Investing in environmental, social and governance (ESG) companies is currently at the forefront of economic news. Many brokerage firms offer products that meet ESG criteria. Additionally, mutual funds and robo-advisors also offer ESG products.

Some companies claim to use ESG practices. However, the precise definition of the scoring criteria is often ambiguous. What is ESG, how is it rated and does it help shareholders?

ESG sets standards for a company’s behavior

Environmental, social and governance criteria have been around since the 1960s, but recently they are increasingly seen as a way to incentivize companies to follow certain standards.

ESG is a set of non-financial standards for corporate behavior. This behavior has three legs. The first concerns environmental criteria: for example, what measures does the company use to combat climate change.

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

And finally, there is governance. This refers to the leadership of the company, executive salaries and shareholder rights.

How ESG ratings are determined

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

Over 150 companies have volunteered to provide ratings. Most of them have their own ESG criteria and ratings.

The four main actors are MSCI, Robeco, Sustainalytics, and Vigeo Eiris. Each of these companies has a different methodology and applies a separate rating. For example, some scores are letter grades like a maximum of “AAA”, and some have a high score of 100 points.

Companies leading the S&P 500 ESG Index

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

Exxon is one of the largest oil producers in the world. In 2019, it premiered more scope 3 shows than any other major Western oil company. And starting in March 2021, Exxon Mobil planned to ramp up fossil fuel production through 2025.

Another company that is among the top ten ESG companies is Nvidia. Nvidia is sixth on the S&P 500 ESG Index. A computer graphics chip developer, Nvidia, manufactures its chips in Taiwan. Nvidia is high on the corporate social responsibility list. But the company deals with chips, which ultimately causes e-waste.

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, JP Morgan Chase and Company.

SEC Regulation of ESG Disclosures

The ESG designation has been pretty much the Wild West when it comes to consistency. But the Securities and Exchange Commission (SEC) is starting to scrutinize companies that claim to practice ESG with 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 has announced proposed changes to the rules and reporting forms, which it says will “promote consistent, comparable and reliable disclosures for investors regarding the integration by funds and advisers of environmental, social and governance factors. (ESG)”.

SEC Chairman Gary Gensler said: “ESG encompasses a wide variety of investments and strategies. I think investors should be able to dig deeper 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 information in annual reports, fund prospectuses and adviser brochures based on the ESG strategies being pursued.

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

Prevalence of ESG investing

Although ESG is the investment push, it hasn’t really caught on with investors. Even if an investor is open to reviewing ESG funds, ESG compliance is usually not an investor’s top priority.

Most investors prioritize stock performance over ESG.

According to a Gallup poll, 78% of investors look “a lot” or “quite a bit” at the expected rate of return when buying stocks. Seventy-four percent of investors place the same weight on the risk of potential losses.

But when buying stocks, ESG research has slipped. For example, only 35% of investors have looked at the environmental impact of the companies they invest in, while 38% have looked at social values. And finally, 41% have reviewed corporate governance policies.

Could ESG harm shareholders?

The problem isn’t just people who want to invest “morally” without a clear definition of what that means; the problem is that large institutions that invest little in these companies, in the name of ESG, arm or label companies against the interests of shareholders.

Your money can be invested in stocks because they are ESG compliant, not because they will make you money. Activists often influence big funds to invest in ESG companies and avoid companies that, although lucrative, do not follow the agenda. A large fund, Vanguard, promotes ESG funds. Investors legally give these big funds their rights to vote the stocks they pay for. And while individuals can switch funds, public employees and teachers may not be able to choose which funds their 401k is invested in.

Is the ESG inclined

Elon Musk commented on Twitter that a good “ESG score” equates to a company’s compliance with the “left agenda”.

Unfortunately, at this time, there doesn’t seem to be any rhyme or reason for assessing a company’s compliance. Investors can look at how lucrative companies are, how environmentally conscious they are, or seek to invest in the opposite way, by investing in companies that don’t keep up with ESG. Whatever the motivation, current grades are of no use.

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

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