Making ESG Real: A Return to Values-Driven Investing

<p>Investing based on environmental, social, and governance factors— ESG investing—faces criticism from two main sources. Conservative U.S. politicians have tried to stir ill-informed hysteria over what they deride as “woke capitalism.” Separately, a very different group of skeptics that includes academics and journalists have relied on serious research and arguments to raise questions about whether current forms of ESG investing can deliver on their promises.&nbsp;</p> <p>Informed by these legitimate scholarly and journalistic critiques, we offer a dramatically different approach that can revive the original goal of ESG investing—namely, using investment decisions to create incentives for companies to conduct themselves in a more responsible fashion.&nbsp;</p> <p>The conceptual error at the heart of current ESG frameworks is that they measure how environmental and social risks may harm shareholders, rather than how business may harm the world. We show how this misconception developed historically and unpack the three reasons that it’s misguided. First, firms often take actions that harm society without shareholders suffering consequences. Second, enlightened ESG policies often add costs that investors are unwilling to tolerate because they reduce shareholder returns, although many E policies and some S policies may be cost-justified in the long-run. Third, centering ESG on financial returns misleads many investors who assume that a fund labeled “ESG” is values-driven. Instead they are fed exaggerated marketing claims by funds that are failing to achieve the traditional objective of protecting society.&nbsp;</p> <p>Much of the legitimate critical literature dwells on the incoherence of current ESG ratings. Scholars agree that the scores given to the same company by different ESG raters are deeply uncorrelated. ESG funds use any number of semi-secret rating frameworks, applying different weights to countless different metrics and criteria. 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.</p>