By: Phil Kernen

Making investment decisions based on a company’s environmental, social, or governing (ESG) policies and associated risks can make sense in theory. However, doing so is a relatively new practice and full of growing risks. Investors have been voting their values for years through Socially Responsible Investing, but ESG is a different animal and is about more than climate change. As ESG investing matures, it faces political and regulatory pressures that will impact the reliability of marketing claims and the ability of investors to apply personal value judgments.

Riding the wave of passive investment funds, Blackrock, Vanguard, and State Street became the largest investment firms in the U.S, controlling about 25% of shares voted in director elections at S&P 500 companies. They leverage their dominance, pressuring corporations to comply with their preferred ESG values. However, ESG standards are not universal – the priorities of one party may not agree with another. In early August, 19 state attorney’s general pushed back on behalf of public investment pools, questioning how Blackrock’s ESG advocacy aligns with its fiduciary duty to investors. As with so much else, ESG now carries a political taint that will impact the degree of investor acceptance going forward.

Meanwhile, how are regulatory bodies protecting investors from conflicts of interest and ensuring accurate information about these same investment organizations with whom they entrust their funds? Europe is leading the regulatory charge over ESG, so reviewing their progress can inform U.S. investors. In March 2021, the European Union agreed to a new rulebook for ESG investing. Regulators designed the Sustainable Finance Disclosure Regulation (SFDR) to do away with inflated sustainability claims from the region’s asset managers, creating three categories for managers to self-identify.

Article 6 funds do not integrate sustainability into the investment process and could include stocks currently excluded by ESG funds, such as tobacco or coal producers. 

Article 8 funds promote social and environmental characteristics but do not have sustainable investing as a core objective. 

Article 9 funds have sustainable investment objectives as a core purpose alongside a designated reference benchmark.

Article 8 funds are the least stringent category that can still carry the ESG label for marketing purposes. Following the implementation of SFDR, the fund rating company Morningstar found that 600 funds have reclassified themselves over the past year from article 6 to article 8, with fewer funds reclassifying from article 9 to article 8. As of June, article 8 funds held 9x more in assets than Article 9 funds.

In part, SFDR responded to greenwashing, the propensity for asset managers to promote their ESG credentials with minimal evidence. Though the rules will force the managers to defend the reclassifications above, they don’t seem to help much. Based on Morningstar’s proprietary classification system, the company concluded that 1200 funds were misstating the ESG qualities of their portfolios and removed them from internal sustainability lists used by clients.

While the SFDR is underway in Europe, the U.S. Securities and Exchange Commission (SEC) moved in May 2022, proposing to establish disclosure requirements for funds and asset managers marketing themselves as ESG-focused. They suggest funds categorize themselves into one of three groups.

Integration Funds – funds that integrate ESG factors and non-ESG factors would be required to describe how those factors assimilate into their investment process. 

ESG-focused Funds – funds that rely significantly or exclusively on ESG factors in making investment decisions must provide detailed disclosures on the factors they prioritize and how they use them.

Impact Funds – a subset of ESG-Focused Funds, Impact Funds seek to achieve a specific ESG impact and would be required to disclose how it measures progress toward that objective. 

Much of the labeling confusion stems from ESG ratings. ESG ratings focus on the financial risks to a company’s bottom line. ESG ratings don’t try to reflect leadership in reducing the impact on people and the planet or working towards a more just and sustainable world. Too often, ESG investing decisions misunderstand this distinction.

While more than a dozen firms offer ESG ratings, most users of ESG scores work with five of the largest, two of whom also provide credit ratings. Unlike credit ratings based on standardized data points, which lead to highly correlated ratings from multiple sources, ESG ratings are not based on standardized data points and exhibit very low correlations across rating firms. 

Perhaps the low rating correlation is due to limited data, whether due to lack of availability or unwillingness to disclose. Observers estimate that half or more of the data used to create ESG ratings is imputed rather than verifiable information. Europe and the U.S. have proposed additional requirements for private businesses to report their ESG impacts. In the U.S. a larger group of attorneys general are pushing back here, too, arguing that non-financial disclosure is outside the remit of the SEC. Even so, it is fair to ask whether more data would help. A 2021 study found that as corporate ESG-related disclosures increase, the variation in ESG ratings increases rather than decreases due to more data points that raters can interpret differently.

Reconciling these rating discrepancies is difficult due to a lack of transparency about the methodologies that support the ratings, adding possible conflicts of interest to questions of accuracy. As a result, there exists a great deal of ambiguity in determining the ESG qualities of a company. While the SEC Office of Credit Ratings (OCR) issued a report in January discussing the ESG products and services offered by credit rating agencies, the report also made clear that regulating ESG scores was not their responsibility. For now, the ESG rating business is checked only by market forces, underscoring the difficulty in investment managers classifying their funds correctly.

ESG investing, plagued with application inconsistencies and lacking standardization, could use its own Fair Packaging and Labeling Act. Until then, buyers should be wary. One option for value-conscious investors is to use separately managed accounts (SMA), an investment vehicle whose benefits include the ability to pick and choose what company shares they wish to own rather than rely on the value judgments of others. While political actors promote their rising agenda and regulators try to bring order and accountability, progress will take time. In the meantime, investing in companies that exhibit your values will be more art than science and perhaps more risk than return.