By Valerie Gardner, Managing Partner

ESG investing is the largest and most profound global trend happening in the capital markets. Its popularity points to the global recognition that investors should and do have an important role to play in helping to solve environmental, social and other issues that have put the planet on a bad trajectory. In fact, no business can survive without investor support so businesses do care to meet investors' demands. Yet, as structured, ESG is not working to fulfill investors' true underlying needs or produce measurable objectives. The good news: there is an easy fix, when we start with "C," assessing climate impacts.

Like many things today, an initiative based upon a meaningful and important purpose, has become mired in controversy. Like the Socially Responsible Investing (SRI) movement that preceded it, ESG (an acronym for rating and selecting companies based upon their environmental, social and governance performance) has emerged to enable investors to focus their investments on companies that are taking care to behave more morally and responsibly vis-a-vis the environment, their employees, their shareholders, their suppliers, their communities and the climate. Many of these types of good corporate behaviors previously went unreported. What's become clear to investors is that short-term profiteering by managers may appear to be beneficial for shareholders but often may not be. It can conflict with what we know are looming issues which need action. Thus, sometimes taking a longer-term view and making corresponding sacrifices or investments that actually reduce overall risks can vastly improve longer-term enterprise value.

ESG has emerged to identify, elevate and reward companies which invest in doing what is right, even if such actions reduce returns in the short-term. It is intended to broaden the metrics on which corporations report information, so investors can make better informed decisions and invest in companies taking ethical actions, treating employees, suppliers and their communities fairly and protecting the environment—much of which costs more but which can reduce risks and other future costs, including litigation, public opposition or climate impacts.

While collecting data to make this type of assessment might seem uncontroversial, traditionally company management was required to focus on meeting only one goal: maximizing shareholder value. Because actions that affect long term enterprise value are often difficult to quantify, management reports have traditionally focused on easier t omeasure financial metrics like Price/Earnings ratios and quarterly profit trends. Deviating from the objective of maximizing per share profits could and often did result in shareholder lawsuits, if management took even smart and common sense approaches which reflected a community value, but which did not clearly improve shareholder value.

Fortunately, in 2019, under the leadership of Jamie Dimon, the Business Roundtable officially changed their statement of purpose and so businesses now broadly recognize that they are also accountable to their employees, suppliers and communities — constituents whose needs and actions can also impact the bottom line — but there is no consensus as to exactly how much or how little is enough and companies employ widely diverging approaches. ESG is now a way that investors can better discern the differences and reward companies that are acting responsibly on environmental, social and governance issues. Unfortunately, it is not working very well.

What ESG Currently Is

The Harvard Law School Forum on Corporate Governance published an article entitled ESG Ratings: A Compass without Direction which aptly summarizes the main issues with ESG as it currently is. The authors describe their findings as follows: "We find that while ESG ratings providers may convey important insights into the nonfinancial impact of companies, significant shortcomings exist in their objectives, methodologies, and incentives which detract from the informativeness of their assessments."

Critically, there's a significant dichotomy between what people commonly think ESG is supposed to indicate and what it actually indicates. Most people believe that an ESG score reflects a company's positive impact on the environment and stakeholders beyond its shareholders, such as employees, customers, suppliers, and local communities as well as the environment—a type of "Doing Good" metric which would tend to produce more shareholder value in the long run. In actuality, most ESG raters are assessing a company for the existence or absence of risk factors that could impact the future value of the company, such as the risk of discrimination in hiring or the risk of climate change on the supply chain. This is more of a "Risk Reduction" approach to data collection.

From an investment manager point of view, any time you can get meaningful information about a company's actions and potential future value, you are generally willing to pay for that—especially when your clients are clamoring for more sustainable investment options and are willing to pay more. Thus, there are now a plethora of third-party ESG rating services working to provide ESG data for a fee and a very large majority of impact-focused investment professionals are using these services to provide more options for clients. But, sadly, the entire space, which is still in its infancy, is chaotic and incoherent.

Studies show very low correlations across ESG ratings providers in total scores as well as across the three distinct components of "E," "S," and "G." Not only isn't there agreement about what an ESG score reflects, there is no standardization in the types of data collected or used and no consistency to the methodologies of collecting, assessing or prioritizing within or across categories. Thus, not only are ESG ratings badly correlated with environmental and social outcomes, the relationship between ESG ratings and financial performance is also uncertain. Those investing in ESG-type funds will typically pay more in fees for having accessed ESG data but they will generally get just equivalent or worse performance.

High and rising demand for ESG information has caused ESG-type rating services and funds to become profit centers, even as the quality, consistency and efficacy of the ratings has failed to provide meaningful results. At the moment, in addition to all of the inherent confusion as to what data matters, how to collect it, how to assess it and then how combine it with many other data points into a meaningful score, there is also the problem of greenwashing. Greenwashing is the deliberate efforts by some companies to game the system and try to obtain better ratings and scores than they probably deserve.

