The times they are a-changin', as Bob Dylan sang. People are becoming more aware of global challenges like air pollution, human rights violations, and greedy corporations. This public awareness has been driving investors to question traditional investment approaches, and many of them now rely on a company's ESG rating to guide their decisions.
That acronym, ESG, stands for "environmental, social, and governance." ESG investing is when investors consider factors beyond financial elements in their decision-making process, says Remy Briand, managing director of ESG research at Morgan Stanley Capital International.
ESG is usually defined by three key components:
Environmental factor, or how a company's operations, such as energy use, energy efficiency, or waste management, affect the environment;
Social factor, or how a company manages its relationships with customers, community, employees, and suppliers, as well as the societal consequences of its operations, such as product safety;
Governance factor, or how a company is governed, represented in criteria such as the diversity of its board members, its stance on shareholder rights, etc.
Basically, think of it as sustainable, socially responsible, and mission-related investing, MSCI explains.
What is the purpose of ESG?
The original purpose of ESG investing was to use investment as a tool to model social responsibility, as investors would exclude stocks and industries from their portfolios based on business activities they considered socially unacceptable.
The practice reached the mainstream in the 1960s, alongside the Civil Rights Movement and the boycotting of companies involved in or that supported the Vietnam War, according to ESL Federal Credit Union. Investors wanted to avoid companies that had bad reputations or acted in a way that didn't align with their ESG goals.
One of the first examples of this was the investor boycott of companies that supported the South African apartheid regime. Apartheid racially segregated South Africa and created policies that harmed Black South Africans. Through ESG investing, American investors helped South African reformers to dismantle the regime. With that success, protest divestment — or directing investment based on social values — became a model for promoting change.
Present-day ESG investing began in the 2000s with the advent of regulations and standards related to ESG, according to Matt Kelley and Chris Sardi of ESL Federal Credit Union. ESG investing continues to evolve in the U.S., as seen in the consistent growth of ESG funds, in the alteration of corporate policies at major companies, and in money managers of large funds taking a stand on ESG issues, said Kelley and Sardi.
What are the limitations of ESG?
Vivek Jamwal of Stradegi Investment Management Consulting says ESG investing is still young and has its flaws. One of the most notable limitations, Jamwal states, is that not all ESG factors are quantifiable.
One can measure an oil and gas company's harmful carbon pollution, but it's more difficult to measure the degree to which industrial agriculture has harmed pollinators like bees, explains Professor Jennifer Howard-Grenville at the Cambridge Judge Business School.
ESG measurements can also make a company's sustainability disclosures seem more credible than they truly are. In what and how they disclose information, companies can skew their data toward processes and procedures rather than actual performance, notes Jamwal, which allows them to use self-reported data to get better ESG ratings and burnish their image as a responsible company.
The other major flaw, Jamwal explains, is that the ESG ratings companies use different methodologies to calculate their ratings, which adds a layer of complexity for companies, investors, and shareholders.
Toxic waste spills, human rights violations, corrupt CEOs, and other controversies can significantly affect investment performance, explains London Stock Exchange Group. And market reactions to bad news are more pronounced than reactions to good news, said Bei Cui, of Monash University's Center for Financial Studies. Research provided by Bank of America Merrill Lynch found that 24 ESG controversies decreased the value of large U.S. companies by more than $530 billion over a six-year period. Such controversies apply more pressure on companies to take social and environmental factors seriously.
How does Elon Musk come into the picture?
In an example of how harsh ESG calculations can be and an indicator that rating systems are still imperfect, Elon Musk recently expressed frustration that ExxonMobil, a gas company that produces an enormous amount of harmful carbon pollution, received a top ESG rating from the S&P 500, whereas Tesla, an automotive company that makes electric vehicles that produce far less pollution, did not make the list at all.
Yes! Stop the outrageous false ESG assessments, where Tesla gets a bad grade, but an oil company can get a good grade. Total gaming of the system!
— Elon Musk (@elonmusk) May 7, 2022
Hiro Mizuno, a director at Tesla, tweeted in support of an ESG rating system that fairly evaluates a company's positive and negative impacts, rather than a system that gives more weight to negative impacts and controversies.
Sure.
— HIRO MIZUNO (@hiromichimizuno) May 8, 2022
To be clear, Tesla is not denouncing ESG investments but urges ESG rating scheme to fairly evaluate a company's positive impacts as well as negative impacts.
The current ratings often overweight reduction of negative impacts while neglecting positive impacts.
The rise in ESG investing reflects the social shifts we have all felt. The public has made clear demands about protecting our communities and the planet, as well as halting corruption within various industries. Investors listened and began rewarding companies that met these ESG demands with funding. With detailed reporting standards, ESG investing is an extremely powerful tool for enacting meaningful change and holding companies accountable.
If you're an investor, you can help to accelerate this change by researching the ESG ratings of stocks in which you're interested, and by consulting reputable companies like AlphaSense, which provides guides that make ESG research easier!
