In the fight against climate change, capitalism isn’t helping. Designed to direct capital to the highest and most efficient use, the companies making the most progress in developing environmentally friendly ways to produce, transmit, or distribute energy are receiving less credit than they should.
In a paper dated March 2021, published by the European Corporate Governance Institute, three authors found that investors who focus their investment decisions on Environmental, Social, and Governance (ESG) criteria are giving too little weight to the companies creating the greenest innovation. ESG investing has been around since the early 2000s. But it was the 2015 U.S. Department of Labor decision allowing fiduciaries to incorporate ESG factors into their investment decisions that pushed acceptance more broadly. As a result, the alternatives for environmentally-minded investors who wish to allocate funds through an ESG lens have exploded.
The challenge, explained here, is the scoring systems created by ESG rating agencies and how well they identify companies making the most impactful contributions to the specific challenge of global warming. Higher ESG scores reflect organizations seen as better equipped to anticipate future risks and opportunities, more inclined to longer-term strategic thinking, and prioritize long-term value creation over short-term gain. With that in mind, it is natural to ask whether the companies supplying the greenest innovation are earning recognition through high ESG scores. And are they thereby claiming a greater allocation of investor capital? According to the authors, the answer is no.
- They found that companies with lower ESG scores – and most likely excluded from ESG funds investment landscape – are producing more and higher quality innovation designed to mitigate climate change.
- They show that a sizable percentage of recent green patent issuance in the U.S. is driven not by highly rated ESG firms but by firms typically excluded from the ESG funds investment universe.
- They show that the energy sector has a sizable percentage of their entirety of patenting activity dedicated to green research.
- They show that the green patents of energy-producing firms are significantly higher quality based on the number of citations.
- They reviewed the green patent universe that examines only those green patents directly addressing “climate change mitigation technologies related to energy generation, transmission, or distribution.” They show the energy sector has nearly three times the relative focus on green innovation in their research portfolio as the average industry.
Out of 50 green patent producers, 14% are energy firms typically excluded from ESG favored funds. These companies are often also the subject of divestiture campaigns based solely on their production of carbon-based fuels. These firms include Exxon Mobile, Honeywell International, Royal Dutch Shell, BP, Conoco Philips, Chevron, and US Oil, which produced 6,969 green patents as of 2017.
Despite these facts, energy firms receive much lower ESG scores, minimizing or eliminating their representation in portfolios driven by ESG factors. When firms with higher ESG scores produce less innovation and earn fewer green patents, it becomes fair to ask whether ESG scores consider the green patent production of firms in the first place. The evidence suggests the answer is no.
If the idea of ESG investing is to reward those companies whose behavior aligns with actions most likely to arrest or reverse climate change, how much progress will we make by minimizing rewards from those companies coming up with the most innovative ideas?
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