Is Investing Based on ESG a Scam?

And Will Proposed Amendments Help?

ESG Sets Standards for a Company’s Behavior. (Deemerwha studio/Shutterstock)

Investing in Environmental, Social, and Governance (ESG) companies is currently at the forefront of business news. Many brokerage firms are offering products with the ESG criteria. In addition, mutual funds and robo-advisors are also offering ESG products.

Some companies are claiming to use ESG practices. However, defining precisely the criteria rating is often ambiguous. What is ESG, how is it rated, and does it help stockholders?

ESG Sets Standards for a Company’s Behavior

Environmental, Social, and Governance criteria have been around since the 1960s, but recently they are being increasingly held up as a way to influence companies to follow certain standards.

ESG is a set of non-financial standards for a corporation’s behavior. This behavior has three legs. The first is the environmental criteria: for example, what measures is the company using to address climate change.

The second criterion of ESG is social. This encompasses managing relationships with customers, employees, communities, and suppliers.

And finally, there is governance. This refers to the corporation’s leadership, executive salaries, and shareholder rights.

How ESG Ratings are Determined

There is no standardized way to determine if a company is following ESG standards. Indeed, a set criterion of standards has not been determined. Ratings are based on perceptions, not reality.

Over 150 companies have stepped forward to offer ratings. Most of them have their own criteria and ratings for ESG.

The four major players are MSCI, Robeco, Sustainalytics, and Vigeo Eiris. Each of these companies has a different methodology, and they apply a separate rating. For example, some scores are letter grades like a high of “AAA”, and some have a high grade of 100 points.

Companies High On S&P 500 ESG Index

In May of 2022, Tesla CEO Elon Musk called ESG a “scam” after Tesla fell off the S&P 500 ESG index. He went on to claim that ESG had been “weaponized by phony social justice warriors.” Musk noted that Exxon Mobil Corporation was number nine on the list.

Exxon is one of the largest oil producers worldwide. In 2019 it created more Scope 3 emissions than any other major Western oil company. And as of March 2021, Exxon Mobil planned to increase fossil fuel production through 2025.

Another company that’s a top ten ESG company is Nvidia. Nvidia is sixth on the S&P 500 ESG Index. A computer graphic chip developer, Nvidia, manufacturers its chips in Taiwan. Nvidia is high on the list for corporate social responsibility. But the company deals with chips, which ultimately causes eWaste. 

As of May 2022, the top 10, in order, include Apple, Microsoft, Amazon, Alphabet Inc. Class A, Alphabet Inc. Class C, Nvidia, United Health Group, Procter & Gamble, Exxon Mobil Corporation, J.P. Morgan Chase and Company.

SEC Regulation of ESG Disclosures

The ESG designation has pretty much been the Wild West when it comes to consistency. But the Securities and Exchange Commission (SEC) is starting to take a hard look at companies claiming to be practicing ESG to their investors. In May 2022, the SEC proposed amendments that would apply to certain registered investment advisers, registered investment companies, and business development companies.

The SEC announced proposed amendments to rules and reporting forms, which it said will “promote consistent, comparable and reliable information for investors concerning funds’ and advisors’ incorporation of environmental, social and governance (ESG) factors.”

SEC Chair Gary Gensler said, “ESG encompasses a wide variety of investments and strategies. I think investors should be able to drill down and see what’s under the hood of these strategies.”

The SEC seeks to categorize certain types of ESG strategies. And it will require funds and advisers to provide more detailed disclosures in annual reports, fund prospectuses, and adviser brochures based on ESG strategies pursued.

This proposal will require specific ESG reporting on Forms N-CEN and ADV Part 1A. These are forms that funds and advisors use to report census-type data.

Prevalence of ESG Investing

Although ESG is the push when it comes to investing, it hasn’t really caught on with investors. Even if an investor is open to reviewing ESG funds, ESG compliance generally isn’t an investor’s highest priority.

Most investors prioritize a stock’s performance over ESG.

According to a Gallup poll, 78 percent of investors look “a lot” or “a fair amount”  at the expected rate of return when purchasing stock. Seventy-four percent of investors place the same weight on risk for potential losses.

But when purchasing stock, ESG research slipped. For example, only 35 percent of investors looked at the environmental impact of the companies they invest in, while 38 percent researched social values. And finally, 41 percent looked at corporate governance policies.

Could ESG Hurt Stockholders

The problem is not only people wanting to invest “morally” without a clear definition of what that means; the problem is that major institutions with little investment in these companies, in the name of ESG, strong arm or label companies against stockholders’ interests.

Your money might be invested in stocks because they’re ESG compliant—not because they'll make money for you. Activists often influence the big funds to invest in ESG companies and avoid companies that, although lucrative, don’t follow the agenda. One big fund, Vanguard, promotes ESG funds. Investors legally give their rights to these big funds to vote the shares for which they are paying. And while private individuals can switch funds, public employees and teachers may not be able to choose in which funds their 401ks are invested.

Is ESG Slanted

Elon Musk commented on Twitter that a good “ESG score” amounts to a business’s compliance with “the leftist agenda”.

Unfortunately, at the moment, there doesn’t seem to be any rhyme or reason as to what rates a company’s compliance.  Investors may be looking at how lucrative companies are, how environmentally conscious they are, or looking to invest in a contrarian fashion—by investing in companies that don’t march to the ESG drumbeat.  No matter what the motivation, current ratings are unhelpful.

The SEC’s involvement could help standardize ratings rather than relying on 150 companies’ interpretations.  Or, it could prove so burdensome that it puts companies out of business. 

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