ESG Investing and the Politics of Compassion

• 062223
• 4 minutes

The power of human compassion is often found center stage when disaster strikes. Many are moved to heartfelt action. For most of us, the best we can do is offer financial support. But we learn this is a complicated proposal. The ‘business of recovery’ can get in the way, misallocating or suspending resources, impeding localized participation—especially in developing areas, and more. The gap between theory and practice can be appalling. Meantime, well-meaning individuals are left to thumb the thousands of words of hope and promise and wonder who truly benefits.*

There’s a practical, if not emotional, parallel between supporting such efforts and ESG (Environmental, Social, and Governance) investing. ESG continues to motivate more investors to reevaluate their approach to the market and embrace this trend.

Others are not so inclined. For example, earlier this year, Republican governors issued a statement cautioning against ESG investing, expressing concerns about its potential impact on the American economy and individual economic freedom. Their criticism stems from the belief that ESG investing prioritizes diversity and environmentalism over profits, potentially threatening the American financial system.

In reality, the pitfalls of ESG investing lie somewhere else entirely.

Contrary to the perception that ESG investing is a recent outcome of "woke" activism, it traces its roots back to socially responsible investing, which emerged in the 1960s. Over time, this approach has evolved, with a focus on positive screening. Many investors seek companies that demonstrate exceptional social or environmental performance today. In response to this demand, numerous ESG rating agencies have emerged, offering investors a simple, easy way to invest in corporations that share their core values.

In theory, that is. The premise weakens under closer scrutiny. Take MSCI, for example, one of the most influential ESG rating firms. A 2021 Bloomberg investigation revealed that the portion of their rating they call “environmental” isn’t, as one might reasonably assume, a rating of a company’s environmental impact. Instead, it’s the projected impact that climate change is anticipated to have on a corporation’s bottom line and how much the company is doing to mitigate that risk. So if climate change isn’t deemed a significant threat to a particular business, its carbon footprint wouldn’t even factor into its environmental rating.

Then there are the wild inconsistencies among different firms’ ratings for the same companies. A 2022 study from Stanford University revealed a meager 61% rate of correlation among prominent agencies’ ratings. The researchers found that the bulk of the discrepancies arose over differences in measurement and scope, not data point weight—highlighting how fundamentally different each firm’s rating systems can be. Since ESG ratings are still largely unregulated, there’s little incentive to standardize rating methodologies.

Lack of regulation also leads to a lack of transparency by ESG rating firms. And while most of these agencies typically hold their proprietary rating methods close to the vest, some telling patterns are discernible. For example, large companies usually see better ratings than smaller ones. Explicit conflict-of-interest situations can go unchecked, with agencies rating affiliated companies or those to whom they sell consulting services.

In addition to an opportunity to invest in line with your values, ESG rating firms also claim that highly rated businesses mean higher returns. The argument is that these ESG-conscious companies have fewer liabilities, better brand reputation and a higher likelihood of financial success. However, a 2020 research study concluded that “the financial performance of ESG investing has on average been indistinguishable from conventional investing.” The data seems to indicate that market conditions impact the performance of ESG investments just as significantly as the next.

And while ESG investing has encouraged companies to disclose more information and consider climate risks, it has yet to result in substantial progress in addressing social and environmental issues. Moreover, there is a growing belief that this rising ESG trend has reduced the demand for government intervention in addressing societal problems. Some argue that the perception of corporations independently tackling these issues through self-regulation via ESG investing has diminished the need for government action. Notably, the CEO of BlackRock, a prominent investment firm, has voiced opposition to government regulation, asserting that ESG investing alone is sufficient to ensure corporate responsibility and ethical behavior.

So are ESG ratings all smoke and mirrors? Not necessarily, according to a paper published earlier this year by a team of MIT Sloan Sustainability Initiative experts. While acknowledging the manifold flaws inherent in the current iteration of ESG rating systems, they contend that, for now, it’s the best we’ve got to measure the ethical behavior of companies. That said, it’ll take much more than simply aggregating the disparate ratings to make sense of the data. For the individual investor inclined toward ethically sensitive investing, the research and number crunching required are daunting, if not inhibitory.

As life becomes more apparently sophisticated, we are losing the simplicity of truth and clarity. New systems make it harder to safely show compassion, demand accountability and act responsibly. Harder—but not impossible. Harder because it requires more from us as individuals. More digging, research and critical appraisal of assumed authority. But possible because we have access to the knowledge and support we need. Especially advisers we trust to know more—than us and for us. And to help us aim our compassion and concern with greater economy and precision.

• financial planning
• investing
• millenials
• diversification