Why ESG Investing is Overhyped

The COVID-19 pandemic has shone light on how investors allocate their money and how companies’ operations may influence our societies.

For companies, the ESG concept promises that the company will become more profitable in the long term, assuming that we have clearly defined what good actually means on a scale. As such, they are better off adopting ESG practices in their operations.

For investors who put their monies into companies with a higher ESG ranking, it promises better returns than “bad” companies with lower ranks.

For society, the promise is that these “good companies” will fight issues that are directly related to ESG, such as global warming, underaged labour, etc.

However, there are questions raised about whether ESG investing is effective in improving our communities.

The fact that ESG exists implies that there will always be a divergence of opinions.

With the rise of ESG, many rating agencies were formed to determine the ESG rating of companies. In many scenarios, different raters’ appraisals diverge. Companies that obtain a good score from one rater are frequently given a moderate or low score by another.

This may be due to the difference in methodologies used by agencies in arriving at the ESG scores. A July 2018 report by the American Council for Capital Formation (ACCF) explored the lack of consistency in ratings between Sustainalytics and MSCI, two major agencies that dominate the market.

The research pointed that when comparing MSCI and Sustainalytis ratings for companies in the S&P Global 1200 index, there is a correlation of 0.32 found between the two firms’ ratings. This indicates weak correlation in measuring ESG factors between the agencies, expressing difficulties in reaching a common concensus. (Correlation value of 1 represents complete correlation and -1 represents negative correlation.)

The report also cited inherent biases: from market cap size, to location, to industry or sector. Bigger market cap companies are awarded higher ratings on the ESG scale as compared to lower market-cap businesses. Big companies might have the financial resources to invest more in measures that improve their ESG profile; such investments might lead to higher ESG scores.

Furthermore, the way rating firms assign weights to each ESG factor may permit companies to achieve high ESG scores even if they cause significant harm to one or more stakeholders, but do well on other parameters.

Take the case of Amazon and Meta Platforms, two companies that form the largest holdings for some of the ESG funds. Both companies received high ESG rating as they do not produce much carbon emissions for their company’s operations. Much of this may be attributed to the nature of their business. Yet not many would consider them to be good corporate citizens.

Amazon has its history of egregious labour practices and predatory pricing. Meta Platform’s core business model involves algorithms that could amplify the use of hate speech among netizens.

This got me thinking:

When companies rank higher in ESG ratings, is it truly because that they are doing better or they are doing better because they find it easier to deliver these measures due to the nature and landscape of its business?

The definition of good varies with different persons. On a smaller scale, what you perceive to be a corporate sin might not register on my list.

Here’s a look at the top issues that investors (by different age group) want their portfolio to address:

(Image taken from: Visual Capitalist)

(Image taken from: Visual Capitalist)

Based on this survey, younger investors of age 25-39 years are generally more concerned with global warming followed by sustainability. These are long-term factors that could potentially affect the later decades of their lives.

Older investors from 55 years are most concerned with data fraud or debt, followed by gun control. These are related to their immediate safety and security.

The threat of Green Washing

With the rise of sustainable investing, the threat of green washing follows.

Green washing is the act of conveying a false of misleading impression about the environmental benefits of a company’s products or services.

Recent evidence of green washing was found in the studies conducted by InfluenceMap. In the 593 equity funds that were examined, 71% of them have a negative Portfolio Paris Alignment score, indicating that their portfolios are misaligned from global climate targets.

Mr Tariq Fancy, the former chief investment officer of sustainable investing at BlackRock, recently described the ESG label as a "marketing gimmick” and a "deadly distraction" from addressing actual issues.

Greenwashing could divert resources and attention away from actual and severe sustainability issues, as ESG-stamped items tend to draw more money from investors who are looking to make a difference.

He also argued that there is a motivation for financial institutions to promote ESG funds as the novelty of them have permitted higher management fees which could improve their profits. Here, the ESG concept becomes a trend for financial managers to capitalize on.

To conclude, I do believe that the idea behind the ESG system is driven by good motives and a desire to do good for society. However, the growing popularity of ESG investing might have encouraged companies with no actual contributions to jump onto the bandwagon, and financial institutions to use it as a marketing gimmick.

What do you think? Feel free to share your perspectives below! :)