ESG: The misunderstood problem child of finance

ESG is having an identity crisis. The news that the S&P Dow Jones Indices 500 will no longer include electric car manufacturer Tesla in their ESG index fund while keeping oil giant Exxon Mobil has left many scratching their heads, asking what role should ESG play in the world of finance?

Breaking down ESG

ESG measures the potential risk a company may face in relation to environmental, social, and governance factors. It can provide a useful lens to examine a company’s operations and impact.

Investors and consumers are becoming more conscious about who exactly deserves their income and why. Demand for ESG products increased by an astounding 303.8% between 2017-2020, driven by varied factors including targets set by the Paris Agreement and increasing social and environmental conscience amongst consumers.

Analysis from Pimco shows by May 2021 ESG was mentioned in almost a fifth of all earnings calls. And that growth is likely to keep trending upward. According to Bloomberg, by 2025 ESG assets could be worth a whopping $52 trillion, representing one third of all assets under management.

Investors are increasingly relying on this new set of criterion to determine their investment decisions - a new movement that is becoming more influential.

Big problems, bigger implications

Despite growing interest in ESG, there’s often a fundamental misunderstanding when it comes to its ratings. These ratings are based on proprietary methodologies created by private rating agencies to determine the risk companies face in relation to ESG criteria.

Let’s make one thing clear: ESG ratings are not a score to assess the impact a company has in these three core areas. Instead, it’s their implications on financial risk that stand front and center. Diving deeper into a seemingly well-intentioned framework reveals core issues.

Often ESG is seen only for its first letter – the environment. Among the most important related issues, 44% of investors were seeking to address or consider climate change in their investment decisions – more than any other issue.

This is one of three main perspectives that often lead to a dissonance between perceived ESG performance and actual rating – a side effect of bundling three topics into one metric. While they frequently interplay with each other, contradictions can and do arise.

Going back to the Tesla’s removal from the S&P Dow Jones Indices 500, the three differing components of ESG come into play. Despite Tesla’s advancements in electric vehicle manufacturing, reports of poor working conditions and racism at its California plant among other issues have impacted its rating.

[Read: Why the future of finance needs to be green]

Clear definitions in the ESG world are also lacking. A recent report found that only 10% of German ESG funds were completely free of controversial companies. Which leads to the fundamental question: What exactly constitutes something as ESG?

General practice used to exclude arms and weapons dealers from being classified with this label; however, a new war in Ukraine has forced many to rethink their positions. Is the defense of democracy considered a positive factor in ESG? These debates fill a regulation vacuum, caused by a lack of standardization.

At the heart of the skepticism is greenwashing. More shine than substance, many funds misleadingly slap ESG labels onto their products to profit off this growing trend. An extreme example of this attitude was recently seen when Deutsche Bank’s sister company DWS was recently raided by German officials in an investigation against greenwashing allegations.

And then there are the ratings themselves. Five main rating agencies with differing methodologies compete in this space and with wildly different outcomes. Research from MIT and the University of Zurich found that the correlation between different ESG ratings ranged from 0.38 to 0.71, in stark contrast to that of credit rating agencies, where the correlations rests at 0.92.

These ratings weigh aspects differently depending on the industry. This results in oil companies with relatively high ESG ratings, yet they should be interpreted as facing relatively low risk compared to similar companies in the same industry.

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ESG is not a litmus test for the general good a company does across environmental, social, and governance issues; it represents potential risks in comparison to similar companies, not actual impact for these issues.

An obstacle to better ESG ratings is a lack of quality and transparent data. Where no such data is available, many of these models rely on imputations to fill in gaps.  Behind a mountain of problems lie areas of immense opportunity for ESG.

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The opportunities for ESG

It’s easy to see that current ESG philosophy doesn’t quite live up to its purpose. The lack of standardization paired with a rapidly expanding yet premature market has resulted in a frustrating concoction of competing private sector solutions, mixed results, and a good deal of confusion.

What’s the big picture here? This far-from-perfect system is brimming with opportunity. It just needs direction.

ESG is young. As the new kid on the block, it has garnered a quite a lot of attention and criticism without the time to mature through trial and error. Officially a little under two decades old, the nascent methodology didn’t really take hold until 2019. Traditional financial metrics took around 80 years to get right – and even they’re not perfect.

Unfortunately, there isn’t much time for it to incubate. A new report by Deloitte lays out the costs of an increase in global average temperature rise by 3 degrees Celsius, set at an eye-watering $178 trillion by 2070. That’s roughly five times the GDP of the world’s two biggest economies, the US and China, combined. The implications for the economy, society, and planet would be disastrous. Acting, however, to keep global warming below 2 degrees Celsius could create $43 trillion in new economic opportunity.

ESG signals a shift. Its rise reflects the broader movements of sustainability and social consciousness, driven by changing attitudes of consumers and businesses. But it needs a new direction. Its good intentions need to be paired with a combination of robust regulation, increased transparency, and more high-quality data.

We need to encourage each and every company to release their climate-related disclosures, because the real problem is the lack of access to quality data and willingness to share it. Normalizing disclosures results in a domino effect of widespread transparency, a key solution to optimizing ESG.

And good news is on the horizon. Significant progress is being made on the regulation front. The European Commission has proposed policies, including the Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy, aimed at standardizing corporate reporting and the labeling of green assets.

[Read: The Green Banking Guide]

The US isn’t far behind. The Security and Exchanges Commission recently announced two new proposals aimed at regulating sustainable finance. One would standardize and mandate climate-related disclosures, a big win for quality ESG data, while the other would crack down on greenwashing with clear guidelines for ESG funds, their naming conventions, and reporting requirements.

While these proposals are still a work in progress and come with their fair share of criticism, they are a step in a more accountable direction.

But the deadline is tight and the future of ESG is still uncertain. Many believe it will eventually be incorporated into regular financial metrics as an extension of risk assessments. Until then, it must undergo several improvements for it to be a viable financial tool that blends purpose with strategy.