By Anna Emilie Wehrle
This essay is a first-prize winner of the Fall 2022 Chair’s Essay Competition on the topic of: “Has ESG Investing a future as a contributor to financing sustainable development?”
Sustainable finance means that financial capital is invested only where it does not harm efforts to reach the Sustainable Development Goals. The EU understands it as “finance to support economic growth while reducing pressures on the environment and taking into account social and governance aspects” (European Commission). ESG Investing is a form of investment, that only invests in firms that fulfil certain standards regarding three criteria: Environment, Social and Governance. To facilitate this, there are private ranking firms, that provide ESG rankings, which are supposed to reflect on a company’s performance in the three sectors.
The problems that come with ESG investment in its current form are multiple and have been much discussed recently, both in press articles and in academia. ESG investment is closely linked to ESG ratings. But, if ESG ratings were to contribute effectively to sustainable development through capital markets, they would have to be improved in three areas. Firstly, the divergences in the weighting of different factors across rating organisations would have to be reduced. Secondly companies would have to be required by regulators to disclose data and information necessary to produce representative ratings, and thirdly the general approach to the evaluation process of a company’s environmental impact would have to be revised.
Currently, ESG ratings vary to a point which makes it very difficult for investors to rely on them. A Wall Street Journal analysis of six ESG rating providers concluded that there was not one firm that received the same rating from all six raters, that the indicators included in the different rankings ranged from 38 to 282 per company, and that “the measurement differences were responsible for 56% of the overall ESG variations. The use of different indicators was responsible for 38% and weightings 6%” (Berg, 2022). An OECD report also found that the environmental aspect in ESG varied widely as rating firms did not weigh factors such as “carbon footprints and intensity, climate risk management, or transition strategies” equally (OECD, 2021, p. 78). In its letter to the European Commission, ESMA also underlines that the “low levels of transparency of methodologies and of data sources were identified as the most relevant factors hampering the reliability of the final ratings and their comparability between ESG rating companies” (ESMA, 2022, p. 19).
This first problem is clearly related to the fact that there is no regulation regarding the obligation to disclose metrics and data needed to provide for relevant and reliable ratings. Gaps in and lack of quality of provided data creates uncertainty in ESG ratings (OECD, 2021, p. 78). Without the obligation to fully disclose relevant information, ESG ratings are inevitable deficient. Lacking information also creates international inconsistency and want for comparability (Boffo & Patalano, 2020, p. 9).
The third problem with the current form of ESG ratings relates to what is actually measured by ESG ratings. For ESG ratings do not actually quantify the environmental impact of a company, but rather what impact climate change has on the financial performance of the company in question (Halper, Grieve, & Shriver, 2022). Ratings can be high if the rater deems that the “company’s bottom line” is not negatively influenced by climate change (Simpson, Rathi, & Kishan, 2021). To break it down, the extensive analysis of the biggest ESG rating firm MSCI conducted by Bloomberg comes to the conclusion, that what is reflected in the ESG rating is the impact of the world on the company and not of the company on the world (Simpson, Rathi, & Kishan, 2021).
It is important to note, that the two first problems relate to the quality of ratings, while the third concerns the nature of the rating in general, while all three relate to how ESG ratings could be improved.
I will argue that this, however, is not exactly the question we should be asking ourselves. For ESG ratings might deliver important insights – if well done – on the resilience a certain company disposes of vis-à-vis climate change, but its contribution to financing sustainable development will always be strongly limited. And that is because ESG investment today is an alternative to ‘traditional’ investment, and as companies that produce massive amounts of carbon emissions do not necessarily have bad ratings, an often greenwashed one, too. Anyhow, sustainable development does not mean “a little less carbon”, it means decarbonisation. And for that, private rating firms that deliver justifications for ‘green labels’ on investment funds are not the answer. Recent studies find that sustainable investment can be more profitable than ‘traditional’ investment. Scholars at Oxford University found a “remarkable correlation between diligent sustainability business practices and economic performance” (Clark, Feiner, & Viehs, 2015, S. 8). A study conducted by scholars from Harvard Business School also showed, that “high sustainability companies significantly outperform their counterparts over the long term, both in terms of stock market and accounting performance.” (Eccles, Ioannu, & Serafeim, 2014, p. 2835) Nevertheless, they Eccles et al. equally underline, how that an emphasis on a long-term vision is indispensable for sustainable profitability, as long-term profit-seeking “often implies a negative externality being imposed on various other no shareholding stakeholders” (Eccles, Ioannu, & Serafeim, 2014, p. 2842). Taking sustainability aspects into account when investing can thus lead to greater returns, though mostly when it comes to long-term profits. The fundamental problem remains.
