The term “ESG” was coined in a 2005 UN report titled “Who Cares Wins: Connecting Financial Markets to a Changing World.” The well-intentioned report urged financial institutions, analysts, regulators, and investors to do their part to help the world by rewarding companies for environmentally, socially, and economically sustainable practices.
Ratings agencies based on ESG began popping up immediately. But ESG really took off in 2013, when studies showed a positive link between sustainability performance and financial performance.
Today, it is nearly impossible to visit a financial news site without seeing a story about ESG. And it’s also now big business, with hundreds of agencies providing ratings that inform an ever-growing share of investment decisions. Bloomberg estimates that more than $35 trillion dollars—$1 of every $3 in global stock funds—are invested in ESG funds.
That is an impressive sum. But after more than a decade of use, there is mounting evidence that ESG ratings are seriously flawed and not particularly useful for their intended purpose. In some cases, they might even be highly misleading. But despite researchers and industry analysts questioning the concept, financial websites, ratings agencies, and investors are still fully committed to the idea.
Confusing, Inconsistent, and Opaque
From a finance perspective, ESG ratings are meant to quantify the risk that a company’s stock price will fall because of issues like pollution, gender inequality, or forced labor in their supply chain. Many investors believe that they predict companies’ financial performance. However, an overview of 1,141 recent peer-reviewed ESG studies found that “the financial performance of ESG investing has on average been indistinguishable from conventional investing.”
If those findings are surprising, it is only because of ESG’s prominence. ESG ratings have always been confusing, inconsistent, and opaque. Ratings agencies are often secretive about their metrics, but the available information shows little consensus among ratings agencies over what areas to measure or how to measure them.
Ratings agencies often disagree over a company’s ESG performance. A recent study of this phenomenon found that “the correlation among prominent agencies’ ESG ratings was on average 0.61,” well below the correlation of 0.92 for credit ratings from Moody’s and Standard & Poor’s. There is substantial room for disagreement because rating ESG is not as easy as counting dollars. When boiling things down to one score, how do you decide what matters more: a tree saved, a ton of carbon sequestered, a factory made safer, or a company with more woman and minority board members? Determining which aspect of ESG gets the most weight is ultimately a moral decision, so it is not surprising that ratings agencies often reach different conclusions.
Researchers have identified other problems with the ratings. The authors of the aforementioned divergence study found that raters tend to give a company similar scores in multiple categories, highlighting the subjectivity of ESG ratings. Other studies show that large companies are typically rated better than small companies. Still others find that the ratings favor companies in places with high ESG reporting requirements (i.e. much of Europe) over those whose governments do not require such reporting (i.e. North America).
What is “high risk”?
While “ESG” and “socially responsible investing” are often used interchangeably, investors who consult ESG scores do not necessarily do so because of moral concerns. Socially conscious people may take comfort in knowing that their money is invested in an ESG fund. But ESG ratings have an interesting moral compass.
Oil companies generally receive poor overall scores compared to those in other industries, reflecting the weight ratings agencies give to the E in ESG amidst a growing focus on climate change. But is it fair to punish only the oil companies for producing the petroleum products that fuel the supply chains of many highly-rated companies? Do consumers who buy plastic products that were transported on fossil fuel-powered trucks bear any responsibility? With the lack of transparency throughout the ESG industry, it is hard to know how individual ratings agencies answer such questions. Or if they consider them at all.
Tobacco companies, on the other hand, often receive surprisingly high ratings, thanks largely to their environmental performance. ESG giant Sustainalytics ranks Phillip Morris International as the 48th safest investment among 596 “food products” companies. Overall, it ranks 4,841 out of 14,982 firms. That puts PMI ahead of Nestlé (59/596 and 5,582/14,982), Tyson Foods (318/596 and 12,196/14,982), and Beyond Meat (527/596 and 14,377/14,982).
Translating those rankings into ESG risk, Sustainalytics classifies both a tobacco firm and a food company that recently faced a child slavery scandal as “medium” risks. Meanwhile, a firm that farms animals for meat is considered “high” risk. And a company that produces plant-based meat alternatives is a “severe” ESG risk.
Toward a true ESG accounting
ESG’s popularity with investors means that publicly traded companies have little choice but to cooperate with ESG agencies, or else agencies often rate them using publicly available information, which can lead to lower scores than they would have otherwise received.
Dozens of companies have heeded the World Economic Forum’s 2020 call to adopt a single set of transparent ESG ratings, reflecting growing awareness that the system is broken. The U.S. Securities and Exchange Commission may eventually intervene and mandate a unified set of ESG disclosures.
But the information encoded, transformed, and diluted into ESG rankings is no substitute for investor due diligence, nor is it a reliable moral guide. Investors and their clients should recognize the limitations of ESG ratings for predicting financial performance—or facilitating truly socially responsible investing. Instead, companies should to set their own ESG goals and be held accountable by the public—and investors—for both their choice of goals and their ability to achieve them.
Andrew Balthrop is Ph.D. economist and research associate within the Supply Chain Management Research Center at the University of Arkansas. His research focus is in freight transportation and government environmental and safety policy.
Travis Tokar, PhD is an Associate Professor of Supply Chain Management at Texas Christian University’s Neeley School of Business. His work has been published in the Journal of Business Logistics, the Journal of Supply Chain Management, Production and Operations Management, and the Journal of Operations Management.