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Do ESG Funds Really Put People Before Profits?

Corporate Governance Think-Tank to ESG Indexes: “Show Us Your Math”

In its early days, environmental, social, and (corporate) governance (ESG) investing was aimed at mitigating the effects of climate change by limiting investments in companies emitting considerable amounts of greenhouse gasses. Over more than 30 years (the first ESG index was launched in 1990), some of the indexes have added weight to investors’ concerns about human rights, discrimination and diversity, executive and worker compensation, corporate decision-making, and more.

It is not uncommon to find a company included in one or more ESG indexes but excluded from others. Different indexes take different approaches to what is called materiality. That is, they attempt to determine how much a factor like carbon emissions is material to a company’s business and its return to shareholders.

“It seems clear to us that ESG indexes and rating firms are making ESG scores based on standards that are either non-existent, arbitrary or driven by a potential conflict of interest,” said Rashida Salahuddin, President of The Corporate Citizenship Project.

The Corporate Citizenship Project, a think-tank focused on bringing a data-driven approach to corporate governance issues, has been making a point of publicly highlighting examples of companies that receive high ESG ratings from rating firms like Institutional Shareholder Services despite having troubling records. This illustrates the fact that ESG ratings do not appear to reflect companies’ true commitment to putting people over profits.

“ISS has appeared to award its supposedly highest honor, ISS ESG Prime Certification, to Anglo American Plc, the parent company of the infamous DeBeers Group – a name associated with indentured servitude and “blood diamonds.” ISS also awarded ISS ESG Prime Certification to Bridgestone, a company that appears to be lacking in diversity and has faced a litany of environmental-related complaints from regulatory agencies.

Both examples showcase how ESG rating agencies lack clear standards. If they have nothing to hide, why won’t they show us how they reached their conclusions,” Salahuddin added.

The Corporate Citizenship Project has publicly reached out to ISS through open letters asking ISS CEO Gary Retelny to explain the alleged inconsistencies in various ratings, including its decision not to downgrade the ESG rating of Russian state-owned oil companies despite Russia’s invasion of Ukraine. They say ISS has failed to respond.

As a result, The Corporate Citizenship Project says they are supportive but not optimistic about the U.S Securities and Exchange Commission’s stated intention to make ESG ratings “consistent, comparable, and reliable.” As things stand today, investors are pretty much on their own when it comes to comparing how ESG factors are incorporated in funds’ investment decisions and strategies.

The SEC’s approach appears to be trying to walk a line between prescribing a definition for ESG and letting the marketplace decide what ESG is. While it may be a good thing to let people decide what ESG means, it’s worth remembering that institutions and the rich own most of the country’s stocks and funds, and it is they who will be making those decisions.

Without some accepted regulatory oversight of what ESG is, it can be whatever is currently on rich people’s minds – and on the minds of companies that create ESG indexes and ESG evaluations for institutional investors. Companies like S&P Global and Institutional Shareholders Services, for example.

The rich may also be more likely to promote the idea that companies should focus on profits and, ultimately, returns to shareholders. If this sounds like a system designed to keep the rich in power one way or another, that’s not an unfair observation.

What the SEC wants to do, essentially, is make markets more competitive because competition, nudged along by reasonable regulation, can force companies to operate in a way that makes economic sense for everyone.

In a study on competition and gender prejudice done more than 10 years ago, researchers Andrea Weber and Christine Zulehner demonstrated quantitatively that “entrepreneurs with a strong prejudice against female workers forgo profits by submitting to their tastes.” The researchers continued:

“Our results show that firms with strong preferences for discrimination, i.e. a low share of female employees relative to the industry average, have significantly shorter survival rates. This is especially relevant for firms starting with female shares in the lower tail of the distribution.”

Can then companies that demonstrate a strong preference for ESG values – however defined – show a beneficial effect on their bottom lines? Right now, rising interest rates, decades-high inflation levels, and declining stock prices are likely to curb demand for adhering to ESG values.

Big investors and their advisors are demanding profitability, and there is not much evidence that ESG values add to profitability. The SEC’s focus on transparency and competition is a reasonable attempt to give ESG values a chance to show that such investment vehicles can be profitable for businesses and people.