How ESG scores conflict genuine green investment

ESG scores for investment decision-making

Environmental, Social, and Governance (ESG) scoring has emerged as a pivotal tool for investors striving to align their portfolios with ethical and sustainable practices. While the intentions behind ESG scoring are noble, it is essential to recognize the limitations that come with this widely embraced framework. In this blog, we unravel the complexities and shed light on the inherent challenges associated with relying solely on ESG scores for investment decision-making as well as the dilution of more objective sustainability goals.

ESG scores may encompass a broad range of factors, including social and governance aspects, but they might not adequately address carbon intensity, as an example.  Investors seeking to build a low-carbon portfolio require precise information on a company’s carbon emissions per unit of revenue or market capitalization. ESG scores might not capture these nuances, leading to an incomplete understanding of a company’s environmental performance. Research conducted by Scientific Beta, has revealed a surprising lack of correlation between companies’ high Environmental, Social, and Governance (ESG) ratings and their carbon intensity. The study found that companies highly rated on widely accepted ESG metrics pollute just as much as low-rated counterparts. Even when considering only the environmental aspect of ESG ratings, there is little to no relation to carbon intensity.

Interpretation and bias

ESG scoring relies heavily on subjective criteria, often determined by the rating agencies themselves. This subjectivity introduces an element of interpretation and bias, as different agencies may prioritize certain factors over others based on their individual perspectives. Investors need to be aware that the subjective nature of ESG criteria may not always align with their specific sustainability priorities.

The demand for ESG investments has been on the rise, with sustainable funds globally attracting substantial inflows. However, the study indicates that incorporating ESG objectives can cancel out the carbon intensity reduction gained by solely focusing on a company’s emissions. Mixing social or governance ratings with carbon intensity often results in portfolios less green than the market capitalization-weighted index.

ESG assessments

ESG assessments are recognized as aggregate products, considering a range of material factors, and may not necessarily align with specific goals like creating a low-carbon portfolio. Some experts suggest that investors need to carefully consider trade-offs in sustainable investing, deciding whether to prioritize carbon reduction or a high ESG rating.

The study’s findings raise questions about the feasibility of ESG as a mass-market product, as different investors have diverse priorities. Customization becomes crucial for large investors, posing challenges for collective investment schemes like ETFs and mutual funds. The addition of unrelated criteria, such as biodiversity, into the ESG equation may further complicate matters, potentially diluting the focus on specific sustainability goals.

While ESG scoring has undoubtedly played a crucial role in promoting sustainable investing, it is crucial for investors to approach these scores with a discerning eye. Acknowledging the limitations discussed above can empower investors to use ESG scores as part of a more comprehensive due diligence process, combining them with other targeted tools and analyses. Striking a balance between the advantages and limitations of ESG scoring is key to making well-informed investment decisions that genuinely contribute to a more sustainable and ethical future.