Are ESG investments really what they claim to be?

Who’s ranking companies for ESG risk?

Rather than rank companies based on ESG success, most firms that provide ESG rankings focus on ESG risk, or the amount of unmanaged risk a company has with regard to its environmental, social and governance practices.

A company with high ESG risk isn’t necessarily a bad investment, but it may fall short in meeting certain investors’ ideals.

There are several ESG ratings companies operating globally today, with MSCI and Sustainalytics widely considered to be leaders in the space. Each has its own complex, convoluted system for evaluating companies based on their ESG risk — and no universal standards to adhere to.

“Some of the data used to compile third-party ESG scores and ratings may be subjective,” reads a February bulletin from the U.S. Securities and Exchange Commission. “Other data may be objective in principle, but are not verified or reliable. Third-party scores also may consider or weight ESG criteria differently, meaning that companies can receive widely different scores from different third-party providers.”

Case in point: Sustainalytics gave industrial giant 3M a score of 34.9, putting it in the “high risk” category. MSCI gave the company a rating of “AAA,” its highest score.

Money.ca reached out to both rating firms for comment but received no response as of publication time

MSCI also gives an “A” rating to Royal Bank of Canada, saying it’s an “ESG leader” in financing environmental impact, despite the bank providing US$9 billion in financing for energy heavyweight Enbridge’s Line 3 pipeline in Minnesota.

“RBC has ESG. Congratulations,” says Jason Pereira, financial planner at Woodgate Financial in Toronto. “How much money are you making in the oilsands?”

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Bridging the gap

Pereira brings up an important point. In evaluating a company based on such broad criteria — its overall environmental sustainability, the diversity of its leadership, its social impact — can a single rating ensure that its entire value chain is 100% clean?

“There’s no way,” Pereira says. “You can’t do that.”

There are also semantic issues at play, says Mark Yamada, president of Toronto-based PUR investing.

What, for example, does a “diverse” C-suite look like? Is a company considered more diverse, and more likely to get passing grades, if it hires an additional visible minority to its leadership team, or a woman?

“The reason to have diversity is to have diversity of thought,” Yamada says. “And there is no way to measure diversity of thought.”

Yamada adds that larger companies often tend to score more favourable ESG rankings because they can afford to put more resources into filling out their evaluation packages.

Investors concerned that ESG ratings may be leading them astray can take some comfort in the fact that, because ESG is such a hot topic with their clients, many financial advisors are doing their own due diligence and digging further into businesses’ ESG practices.

“There are plenty of advisors I've met who specialize in this and dive deep into really understanding if those readings actually are matching the clients’ principles and values,” Pereira says. “The ratings are a shortcut on due diligence.”

What’s an investor to do?

There are reasons to be skeptical of the ESG movement.

When you visit the site of an ESG ratings provider, you tend to find an awful lot of content telling companies why leaning into ESG is good — not necessarily for the planet, but for attracting capital.

Yamada says a similar form of self-interest may also be driving up the number of large investment firms, like BlackRock, who have entered the ESG space over the past few years.

“You have to have a vegetarian offering, even at a steakhouse,” he says, adding that actively managed ESG funds regularly charge higher fees. “Even if you don't believe in it, somebody is going to want it.”

BlackRock’s former CIO of sustainable investing, Tariq Fancy, questioned the validity of ESG in a November interview on CNBC. Fancy said there is no evidence that ESG is having a demonstrable effect on the planet’s problems, and that the movement may actually be a “deadly distraction because we’re putting all our effort into this and we’re ignoring what the experts are telling us” — that policy reforms, not investing decisions, are a surer path to a more sustainable future.

Fancy also argued that ESG isn’t useful as an investing strategy.

That said, ESG funds have been holding their own amid the beatdown the stock market has been taking to start 2022.

BlackRock’s iShares ESG Aware MSCI Canada Index ETF is up almost 15% in the last year. The TD Morningstar ESG Canada Equity Index ETF has risen 18.4% over the same period.

If profit is what brings you to ESG, it’s nothing to be ashamed of. It could be argued that ESG investing might even be a more frictionless experience for people who don’t care about how companies rank in terms of their ESG performance.

But if you’re investing primarily as a means of making a difference, you’re taking a leap of faith that ESG ratings agencies are evaluating companies using the same criteria you would. Don’t bet on that.

Hence the predicament investors find themselves in when it comes to ESG investing: the returns might be the most trustworthy thing about it.