Dartmouth Women Investment Fund
The ESG Conundrum: A Deep Dive

Amber Bhutta, Dartmouth '23
September 7, 2022 — Buoyed by the pandemic and rising concerns over climate change and sustainability, ESG investing has risen to the forefront of contemporary investment considerations. To this end, roughly a third of all professionally managed assets now fall under ESG criteria. Despite the demonstrated status of ESG as an investment buzzword, evidence suggests that ESG ratings have a low association with environmental and social outcomes and that the relationship between financial performance (as measured by share price) and ESG ratings is uncertain. As such, this article provides an overview of ESG, investigates its metrics shortcomings, and discusses potential for improvement.
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Broadly speaking, ESG–short for environmental, social, and governance–insights provide information about the relationship between corporations and non-investor stakeholders. This can be in the context of, for example, how a company interacts with its employees or how a company impacts the environment of the communities it operates in. Calls for corporate accountability for social issues predate the term ESG, assuming various forms throughout the 20th century from banning new investment in South Africa in protest of apartheid to considering environmental issues such as deforestation in new investment decisions. The term ESG entered the financial lexicon in 2005 as part of a UN report calling for companies to integrate ESG concerns into their activities in capital markets. Since then, ESG has grown into a widely accepted investment criteria, with a number of countries adopting mandatory ESG disclosure rules as part of regular financial reporting.
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For example, the Florida State Board of Administration recently adopted Governor Ron DeSantis’ proposal to ban ESG considerations from investment decisions for the state’s pension fund. Similarly in Texas, the state comptroller recently announced an effective ESG “blacklist” which listed a number of companies and investment funds–including BlackRock–prohibited from doing business with the state due to their boycott of fossil fuel companies.
Many of the above critiques of ESG stem from the perception that ESG investing furthers a specific political ideology over another. Other critics, however, point to the measurement of ESG ratings as grounds for scrutiny, calling into question how an ESG score might be misleading to investors. As an example, we can look at how data inputs affect ESG ratings. By their very nature, ESG ratings are less structured, less complete, and typically of lower quality than financial data which is required to be audited and presented in a standardized manner. Moreover, quantifying environmental and social impacts is often challenging given their qualitative nature and lack of historical data. This lack of standardization in the data required for ESG calculation and reporting can lead to rating inconsistencies. More specifically, ESG data providers generally develop their own sourcing, research, and scoring methodologies. As a result, the rating for a single company can vary widely across different providers. Moreover, the methodology behind an ESG rating is typically considered proprietary information, leaving investors to interpret ESG scores without fully understanding how a ratings agency might have arrived at their conclusions.
Another important challenge to ESG investing lies in the higher fees. Research has found that, for example, ETFs with an explicit ESG focus have 43 percent higher fees than widely popular standard ETFs. At the end of 2020, ESG funds’ average fee was 0.2 percent, while other standard ETFs which invest in U.S. large-cap stock had an average fee of 0.14 percent. While the higher fees alone may not necessarily pose a problem, they create an incentive for financial institutions to slap the ESG label onto funds or securities which may toe the line of sustainability. As just one example, Deutsche Bank has recently been under investigation for prospectus fraud after selling supposedly ESG investments under false claims to generate higher fees. Goldman Sachs is facing a similar investigation to misleadingly marketing certain mutual funds as ESG investments.
Another element of ESG investing which warrants a closer look is green bonds. Green bonds–bonds issued to raise funds for projects with environmental and sustainability benefits–have skyrocketed in popularity in recent years; sales of green bonds have boomed to around $250 billion annually from about $50 billion in 2015. Part of this popularity arises from companies eager to boost their appeal with environmentally conscious investors. The bonds, however, have recently come under regulatory scrutiny for greenwashing. Investors have protested loopholes which allow some companies to use capital raised from green bond issuance for projects not related to positive environmental impacts. Others question the overarching environmental track record of companies which issue green bonds; JP Morgan, for example, is the largest underwriter of green bonds for other companies and issued green bonds in 2020 to finance its transition to sustainable buildings and renewable energy. It also had about $40 billion of lending exposure to oil and gas companies in 2020, leading some investors to question the bank’s commitment to sustainability.
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One possible solution to improve ESG rating standardization through regulation. In the UK, for example, the Financial Conduct Authority–the country’s financial regulatory body–is working toward regulations mandating transparency and accountability for ESG data and ratings. By adopting similar measures in the US, the SEC could improve transparency around ESG ratings and help investors make more informed decisions. The SEC has also already taken steps to address greenwashing and crack down on misleading claims made by ESG fund managers. Earlier this year, BNY Mellon faced a $1.5 million fine for “material misstatements and omissions” about the consideration of ESG principles in investment decisions for certain mutual funds overseen by the firm. While the fine is a relatively small amount compared to other SEC penalties, many industry experts expect more significant fines as the SEC continues to investigate other companies. As the SEC signals that regulating ESG investments is a priority for the current administration, we can expect to see more stringent rulings on greenwashing and other ESG shortcomings previously discussed.
Ultimately, while ESG is not a foolproof investment strategy, it does have an important role to play in mobilizing capital to help address the climate crisis and improve corporate governance. While the exact nature of this role will continue to evolve over time, shifting consumer preferences, the worsening climate crisis, and the pandemic have made it clear that the core principles of ESG are here to stay for the foreseeable future.

Despite its numerous proponents, ESG investing has also met criticism from certain policymakers.
It’s important to note that many of the aforementioned criticisms of ESG do not necessarily challenge the underlying principles of sustainability and social responsibility. Instead, they arise from data challenges and various forms of misrepresentation which can be addressed.
Linked Sources:
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https://www.nytimes.com/2022/08/24/business/dealbook/desantis-florida-esg-investing.html
https://www.mckinsey.com/business-functions/sustainability/our-insights/how-to-make-esg-real
https://breckinridge-fs.s3.amazonaws.com/files/uploads/evolution-of-esg-timeline.pdf
https://home.kpmg/xx/en/blogs/home/posts/2021/03/sustaining-esg-momentum-in-post-pandemic-world.html
file:///Users/amberbhutta/Downloads/SSRN-id4179647.pdf
https://www.wsj.com/articles/tidal-wave-of-esg-funds-brings-profit-to-wall-street-11615887004
https://www.wsj.com/articles/bond-investors-challenge-wall-street-greenwashing-11635850800