A major stock index tracking sustainable investments removed electric vehicle maker Tesla from its list in May 2022 — but it kept oil giant ExxonMobil. That move of the S&P 500 ESG Index has sparked a debate over the value of the ESG rating.
ESG stands for Environmental, Social and Governance, and ESG ratings are meant to measure the performance of companies in those areas. About a third of all investments under management use the ESG criteria, yet many environmental problems continue to worsen. Tesla CEO Elon Musk downgrades ratingsscam“And the US Securities and Exchange Commission is discussing whether to propose new disclosure rules for their use.
The Conversation asked Tom Lyons, a business economics professor at the University of Michigan who studies sustainable investing, to explain what happened and how the ESG rating could be improved to better reflect investor expectations. Is.
How does a company like Tesla, which makes electric vehicles, miss out on the S&P 500 ESG index while Exxon still is?
ESG rating agencies typically rate companies against others within their industry, so oil and gas companies are rated separately from automotive companies or technology companies. Exxon stacks up fairly well against others in the oil and gas category on several measures. But if you compare Exxon to Apple, Exxon will look terrible on its total greenhouse gas emissions.
Tesla may rate well on a number of environmental factors, but social and governance factors are dragging the company down. S&P listed allegations of racial discrimination, poor working conditions at the Tesla factory and the company’s response to a federal safety investigation as reasons for leaving the company.
There are also some biases in the way the ESG criteria are measured. For example, ratings consider a company’s direct greenhouse gas emissions, but not its Scope 3 emissions – emissions from the use of its products. So Tesla doesn’t get as much credit as it could, and Exxon isn’t penalized as much as it could.
What can be done to make ESG investments better reflect investor expectations?
One strategy is for investment firms to invest in a small number of carefully screened companies and then use their influence within those companies to monitor behavior and drive change.
The second is that raters should stop trying to aggregate all the different measures into a single rating.
Investors concerned about ESG often value different objectives – one investor may genuinely care about human rights in South America while another focuses on climate change. When ESG ratings try to apply all of those objectives to the same number, they obscure the fact that there are trade-offs.
ESGs can be broken down, so ratings are focused on each piece individually.
Environmental issues have a lot of available data, making E the easiest category to rate in a consistent way. For example, there is scientific data available on the health risks a person may face when exposed to benzene. The EPA’s Toxic Release Inventory shows how much benzene is released by various manufacturing facilities. It is then possible to create a toxicity-weighted exposure measure for benzene and other toxic chemicals. A similar remedy can be made for air pollution.
It is very difficult to aggregate social issues and governance issues into a single rating. Within the G category, for example, how do you add diversity to the board room based on whether the CEO personally appointed all board members? They occupy fundamentally different things.
The SEC is considering a third strategy: increasing disclosure requirements so that investors have access to better information about what is in their ESG portfolios. It plans to raise the issue at its meeting on May 25, 2022.
What else do ESG ratings overlook?
ESG ratings often omit important behaviors and choices. One that is particularly important is corporate political activity.
Lots of companies like to talk about the green game, but investors rarely know what these companies are doing behind the scenes politically. Anecdotally, there is evidence that many people are actually playing quite the dirty game politically. For example, a company might say it supports a carbon tax when lobbying for members of Congress and groups opposing climate policies.
To me, this is the most serious failure in the ESG domain. But we don’t have the data to adequately track this behavior, because Congress doesn’t require disclosure of all forms of political spending, especially so-called “black money” from super PACs.
Some organizations are collecting more detailed information on specific issues. Influence Map, for example, invests a great deal of time to rate companies’ annual reports, tax filings, press releases, advertising and any information about lobbying and campaign spending. It gave ExxonMobil a D-grade for its political action on climate.
What can investors looking for a positive impact do if ESG ratings do not respond?
Investors can always take a more targeted approach and invest in specific categories that they believe will provide the solutions they need for the future. For example, if climate change is their major concern, this could mean investing in wind and solar power or electric vehicles.
ESG funds often claim that they outperform the market because companies with strong management in the environmental, social and governance sectors manage better overall. And on average, firms with higher social performance have higher financial performance. However, some insiders, such as BlackRock’s former permanent investment chief Tariq Fancy, argue that ESG portfolios are not much different from non-ESG portfolios today, and often all hold nearly the same amount of stocks.
Against the backdrop of all this, there is also a big question: Is investment pressure really going to drive us towards a more sustainable future?
If you want to make a difference, consider spending time working with activist groups or groups that support democracy, because without public pressure and democracy, countries are unlikely to make good environmental decisions.