Short-term profits are often prioritised over long-term sustainability ambitions (Doorasamy & Baldavaloo, 2016, p. 80). ESG investment in its current form constitutes an alternative for those that seek long-term returns rather than short-term. The environment, however, cannot bear both. To reach net-zero by 2050, which is generally acknowledged to be needed to keep the global temperature increase caused by carbon emissions under 1.5°C as agreed on in the Paris Agreement, McKinsey expect that “spending on physical assets on the course to net-zero would reach about US$275 trillion by 2050, or US$9.2 trillion per year on average, an annual increase of US$3.5 trillion” is needed (Kumra & Woetzel, 2022). To compare, US$3.5 trillion equals “about half of global corporate profits, one-quarter of total tax revenue, and 7 percent of household spending.” (Kumra & Woetzel, 2022) The most recent ICC Assessment Report states that “there is at least a greater than 50% likelihood that global warming will reach or exceed 1.5°C in the near term, even for the very low greenhouse gas emissions scenario” (IPCC, p. 8). In this situation, ‘traditional’ or ‘non-sustainable’, short-term profit-seeking investment in fossil fuels, de-forestation, or any other to climate change contributing industries cannot remain an alternative way that investors can choose if their conscience allows them to. From another point of view would it be naïve to believe that it is possible that a big majority of investors accepts to have smaller short-term returns than the market allowed for over decades, out of pure consideration for the environment and in time for temperature increase not to hit 1.5°C degrees.
The sustainable development needed to respect the Paris Agreement will realistically not be funded through an alternative way of investing, chosen by investors that adopted in very little time a completely different approach to financial returns of investment. However, ESG investment should not be thrown out just yet for two reasons: First of all, for now, it is all we have. Second, there might be a way of improving current ESG ratings which could blaze the trail for making finance markets greener in the long term.
ESG investing might not be the solution, but it is the only existing answer to an increasing demand in sustainable investment. More importantly, however, a regulation of ESG ratings and benchmarking could pave the way for a more ambitious regulation of capital investments at a later point. As I have argued earlier, investing in sustainable development cannot remain an alternative pathway, it must become the norm to reach net-zero. Regulating capital and financial markets, however, always comes at great risk of economic losses. If the current loopholes of ESG investing were dealt with by regulators, a pathway to restricting non-sustainable investments would be prepared simultaneously. If regulators mandated the disclosure of information relevant to a company’s impact on the environment and on their impacts in the social and governance domain, ESG ratings could be more transparent and more meaningful. The same goes for if ESG ratings were more transparent in the weighting of their rating factors. And if ESG factors were benchmarked, transparent, and public, it would be much easier to change the logic with which ESG ratings assess the environmental impact of a company.
Once there is a functioning due-diligence and transparency practice regarding a company’s environmental impact in place, regulators can use them as levers to limit non-sustainable practices progressively. And since regulating financial markets is a delicate matter from which regulators will probably continue to refrain, improving ESG rating mechanisms now, does not only improve transparency for investors seeking investing in sustainable companies immediately. Under these circumstances, ESG Investing would have a future as a contributor to financing sustainable development.
Boffo, R., & Patalano, R. (2020). ESG Investing: Practices, Progress and Challenges. Retrieved October 2022, from OECD Pairs: http://www.oecd.org/finance/ESG-Investing-Practices-Progress-and-Challenges.pdf
Clark, G. L., Feiner, A., & Viehs, M. (5. March 2015). From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance. Von https://ssrn.com/abstract=2508281 abgerufen
Doorasamy, M., & Baldavaloo, K. (2016). Compromising Long-Term Sustainability for Short-Term Profit Maximization: Unethical Business Practice. Foundations of Management, 8, pp. 79-92.
Eccles, R. G., Ioannu, I., & Serafeim, G. (2014, November). The Impact of Corporate Sustainability on Organizational Processes and Performance. Management Science, 60(11), pp. 2835-2857.
ESMA. (2022, June 24). Outcome of ESMA Call for Evidence on Market Characteristics of ESG Rating and Data Providers in the EU. Retrieved November 2022, from ESMA (European Securities and Markets Authority): https://www.esma.europa.eu/sites/default/files/library/esma80-416-347_letter_on_esg_ratings_call_for_evidence_june_2022.pdf
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Kumra, G., & Woetzel, J. (29. January 2022). What it will cost to get to net-zero. Abgerufen am 2022 November von McKinsey Global Institute: https://www.mckinsey.com/mgi/overview/in-the-news/what-it-will-cost-to-get-to-net-zero
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Simpson, C., Rathi, A., & Kishan, S. (2021, December 10). The ESG Mirage. Retrieved November 2022, from Bloomberg: https://www.bloomberg.com/graphics/2021-what-is-esg-investing-msci-ratings-focus-on-corporate-bottom-line/