In August, Oliver Schmidt pled guilty to helping Volkswagen evade clean air laws with special software that tricked emissions tests. The software worked even with cars whose emissions were 30 times higher than normally allowed.
In December, a Michigan judge sentenced Schmidt to seven years in prison along with a $400,000 fine, which is peanuts compared to the estimated $30 billion the scandal has cost Volkswagen.
The incident does not exactly represent a high point of corporate commitment to the environment, to say the least.
Buzzwords like sustainability and corporate citizenship have become popular for companies trying to shed the image of rapacious capitalism in favor of—for lack of a better term—kinder, gentler corporate juggernauts. For many companies, pursuing such an image-change can be vital, given consumers’ easy access to corporate information, mobs on social media, and video cameras in every potential whistleblower’s pocket.
If customers do not like a company’s behavior, they can spend their money elsewhere.
This does not just affect corporations at the consumer level, but among investors as well. The 21st Century has given rise to Environmental, Social, and Governance (ESG) investing – someone who agrees with a company’s values may be more inclined to invest in it. Environmental criteria show how green the company is, social criteria look at treatment of employees, suppliers, and corporate governance deals with stuff like executive pay.
One columnist with Investment News recently insisted that ESG investing is “going mainstream,” noting that “critics who once held the high ground of quantitative and rational analysis are starting to feel the ground slowly crumble beneath their feet.”
While it may be good that the market provides this information, if it is criteria investors truly want to base their investment decisions upon it, the problem with most ESG data is the data itself.
While the goal of these companies—to reward good corporate behavior with laudatory publicity and more investment dollars—may appear laudatory, there are a few issues that complicate such matters.
A few major ESG ratings agencies—MSCI ESG, Sustainalytics, and RepRisk (ISS)—are the primary gatekeepers for this investment capital, but dozens of companies make these evaluations. Each agency uses a different methodology, metrics, and weighting, and there are different perspectives about what constitutes ESG. This means that ESG ratings remain somewhat subjective. What’s more, many ESG rating agencies disclose only a few of the indicators they evaluate, and few disclose the actual material impact of each indicator.
While the rating agencies may demand transparency from companies they tend not to be particularly transparent themselves. One investment executive fretted that “Screening out companies in a vacuum will lead to underperformance.” Instead of a vacuum of ignorance, retail investors instead find themselves in an asteroid field of too much, too inconsistent information.
And these flaws have investors grumbling about the process: More than 80 percent of investors are dissatisfied with how ratings agencies identify and quantify ESG criteria, according to a PwC study.
What’s more, these rating agencies have no jurisdiction across the wildly different regions where multi-nationals now operate means, so they must rely on information companies voluntarily disclose. Unsurprisingly, companies that volunteer to participate in this kind of thing inevitably attempt to do so in the most flattering ways possible.
And it’s worth noting that much of the data pertinent to such indices that is publicly available can be accessed outside of ESG reports: Roughly 75 percent of information in sustainability reports is already addressed in SEC filings, according to the Sustainability Accounting Standards Board.
The data lacuna creates a moral hazard issue in the market: to incentivize voluntary disclosure, ratings agencies often reward disclosure itself more than whatever actual risk those disclosures might reveal. Hence, a company with significant historical violations of ESG criteria can boost an ESG score by temporarily adopting more robust disclosure practices—despite having a higher overall ESG risk.
Moreover, the agencies appear to be inherently biased toward larger companies. Is this because larger companies are more committed to the demands of ESG principles or merely that they can dedicate more resources to preparing their disclosures? It appears that the latter is more likely.
There are also accusations of bias based on industry—with utilities at the top and healthcare at the bottom—and even geography, with an apparent bias in favor of European countries and against North American ones.
Retail investors should have access to as much information as possible in deciding where to put their money, but the idea that information pertinent to this vague notion of corporate good citizenship, vaguely defined by a few private entities not inclined to show their formulas, will be a boon for investors is absurd.
Jared Whitley has worked in the Senate, the White House, and the defense industry. He recently completed an MBA from Hult International Business School in Dubai.
