“ESG” investing: a climate friendly choice?

Facing the huge challenge to prevent global warming going beyond 1,5 degrees Celsius, many countries are relying on the private sector for much of the investment needed in renewable energy and other low carbon solutions. While every sector of society must play its part – and urgently – the role of investors and their decision-making processes needs more scrutiny say SOMO’s senior specialist on finance, Myriam Vander Stichele, and executive director, Audrey Gaughran.

Responding to pressure for the investment sector to be more socially and environmentally responsible, investors have increasingly embraced the use of so-called “Environmental, Social and Governance” factors in their decision-making process. Known by the abbreviation ESG, this positive-sounding approach is actually leading to some deeply troubling developments.

ESG: booming business without a clear methodology

One warning sign is that ESG is becoming a billion dollar industry. To feed the demand of investors for ESG information, commercial service providers -often serving the financial sector– have started providing ESG ratings and data products. Some of these products use language similar to credit ratings. Notably, some of the world’s biggest credit rating agencies, such as S&P Global, have gotten into the ESG business.

The data and methodology behind these ESG products are seldom fully disclosed. Rating agencies rely heavily on information provided by the companies they are assessing, and independent fact checking appears limited at best. Social and environmental groups, and even leading financial industry bodies and regulators, have expressed concerns about the lack of transparency and reliability, and risks of green washing.

But that’s not the only problem with the ESG industry.

Focused on investor risks more than impact on climate

There is a significant gap between what is assessed by many ESG ratings and data products and what is assumed to be assessed: ESG ratings and data products increasingly focus on risks that will affect the investor. That means that environmental, social and governance impacts of companies (for example, actual impacts on the climate) are not the primary consideration.

This becomes problematic when the marketing of these products as “environmental, social and governance” ratings or assessments leads to the perception that such tools measure how well a company is doing in terms of its social, environmental and good governance impacts. Often, what they actually assess is how well a company manages financial risks and/or the material financial risk to the investment. ESG related investment products that use and refer to these ratings may also mislead (retail) investors who want to invest in companies that have positive ESG impacts.

Speaking specifically to climate issues, the OECD(opens in new window) recently noted that ESG rating is being increasingly used as a tool to align investments with a low-carbon transition. The same report also commented that “Notwithstanding noteworthy progress, there remain considerable challenges that hinder the efficacy of these approaches, and notably ESG investing, to support long-term value and climate-related international objectives.”

Greenwashing

This is not the first time the language of social justice and environmental sustainability has been appropriated and re-defined by big business interests. In this case, the implications go beyond PR; ESG ratings and data are already the basis for billions of Euro in investment decisions.

Earlier this year a financial industry insider turned whistleblower(opens in new window)  described  sustainable investing as “little more than marketing hype, PR spin and disingenuous promises from the investment community.”

And, while the use of ESG rating and data products is on the rise, there are hardly any regulatory frameworks that explicitly cover the providers of these “products”.  The lack of any real standards for what goes into an ESG product prompted The International Organization of Securities Commissions (IOSCO), to propose recommendations to bring some openness and quality into the ESG sector.

SOMO comments on the issue of ESG ratings

SOMO has provided input for IOSCO’s consultation, and raised some overarching concerns regarding more systemic problematic issues surrounding ESG ratings and the companies’ long term impacts on planet and people.  IOSCO (and the OECD) have framed the challenge as being to make the ESG products better. There are, however, more fundamental questions about the risks involved in developing a range of financial market products. SOMO’s submission to IOSCO can be found here.