There is a ‘conceptual error’ at the heart of ESG frameworks, according to a new report, which says they ‘measure how environmental and social risks may harm shareholders, rather than how business may harm the world.’
Proposing a more values-based ESG investment scene, the report argues that the theme is being attacked from both sides by those with an anti-woke agenda as well as those arguing for a more stringent approach. Shifting results from profits to ethics would dilute these arguments, it says.
ESG ratings are a particular area of concern for the report author. ‘Scholars agree that the scores given to the same company by different ESG raters are deeply uncorrelated,’ writes Michael Goldhaber, senior program manager at the NYU Stern Center for Business and Human Rights.
He adds that ‘some of the most crucial data – for instance, on global value chains – is chronically missing or goes unmeasured. Firms that excel in one facet of ESG may lag in another, and the component factors often work at cross-purposes, yet the frameworks typically assign companies a single composite ESG score. With so much noise around the ESG signal, no one can quite tell what values investors are expressing or what conduct they’re encouraging.’
Goldhaber says he would like to see regulators force financial services firms to ‘be more transparent about their ESG methodologies and force companies to report more extensive ESG data’. Talking to IR Magazine, he says that on the company side, firms should be taking the same approach to social risks in the value chain as they are asked to do with climate change.
‘Standard setters increasingly expect companies to report any risks that could reasonably be expected to affect their financial returns over any timeframe,’ Goldhaber says. ‘Indeed, IFRS S1 refers to the ‘long term’ no fewer than 17 times in its general requirements for sustainability disclosure. On that basis, the IFRS Foundation has advised that all firms facing significant climate risks are likely to find them material under the IFRS Sustainability Disclosure Standards. We’d like to see companies reach the same conclusion for many significant social risks – including labor and human rights risks in the global value chain.’
Targeted E and S funds
The report, titled Making ESG Real: A return to values-driven investing, argues that, on the asset management side, ESG within portfolios should be unbundled, allowing a more personalized investment experience. These changes would not, however, address what Goldhaber describes as the ‘most elemental conceptual error’ in ESG: the continued pursuit of shareholder return over stakeholder protection.
‘We propose that motivated ESG investors expressly authorize their advisers to prioritize specified ethical objectives over financial return,’ he writes. ‘Although fiduciary law would foreclose this path to pension investors, other investors are free to choose their own investment strategies and to loosen their advisers’ fiduciary duties by agreement.
‘With these clients, the way is clear for innovative asset managers and wealth managers to offer investment products that incorporate all of the lessons learned from good-faith ESG critiques. We envision the creation of targeted E and S funds, giving interested investors the option of expressly stating that they prioritize values over value, and are ready to sacrifice return in the pursuit of specific environmental or social objectives. Call it ESG Values investing.’
Goldhaber accepts that this approach wouldn’t appeal to all ESG investors but he argues that there is a cohort already willing to sacrifice financial returns for social and environmental good.
‘A variety of evidence suggests there already exists a significant constituency of values-driven investors that are willing to forego some return in pursuit of ethical goals,’ he tells IR Magazine. ‘ESG fund flows are consistently less sensitive to financial performance than other funds’ flows. Impact investors are clearly willing to sacrifice return. Values-driven ESG funds would appeal to these groups, as well as others.
‘Family offices, ultra-high-net-worth investors and young investors are all booming market segments. Creative asset managers and wealth managers should recognize the opportunity and offer a values-driven ESG option. Of course, it would only be an option. We appreciate that this path would be closed to some institutional investors, and hold no appeal for others.’
The value of ESG
Talking about whether or not ESG ‘pays’, Goldhaber says this is ‘very much in the eye of the beholder’. Some research points to an ESG focus delivering ‘strong and definitive’ returns, while other studies find links ‘weak to non-existent’. Results, he points out, may depend on market or industry conditions, how you define ESG or how you define ‘pays’. For him though, all this misses the point.
‘Our view is that a tension between purpose and profit persists,’ he explains. ‘To pretend that this tension has vanished distorts ESG investing, and leaves it vulnerable to attack. The defense of ESG investing shouldn’t depend on whether it makes money. If the studies don’t show that ESG pays (or stop showing it), then the field’s enemies will pounce. If the studies do show that ESG pays, that’s because they’re mostly measuring the wrong thing.
‘We should hardly be surprised that funds designed to yield comparable returns yield comparable returns. We’d like to see those funds focus more on protecting the environment and society.’