According to standard environmental and social governance (ESG) ranking systems established by investment firms, tobacco and oil companies received a passing ESG ranking this year. Given these industries' impact on the environment, the fact should call into question the legitimacy of ESG ranking metrics.
Earlier this year, BlackRock, the world’s biggest asset manager, began implementing its “fast-exit” rule which halved the time that a company failing to meet environmental, social, and governance standards is removed from its exchange-traded funds. This means if a company ranks poorly in measurements of stakeholder impact ranging from their positions on climate change to product safety, they can quickly be dropped from the market. Yet, since BlackRock still supports coal investment in Europe amongst other contradictory investments, environmental activists and ESG skeptics alike have criticized the firm’s efforts and its CEO Larry Fink for greenwashing.
By shutting the door to certain investments based on poor ESG ratings while simultaneously holding millions of dollars in fossil fuel funds, BlackRock and other investment firms give the lie to their ESG agendas. Both internal and external shareholders as well as third-party assessment companies create a firm’s ESG agenda, but the methodology behind these metrics leaves room for double standards and contradicting policies. For now, index fund managers have promoted themselves to the rank of de facto bureaucrats who are able to decide whether a company can survive or prosper based on highly subjective rankings. This effectively establishes a nonlegal legislative process by which an investment firm can regulate an industry according to arbitrary standards. To effectively reach the socially responsible goals of ESG, legislators should require investment firms to coalesce around one, comprehensive, fair, and transparent set of ESG standards to eliminate corporate bias as well as environmental waste.
ESG ratings function like a credit score, as investing firms like MSCI weigh a company’s ESG value based on a variety of factors, ranging from energy consumption and fossil fuel emissions to worker relations and diversity. On average, institutional investors spend $487,000 a year on external help for calculating these ratings alone. These ratings often differ across a single agencies’ various analyses — displaying a wide range of what factors are included and how they are weighed. Unsurprisingly, they are highly subjective and prone to favoritism or error.
Half of the companies rated by MSCI were upgraded in ESG rankings without a substantial environmental or social change, but rather for methodological changes such as running a survey of employees. These provisions allow companies to game the system by doing the bare minimum instead of meeting expectations like reducing carbon output. An MIT study found that there was only a 61% correlation between different ESG ranking agencies such as Moody’s, MSCI, and S&P Global, whereas the credit score correlation between Moody’s and S&P was 99%. The ratings don’t account for the large gap between ESG scores and ESG performance. Because they differ across firms due to stakeholder priority, they can be skewed in different directions.
The inflated ranking of environmentally damaging companies demonstrates the flaw in the ESG system. The cigarette company Phillip Morris is part of the Dow Jones Sustainability Index along with other companies positively ranked for ESG despite the fact that the tobacco goods they produce are the subject of “Merchant of Death” satire so championed by ESG proponents. Similarly, Exxon and BP, two oil companies that activists argue are the face of global warming and which one would expect to receive extremely low ESG ratings, are both ranked BBB — that’s the middle of the pack in terms of ESG-investing firms. If two companies expected to be in the bottom of ESG rankings can weave their way into a favorable position in the rankings, one has to doubt the validity of the metrics. Net-zero pledges are optimistic, but they don’t completely eschew current pollution.
These highly arbitrary ESG ratings are even more unfair since the publicly traded products they condemn are completely legal. For instance, GMI Ratings ranked media giant Discovery Communications very low due to its governance structure, despite the fact that its programming is in full compliance with US law.
ESG has become a new form of nonlegal regulation by a new “bureaucracy” made up of non-elected investment professionals picking and choosing winners based on their own metrics. Investors and shareholders have the freedom to invest in what they please, but ESG creates situations in which partner companies and shareholders are forced to invest or divest just to meet a new nonlegal standard.
Legislators, companies, and everyday shareholders and investors are right in demanding that the “new status quo” of ESG in investing be more transparent about how its rankings are made and by whom. We need a standard, codified ranking system to remove the vast subjectivity of ESG investing rules.