ESG: Myth or Magic?
Written by IN, Illustrated by M
‘ESG’ is one of the hottest acronyms these days in the grubby world of finance. But what does it stand for, really?
ESG, or Environmental, Social, and Governance, is a term to describe standards or frameworks that investors use to evaluate a company’s behaviour in terms of sustainability and deem them fit for socially-conscious investing. ESG ‘promises to combine ethical or environmental considerations with financial reward’; in other words, it’s supposedly a more ethical way to invest your money.
This makes it popular with investors who want to channel their money in a more socially conscious way. A recent survey by Standard Chartered Bank found that at least one-third of respondents want to have more than 15 per cent of their portfolio in sustainable assets in the next two to three years. In particular, young investors are most likely to consider a company’s ESG standards when investing. Overall, total investment in ESG funds could reach US$1 trillion by 2025.
Does this seem too good to be true? Can you really save the world — and make money while trying? Degrowth proponents would be quaking in their boots. The reality is more nuanced — as of now, there’s a lot of smoke surrounding ESG. There is some promise, but ultimately the basic principle should be whether these investments can lead to a reduction in absolute emissions — and it is unclear if that is happening at all.
Criticisms of ESG
One of the key criticisms of ESG investing is that it is a way for companies or funds to greenwash their activities. Companies present their production activities as ‘sustainable’ in nature, or announce that they’re pivoting towards greener business strategies, and investment funds lap it up.
However, in recent months, several companies have landed themselves in hot water with their bold claims of ‘green’ investing. On 31 May this year, Deutsche Bank’s investment arm, DWS, was raided by prosecutors after allegations by their former group sustainability officer that the fund had misrepresented their ESG credentials. DWS’ CEO resigned hours later. In June, the US Securities and Exchange Commission (SEC) said that they are investigating Goldman Sachs over its investment arm’s ESG mutual funds.
One investment analyst also analysed the emissions data disclosed by companies in several popular funds, and found that they were indeed less carbon-intense than funds tracking the S&P 500 (a stock market index tracking 500 of the biggest companies listed in the US). However, the study also showed that a hypothetical fund that excludes the five ‘dirtiest companies’ in each sector of the S&P 500 would be even less carbon-intense than many of these ESG funds. This hinted that the funds weren’t trying very hard in identifying truly ‘sustainable’ investments.
Another study found that one in seven ‘sustainable’ funds were more carbon-intense than the average of all investment funds. Many of these funds also continue to invest in fossil fuel companies like ExxonMobil and Shell — hardly paradigms of sustainability. How could this happen? As always, you have to check the fine print.
The root problem lies in the standards that are used to guide ESG investing. ESG ratings reportedly only tally a little more than 50 percent of the time (other credit ratings tally around 99 percent of the time), which means different ratings agencies are ranking firms’ ESG practices differently.
The components of such ratings are also dubious. Some ESG ratings prioritise the ‘S’ and ‘G’ over ‘E’, instead of ranking them equally. For example, MSCI, the largest ESG-rating company, gave McDonald’s an ESG rating upgrade after dropping their carbon emissions from their ratings evaluation, because it was deemed that the emissions posed no risk or offered opportunities for their bottom line.
In fact, ‘almost half of the 155 companies that got MSCI upgrades never took the basic step of fully disclosing their greenhouse gas emissions’. And of the 10,000 firms in MSCI’s world index, less than 40 percent reported scope-one and -two emissions (see here for the definition of scope one, two and three emissions), while even more alarmingly, only 55 percent European oil and gas companies released scope three emissions data, even though that was the bulk of their carbon footprint. These signal a real need to pressure firms to measure such emissions - how can they be considered ‘green’ if we don’t even have the data to judge them by?
Lastly, there is also the argument that grouping ‘E’, ‘S’, and ‘G’ together may work at cross-purposes. Some analysts have argued that weapons manufacturers and defence companies can be included in ESG funds as they help to defend the values of liberal democracies, especially during a time of conflict such as Russia-Ukraine. There needs no elaboration why war can hardly be construed as good for the environment. Some companies like Tesla are also included in many ESG funds due to their production of electric vehicles, but amid reports of exploitation at Tesla factories, they can hardly be considered to have good corporate governance.
ESG: A Potemkin Village of Sustainable Finance?
So, is ESG just a catch-all term used by investment funds to hide their rapacious ways behind a facade of sustainability?
Not quite. The general principle of investing in firms that can make a tangible reduction in carbon emissions whether through development of new technologies or adopting greener methods of production is logical to some extent. The trick is to improve the way that investments are properly channeled, and to ensure that these firms are delivering what they claim.
Firstly, the ‘E’ in ESG remains highly nebulous and vague. It should be simplified to focus on another ‘E’: emissions. This means that green funds should not invest in any fossil fuel companies until they divest fully from all fossil fuels.
Secondly, there should be more rigorous and stringent green taxonomies that classify ‘green’ assets and guide ESG ratings. A promising example is the new disclosure and reporting guidelines for ESG funds issued by MAS to take effect by January 2023. This is a good start, and in the near future, there should also be further requirements for all firms listed in these funds to have met a minimum threshold of reporting their Scope 1,2, and 3 emissions.
Lastly, like it or not, firms or fund managers are primarily motivated by profits, and they will be eager to find ways or loopholes to evade such regulations. Thankfully, this works both ways; if firms or fund managers know they will lose investments if they do not adopt greener standards, this raises the externalities of pollutive production methods. Civil society organisations can hold firms or funds accountable to these standards and monitor the disclosure of their emissions data. Public pressure should be put on them if they do not meet their targets. These will increase the reputational risks of the companies involved and incentivise them to walk the talk.
As Tariq Fancy–former chief investment officer at BlackRock who spearheaded the incorporation of ESG into BlackRock’s investments–puts it, sustainable investing as it stands is ‘little more than marketing hype, PR spin and disingenuous promises’. As we’ve written before, we must reject the dogma of endless profit which guides the markets at the expense of our planet. If we are to have some form of green finance, it should not be left solely up to the purview of fund managers who receive exorbitant salaries for ensuring their clients’ accounts grow.
Perhaps one day, we can even have public financing integrated with more participatory democratic processes that decide where such funds are channeled. Could we even one day integrate global markets and issue a ‘carbon coin’ as currency, proportionate to the amount of carbon emissions mitigated, a la Kim Stanley Robinson’s The Ministry For the Future? If we don’t dare to dream bigger, we can never dream of a better world beyond the limits of the market.
The author would like to thank the anonymous contacts who assisted with background information for this piece.
 Broadly speaking, the ‘E’ comprises of criteria relating to carbon emissions, management of pollution, and compliance with environmental standards; ‘S’ comprises of criteria relating to workplace conditions, engagement with local communities, diversity, equity, and inclusion (DEI), and health and safety; and ‘G’ comprises of criteria relating to corporate governance integrity, conflicts of interests, and illegal conduct. The above is just a snapshot and the actual criteria is often decided by ESG ratings companies.