Everyday, $8 billion gets invested in funds that promise to yield good returns while also helping to save the planet or make life better for its people.
This is the promise of environmental, social, and governance investing.
When I first encountered the concept of ESG investing, I thought it could be transformative. The idea is optimistic: investing in companies that do good will help companies grow faster, while simultaneously creating an incentive for peers to be more socially and environmentally conscious. I was excited to see ESG investing emerge as a hot investment trend.
But the more I research ESGs, the more I realize ESG won’t deliver on its promise until the ESG rating system changes.
MSCI, Morgan Stanley Capital International, is an investment research company that provides stock risk and performance reports to institutional investors. Since ESG is a type of stock portfolio, MSCI rates and ranks companies in terms of their ESG readiness. In fact, MSCI is the largest ESG rating company. MSCI claims its mission for ESG rating is to help global investors build better portfolios for a better world.
However, there seems to be little connection between MSCI’s mission and its methodology. MSCI grades ESG funds on a scale that ranges from CCC to AAA. MSCI’s rating does not measure companies against universal standards; instead, it compares them to their industry peers. Thus, an average company in a particular industry will receive a BBB rating.
Consider McDonald’s: MSCI rates it BBB. McDonald’s is one of the world’s largest beef purchasers and generated more greenhouse gas emissions in 2019 than Portugal. Its supply chain and operations emissions have increased 7% since 2015. However, since McDonald’s emissions neither posed risks nor opportunities for the company itself, it had no impact on its MSCI rating. McDonald ESG rating actually went up in April 2021 because the company adopted measures to curb waste and promote recycling — an issue that MSCI considered a risk factor for the company.
Even more surprising is Coca-Cola: MSCI rates it AAA. Coca-cola is one of the world’s largest contributors to plastic pollution and its products are a major cause of diabetes, obesity and early mortality. Yet since all carbonated beverage companies share these problems, it doesn’t affect their score.
The examples of McDonald’s and Coca-Cola highlight the fundamental flaw in MSCI’s rating system. The rating does not consider how much harm a company brings to the world. Instead, it reflects how much risk a company will face. In the end, the ESG scores are done for investors to make investment decisions; and to them, how risky a company is matters.
The reason the MSCI ESG rating system is structured this way is about profits. Robert Zevin, one of two money managers credited with formalizing ESG practice in the 1980s, explains how capitalism has flipped sustainable investing on its head. “It’s not just Wall Street,” he said, “it’s capitalism. It always finds some way to repackage an idea so it’s profitable and mass-producible, and that’s going to be hard to overcome.”
This is a problem the market isn’t going to solve. Regulations are needed to ensure that factors like greenhouse emissions, waste management, and risky working conditions don’t pose financial risks for companies.
The Securities and Exchange Commission plays an important role in adopting such regulations. Right now, the commission is finalizing rules that require public companies to disclose greenhouse gas emissions from their operations.
The SEC needs to go even further. The commission needs to propose major changes to the role of rating agencies, yet this is not within the purview of the SEC.
Currently, MSCI dominates a foundational yet unregulated piece of ESG investing. This is hindering ESG investing to deliver its promises. Reports MSCI produces are a way for investment firms to justify their decisions and label stocks and funds as “sustainable”. Right now, ESG investing is becoming another form of greenwashing. Regulation action is essential to ensure that ESG delivers on its promise and makes it possible to invest for our society and planet, not just profit.