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Elon Musk and the Black Hole of ESG Investing

S&P Global announced in late April that it would drop Tesla from its widely followed ESG Index, citing a lack of low carbon strategy, claims of racial discrimination and crashes related to the automaker’s Autopilot self-driving software. At the same time, the index added oil refiner Phillips 66 and oil producer Marathon Oil to the index.

ESG, an acronym for environmental, social and governance, was a hot issue in 2021. Flows into U.S. ESG mutual funds and exchange-traded funds rose by a third to $400 billion in total assets under management last year. While that may sound like a lot, it represents just 1.4% of all U.S. ESG-related assets.

The decision by S&P Global sparked debate. How does a universally acknowledged environmentally conscious company like Tesla get booted from a major ESG index and two “fossil fuel” companies get added? Are ESG funds just greenwashing by investment management firms pretending to care about what the acronym stands for without really meaning it?

Part of the problem, of course, is that each of the terms in ESG is open to interpretation. And those interpretations can lead to a wide range of investment strategies. Should an ESG investment focus more on the environment than the social or governance, or should all three be weighted equally?

“It is challenging when ratings agencies claim to quantify what are essentially moral judgements,” said Bryan Junus, chief analyst for The Corporate Citizenship Project, a Des Moines, Iowa-based think-tank that advocates a data-driven approach to corporate governance matters.

“For example, some investors may want to avoid investing in gun manufacturers because of the recent tragic mass shootings. However, other investors say that the root of these shootings can be traced to violent video game makers or social media companies. Are ratings firms like ISS and S&P really qualified to wade into and quantify these deeply political and philosophical issues? We don’t think so and that’s the root of why the field of ESG is so flawed and open to abuse. The industry needs much more quantifiable metrics,” Junus added.

Currently, there is no standard definition of ESG. Bloomberg’s Matt Levine summarizes the problem neatly: “To some extent ESG means ‘buy companies that you think are making the world better,’ and if different people have different conceptions of what makes the world better then they will disagree about what ESG demands.”

Yet, not all voices are equal. Individual investors can vote with their wallets, choosing their own strategies and companies. There is no shortage of advice and guidance for them to review either at no charge or for some relatively modest fee.

Institutional investors have another choice. They can outsource the vetting of ESG claims to organizations like Institutional Shareholder Services (ISS) or Glass Lewis that advise these big investors on issues that company or fund shareholders are being asked to vote on. These could include management salaries, an activist investor’s attempt to elect members of a company’s board or the sale of the company, among other things. However, their advice also has come under scrutiny, given that these firms provide both ratings and simultaneously “consulting” services.

The Corporate Citizenship Project’s president, Rashida Salahuddin, cautioned investors on the reliability of ESG ratings: “The fact that ISS provides ESG ratings on publicly traded companies and simultaneously offers ‘ESG consulting’ to those same companies should be a cause for concern for socially-conscious investors. Just like wealthy parents help their kids game the SATs, wealthy corporations can essentially ‘game’ the ESG ratings process.”

As a result of this increased scrutiny on the ESG field, government agencies have started taking action. Late last month, the U.S. Securities and Exchange Commission fined Bank of New York Mellon’s investment advisory group $1.5 million for misstating or omitting ESG investment considerations for the mutual funds the bank manages.

Two days later, the SEC proposed amended rules and reporting requirements to promote “consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of environmental, social, and governance (ESG) factors.” The proposed changes address establishing broad strategic categories for ESG funds and require funds and advisors to be more transparent in the materials they provide investors.

SEC Chair Gary Gensler commented: “ESG encompasses a wide variety of investments and strategies. I think investors should be able to drill down to see what’s under the hood of these strategies. This gets to the heart of the SEC’s mission to protect investors, allowing them to allocate their capital efficiently and meet their needs.”

“In a field that is highly subjective, complete transparency is key,” added Junus. “As we see it, investors can be taken advantage of by opaque ratings systems in two ways. Either one person’s definition of ESG is not another’s or the ratings themselves are the result of a pay-to-play type situation. In either circumstance, the remedy is clear: quantitative data and transparency.”

What SEC oversight of ESG funds means remains something of a black box, though perhaps it would standardize somewhat decisions like the one by S&P Global.

For more information on The Corporate Citizenship Project, please visit www.CorporateCitizenshipProject.com.