The Problems With ESG

Many investors want to invest sustainably. This has led to the creation of the ESG concept. The idea behind this concept is that companies should be rated based on their environmental and social impacts, and on their governance. Banks and asset managers have been introducing new ESG products to the market for some time now. But not everyone is satisfied with the ratings, the models they are based on, and the promises being made to customers. This article lists the most widely-voiced criticisms of ESG.

• There are no unified ESG ratings

ESG should indicate that a company does something sustainably. But because there is no unified standard for measuring sustainability and determining which values should be accounted for, neither investors nor asset managers can agree on which companies deserve high ESG ratings, and which do not.

There can be massive differences between different ratings, depending on which rating system is used. ESG critics consider these discrepancies to be proof that these evaluations, in their current form, are almost arbitrary.

• ESG does not promote sustainability

Critics argue that while ESG may result in a feel-good experience for investors, it does nothing to change the world for the better. A company becoming more sustainable does not necessarily result in any positive change in the whole picture. For example, a company may simply spin off a controversial business into a separate company. The damage to the environment or society remains exactly the same – it is simply being done under a different name. Another concept which has been called into question is the idea that companies can make up for their negative impacts by simply buying environmental certificates.

Furthermore, pressure on companies from investors and public markets can result in controversial businesses being privatized. Once a business is no longer open to public investment, the market has even less influence over its activities.

• ESG ratings are based on hindsight

Some providers of ESG products argue that ESG ratings help investors to avoid risks. The logic behind this notion is that a sustainable company should – at least theoretically – have lower chances of becoming embroiled in an environmental or social scandal. But critics claim that ESG ratings often do not account for potential risks in advance. A company’s rating is only lowered once problems have already surfaced.

For example, until the data scandal of 2018 occurred, Facebook was considered to be a sustainable company from an ESG perspective. But ratings do little to prevent investment risk if potential disasters are only accounted for once they have already occurred.

• ESG does not bring higher returns

Companies which sell ESG products often claim that higher ESG ratings result in better investment performance. But critics question whether there really is any causal link.

For example, in the past, tech companies generally received good ESG ratings because the rating models placed a strong emphasis on the use of fossil fuels. Silicon Valley companies tend to perform well, in that regard. Because tech stocks boomed for many years, returns on tech portfolios over that period tended to be higher than those of the market as a whole. ESG portfolios which include large tech components rode this same wave. But that does not say anything about whether or not sustainability had anything at all to do with performance. There are no studies which show that a company becomes more profitable when its ESG ratings improve.

• ESG is marketing

Sustainability is a useful tool for companies to improve their reputations among the general public and with some investors. That means achieving good ESG ratings is in a company’s best interests. But a company does not necessarily have to be sustainable in order to get good ratings. It simply has to understand how the rating process works.

For example, companies which publish more data about their operations tend to get higher ESG ratings – whether or not that data shows sustainable business practices. Big companies tend to receive higher ESG ratings just because they have the resources and can afford to play this rating game. Critics see that as a sign that ESG is primarily a marketing resource for companies, rather than a concrete indicator of a company’s sustainability.

• ESG is a money-making scheme

ESG funds are often more expensive than conventional products. Service providers justify the higher cost by citing the additional work involved in choosing investments which are compliant with ESG analyses. But that does not change the fact that some ESG products barely differ from conventional offers. For example, many Swiss investment funds which are marketed as sustainable invest primarily in the three Swiss heavyweights Nestlé, Roche, and Novartis. Those same companies are strongly weighted in the Swiss Performance Index, which indicates the state of the Swiss stock market without any focus on sustainability.

For critics, that clearly shows that ESG is just about the money. Because demand for sustainable investment products is high, asset managers and banks can charge higher prices for ESG offers, even if they are nearly identical to conventional investment products, and provide hardly any added value.

More on this topic:
What is sustainable investment?
ESG explained
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