ESG Critics Ultimately May Help Improve the Strategies

Subjective and arbitrary decisions do affect ESG rankings — but ongoing challenges may lead to more accurate assessments.


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If those on either side of the debate over environmental, social, and governance investments feel thoroughly convinced of their arguments, they should think again. Getting ESG closer to right will be extraordinarily challenging but likely worth the effort.

Even when mindful of ESG, many allocators may not have a thorough understanding of how their positions are making a difference on issues of key concern.

In fact, three-quarters of 131 largely U.S.-based allocators didn’t even track ESG metrics, according to a 2021 survey by Backstop Solutions.

But they wanted to.

Holding them back was a lack of universal reporting standards and challenges in obtaining meaningful data. Many investors believed that even if ESG wasn’t driving business decisions then, it would be.

ESG-related investments are expected to top $34 trillion by 2025, according to consultancy PwC. That means it’s essential for investors, allocators, politicians, and regulators to better understand this contentious and complicated topic.

The concept that investments can shape the behavior of companies and countries isn’t new.

Apartheid was law in South Africa. A global boycott of all things South African in the latter part of the 20th century helped to abolish apartheid, which openly discriminated, punished, and killed without any form of due process.

The problem with much of the current discourse: it’s often abstract, attempting to grade behavior and then neatly rank an amalgamation of concerns.

Actually identifying the potential real-world benefits of ESG reporting may help everyone better understand the point of this exercise.

Imagine what might’ve happened if disclosure requirements had forced Exxon to release its scientists’ findings about the effects of burning carbon on the climate when they initially made them three decades ago?

Or if investors had known Boeing Co.’s governance was not sufficiently focused on safety issues while empowered to largely self-certify its 737 Max airplanes?

In the U.S., the politicization of ESG has muddled the value of a process that at its core seeks to highlight risks.

Regardless of what’s motivating this pushback, it is prompting a reassessment of ESG — from arbitrary and confusing ESG scores to recognizing issues are not always black and white.

Wall Street ran into this problem when it sought to stop lending to oil companies. Carbon fuels are essential during the transition to cleaner energy. Mining can have terrible impacts on workers’ health and the environment. But green technology depends on unearthing these minerals. And nuclear energy is being reconsidered as a clean alternative to other sources of power.

Then, as with any rapidly expanding business, there’s the legitimate question of whether consultants and rating agencies, which have made big bucks promoting ESG, can assess various issues in a way that adds real value.

There are also clear ranking problems. We’ve seen oil companies and cigarette makers outrank electric-car manufacturers. And plant-based meat operations have received below-average ESG ratings even though factory farming is a key source of global greenhouse gases.

We’re now seeing leading global rating agencies rethink certain ESG metrics. The European Union is also revamping rating standards.

But here in the U.S., the Securities and Exchange Commission has given the impression of being far more focused on sanctioning managers for green-washing than on helping to clarify what constitutes sustainable and socially responsible investing, according to Anna Niziol, former chief marketing officer and head of product management at global asset manager Rothschild & Co.

How much of the massive flows into ESG investments are impactful is hard to discern.

The EU’s Sustainable Finance Disclosures Regulation, which guides by far the largest amount of ESG investments in the world, should require far greater transparency. It identifies different levels of engagement where asset managers can just consider issues or actively target sustainable objectives.

The United Nations’ Principles for Responsible Investment — which kicked off the current ESG movement in 2006 — is even vaguer. Its signatories account for $68 trillion in assets under management. But they aren’t obligated to do anything more than consider ESG issues before making investments.

So how many ESG dollars are changing anything? Therein lies the rub.

Niziol believes there is significant misrepresentation of the impact because it’s difficult to separate ESG assets that meet the bare compliance minimum from those that are actually making a difference. She believes asset managers claiming to be mindful of ESG should be required to distinguish their level of commitment to these issues.

New York University finance professor Aswath Damodaran, an outspoken ESG critic, wants it to simply disappear. “You’re trying to standardize something that by definition can’t be standardized,” he says. “Goodness is defined by each of us individually. The notion that [ESG raters] can come to a consensus and measure that goodness strikes me as just about impossible.”

ESG is certainly more than rating good versus irresponsible behavior; it’s seeking to make longer-term investments more productive while reducing risk. Yes, subjective and arbitrary decisions affect rankings. But are they any greater than biases involved in sell-side equity and credit ratings that vary widely?

Manuela Cedarmas, head of ESG at global allocator Investcorp-Tages, sums up the case for ESG. “At its heart, ESG is a powerful risk management tool that expands the meaning of risk beyond its traditional bounds,” she says. “This doesn’t mean there’s a blanket approach to assessing every company across every sector. The assessment is far more nuanced and ever-evolving. And failure to understand this process is leading to confusion.”

Not so long ago, a number of airplanes inexplicably fell out of the sky while landing. In response, airplane manufacturers installed wind shear detection units into cockpits. Initially, they annoyed pilots because they frequently generated false positive alarms. Many pilots disabled the systems. But eventually wind shear detection was refined, and it’s now universally celebrated as an essential safety feature.

New systems take time to evolve. With the growing urgency of climate, sustainability, governance, and equity, it’s far more important to improve ESG than to abandon it. But this will happen only if regulators (and asset managers) establish clear, meaningful standards to close the gap between ESG mandates and what’s actually being accomplished.

This won’t be easy. But if it happens, there will be a better chance that ESG will track a similar glide path as wind shear detection.

Eric Uhlfelder is based in New York and has been covering global capital markets for more than three decades.

Opinion pieces represent the views of their authors and do not necessarily reflect the views of Institutional Investor.