Which points to a growing problem in the ESG space. Companies control what data they will share with which rating groups, creating an inherent ability for companies to influence their scores by refusing to give their data to groups that don't rate them highly. This has rendered the existing ESG industry scores almost meaningless, since many of these raters are dependent upon the good will with the companies they are rating to get the data they need.

There is no better example how badly ESG is doing for guiding investors to more ethical and sustainable companies than when the S&P Sustainability Index did its rebalancing in May 2022. At that juncture, the S&P ESG team ejected Tesla (the largest EV car maker and one of the most successful climate companies on the planet) from the Index but welcomed ExxonMobil (a renowned climate villain), prompting Elon Musk to call the S&P Sustainability Index a "scam."

This decision caused a broader uproar within the sector and forced Senior Director and Head of ESG Indices Margaret Dorn to publish an explanation. Not only was this shift a climate and ESG travesty but, in fact, the S&P's "delicate balancing act" revealed that ESG raters and ratings are meaningless for a whole host of reasons, predominantly because there is just too much data, too much manipulation, and not enough understanding of what really matters. ESG raters appear to be so lost in the trees, they have effectively lost sight of the forest, namely the critical issue that matters the most to investors: climate change.

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What ESG Isn't

Investors are looking to ESG ratings to enable them to invest in companies that are doing better on a wide range of areas but, most critically, are environmentally responsible, especially around reducing carbon emissions. For many, this means working to provide solutions along the lines outlined by the United Nationa's Sustainable Development Goals. ESG investors care to invest in companies which improve global sustainability and solve climate change.

There are plenty of dire human, environmental and governance problems—you could name dozens—but none that threaten to seriously and even permanently disrupt the planet, human society and economic order as much climate change, the forced heating of our climate caused by burning fossil fuels. This crisis dwarfs everything.

So, while it may be troubling that there are reports of a toxic "bro" culture at Tesla, every single day, Tesla ships electric vehicles that enable people to stop purchasing and burning fossil fuels, which is the primary driver of climate change. In stark contrast, every single day ExxonMobil strives to greenwash their aspiration to keep selling more and more fossil fuels for as long as they possibly can—threatening not just human survival but that of all species and potentially our well-functioning societies, which could effectively wipe out the concept of wealth as we know it.

Shockingly, ESG as it is currently designed doesn't enable either the experts or investors to clearly assess companies on the single most important metric of sustainable performance—whether the company contributes to climate change or if they provide solutions to climate change. The average ESG investor, however, thinks that this is primarily what ESG does. Clearly, if ExxonMobil is rated highly but Tesla is not, ESG is not just meaningless, it is actually misleading for the average impact investor.

Fortunately, in order to fix this problem, ESG doesn't need to change that much, it just needs to make a small, relatively easy modification, which will then substantially improve its effectiveness and performance and begin to have a truly beneficial impact on humanity's ability to invest "sustainability."  I propose a very basic approach for doing that below.

ESG Can Easily Be Fixed:  Start all ratings with a "C" assessment

As those concerned about what's happening with our climate saw, 2023 experienced a succession of seven record-shattering and "gobsmackingly bananas" (in the words of two climate scientists) hottest months on record. Not surprisingly, 2023 was also a record-breaker for climate disasters in the U.S. and around the globe, which have cost humanity billions annually. The bill for extreme climate disasters in the U.S. since 1980 now totals over $2 trillion and growing. Hundreds of millions of people are already being affected and/or displaced by the extreme weather events resulting from burning fossil fuels and allowing the CO2 pollution to escape into the atmosphere. These climate events are impacting the global economy, national security, geopolitics, businesses and politics in a range of ways but especially by increasing over systems risk.

Not surprisingly, at COP 28 in December, 198 nations gathered in the United Arab Emirates and finally agreed that we need to "transition away from fossil fuels." Though fossil fuel exporting nations like the UAE, Saudi Arabia, Russia and Iraq fought hard against adopting the specific words "phasing out fossil fuels," this is a pointless distinction, since it is abundantly clear that humanity needs to stop using fossil fuels as fast as humanly possible, whether transitioned or phased out. The climate is so bad, even Middle Eastern countries, whose primary source of revenue is fossil fuels, finally acknowledged what we've known for a very long time: only by eliminating the use of fossil fuels will we start to turn the tide against our worsening climate change and the dire ecologic and economic crisis that it threatens.

