ERPs in terms of their methodology, objectives, the quality of their ratings, transparency standards and coverage. This results in high levels of variance in their ratings which, in turn, contribute to difficulties for investors and fund managers seeking ESG investments. The extent of the problem becomes evident considering the fact that a team of Massachusetts Institute of Technology researchers found only an average correlation of 61% in the ESG rating of six major ERPs, as opposed to a 99% correlation between the scores of credit rating agencies. It is relevant to note that this extreme divergence can be, in part, attributed to the inconsistency in the selection of indicators utilized by ERPs for determining a rating. Bloomberg ESG Data Service covers close to 120environmental, social and governance indicators while evaluating ESG ratings. On the other hand, Thomson Reuters ESG Research Data analyzes 400 different ESG metrics, selecting 178 of the most important indicators to arrive at its ratings. Meanwhile, RepRisk and MSCI ESG Research focus on 28 and 37 ESG key issues, respectively, while conducting their research.

However, such an extreme degree of variation can decrease a corporation’s incentive to improve its ESG performance, as it does not allow them to have a clear understanding of their strengths and weaknesses. The mixed signals from various ERPs also do not allow companies to effectively evaluate if their efforts in introducing initiatives are paying off. Further, the inconsistency of ratings across ERPs also inhibits effective pricing of companies’ ESG performance in the market.

Nevertheless, the disagreements in ESG ratings are not a result of bias or incompetence. Instead, these differences in ratings exist because ESG performance is a difficult parameter to capture, and reasonable individuals can disagree.  This does not imply that ESG ratings are unreliable or that they cannot be utilized. Rather, the individuals utilizing these ratings and the investors investing in ESG funds need to pay closer attention to what different ERPs are trying to capture, as different ERPs define ESG differently. That being said, it is also important for the securities markets regulator, SEBI, to take active steps to highlight the differences between ‘risk based’ and ‘impact based’ ESG ratings to eliminate misinformation in the markets.

– Shuchi Agrawal