Against this backdrop and in light of the fact that ESG analyses and ratings are clearly still in "beta," we believe that ESG raters could make a very minor modification and start to have a much more significant impact. Simply by commencing vetting with one very simple sorting action, they would improve the coherence of ESG ratings by a lot. Prior to applying the rankings from hundreds of data points amassed regarding a plethora of corporate actions, ESG needs to divvy up the universe of companies into three distinct buckets: Climate Villains, Climate Neutral companies and Climate Heroes. This is a very easy distinction to make. Climate villains are those that are actively extracting, refining or selling virgin fossil fuel products or related services. Climate neutral companies are those that doing other business and are merely energy customers. Climate heroes are those companies which are actively developing and/or delivering key solutions to climate change (unrelated to ongoing fossil fuels operations), like low-carbon and carbon-free energy such as nuclear power, hydropower, wind, solar, geothermal and wave power; providing electrification support, such as with electric vehicles, heat pumps, charging stations and energy efficiency; and lastly carbon management, including carbon capture, carbon utilization and carbon sequestration (so long as unrelated to fossil fuel operations).

Once this vetting process has been done, then all of the current ESG metrics can then be assessed for more comparative performance relative to a company's other environmental, social and governance risks. But the top line assessment will easily enable every ESG-rated fund to exclude all Climate Villains. ESG funds will then be able to select their choices of best-performing companies from the other two categories for a mix of risk and return characteristics and use whatever type of analyses they wish. Investors will then have a very clear sense of what the composition of the fund is, across these three categories. Companies whose business is actively extracting, refining, distributing or selling fossil fuel products or services that cause climate change will likely still be included in standard, non-ESG funds, of course, but even these funds would easily be assessed for their climate impacts. Such funds could also be assessed for their ESG conformance, relative to other similar funds. But with this big bucket approach, no company or fund would be able to manipulate their "S" or "G" ratings in such a way as to feign that they are environmentally sustainable or acting responsibly relative to climate risk or sustainable development goals, when they are not, which is what impact investors mostly care about.

Summary

Despite inconsistencies in and controversy over ESG, we believe that demand for ESG research and investment vehicles remains strong largely because of concerns about climate change. Investors demand greater clarity about which businesses have more sustainable and ethical business approaches and want to own those and not companies shirking their responsibilities to future generations. Although ESG is in a nascent and chaotic state and not currently delivering the data ESG investors really need, a simple modification will be enough to ensure that more investor capital is directed into sustainable ventures.

Here's how we think it can work.

Prior to running the current slate of ESG assessments, each company should be given a climate score:  "C Minus" is given to "Climate Villains," companies whose products and services are contributing to climate change, namely the fossil fuel extraction, refinement, distribution and sales companies that are responsible for contributing millions of tons of carbon emissions. Companies that not involved with climate-impacting businesses (such as those in healthcare, education, textiles, manufacturing, etc.) would be deemed "Climate Neutral" and get a straight "C" since their business is not directly causing climate change other than through their energy usages (or idiosyncratic emissions). Lastly, the final category are the Climate Heroes who get rated "C+" as they are actively working to solve humanity's need for clean energy and/or carbon services, which seek to restore the natural carbon balance in the atmosphere.

Once these very broad but clear buckets are determined, ESG ratings can be applied to provide more nuanced distinctions between the companies in each of the three buckets, based upon their treatment of employees, governance policies, whether or not they take care of their toxic emissions or waste products, whether they protect water sheds or try to use clean energy for their operations, etc.  In this way, Tesla will be in the C+ bucket with other climate heroes and rated in comparison to other electric car companies but will never be in the same climate bucket as disgraced Climate Villain, ExxonMobil, which must try to out-maneuver other fossil fuels purveyors stuck in the C- bucket.

If this simple change were implemented, ESG funds could showcase their percentage of holdings that are C+ versus C, and ESG would finally become a highly effective tool for enabling investors to invest towards increasing the sustainability of our planet.

References

Columbia University, Climate Science & Solutions, Groundhog Day. Another Gobsmackingly Bananas Month. What's Up?, by James Hansen, Makiko Sato, Pushker Kharecha, January 4, 2023, the title is taken from a tweet by Zeke Hausfather.

NOAA National Centers for Environmental Information (NCEI) U.S. Billion-Dollar Weather and Climate Disasters (2023). DOI: 10.25921/stkw-7w73.

Fortune, Musk claims S&P ‘lost their integrity’ after Tesla gets booted from sustainability index while Exxon is included, by Christiaan Hetzner, May 18, 2022.

New York TImes, Sustainability Index Drops Tesla, Prompting Insult from Musk, By Jack Ewing and Stephen Gandel, May 18, 2022.

4. The (Re)Balancing Act of the S&P 500 ESG Index, by Margaret Dorn, Senior Director, Head of ESG Indices, North America, S&P Dow Jones Indices, May 17, 2022.

5. Harvard Law School Forum on Corporate Governance, ESG Ratings: A Compass without Direction, by Brian Tayan, a researcher with the Corporate Governance Research Initiative at Stanford Graduate School of Business, David Larcker, Professor of Accounting at Stanford Graduate School of Business; Edward Watts, Assistant Professor of Accounting at Yale School of Management; and Lukasz Pomorski, Lecturer at Yale School of Management, August 24, 2022.