In the last few years, trillions of dollars have flowed into stock funds that are focused on environmental, social, and governance (ESG) issues. These funds appeal to our better angels, using slick marketing to encourage investment in socially-responsible companies. The individuals and institutions that invest in such funds likely believe their money is supporting companies that are reducing climate emissions, treating their workers well, and keeping excessive pay for executives in check.
But, for the most part, that isn't happening.
Part of the issue is that there are no standards for ESG funds. Each fund makes its own rules. And the ESG concept lumps together three issues that, individually, encompass a broad array of issues. As a result, the fact that a company's stock is included in an ESG fund could mean virtually anything.
To understand the problems with ESG investment vehicles, it's helpful to dive into the most popular one: ESGU, which is managed by BlackRock.
Larry Fink, BlackRock's CEO, is one of the leaders of the current ESG movement. In 2020, Fink released a highly-influential public letter declaring the world was on the precipice of "a fundamental reshaping of finance." Fink wrote that "a company cannot achieve long-term profits without embracing purpose and considering the needs of a broad range of stakeholders." The risk of climate change, in particular, would drive "a significant reallocation of capital." BlackRock, Fink wrote, would begin to use include ESG funds, including ESGU, in its "flagship model portfolios." Today, almost $23 billion is invested in ESGU.
BlackRock, however, does not conduct the analysis that determines whether a company is included in ESGU. It outsources that task to another company, called MSCI. But the process that MSCI uses to create its ESG ratings is counterintuitive. MSCI's ratings "don’t measure a company’s impact on the Earth and society." Rather, MSCI's ratings measure "the potential impact of the world on the company and its shareholders." This approach, as Bloomberg revealed in a 2021 exposé, results in the inclusion of companies that undermine the purpose of ESG investing.
McDonald's, for example, is "one of the world’s largest beef purchasers" and "generated more greenhouse gas emissions in 2019 than Portugal or Hungary." And greenhouse gas emissions attributable to McDonald's are steadily increasing, rising 7% over a recent 4-year span.
But MSCI upgraded the environmental rating of McDonald's in April 2021. Why? First, MSCI "determined that climate change neither poses a risk nor offers 'opportunities' to the company’s bottom line." In other words, if governments crack down on emissions, McDonald's is not likely to suffer because it does not directly produce the emissions. Rather, the emissions are generated from its supply chain. So MSCI does not consider emissions from McDonald's because it has decided climate change is not a threat to the corporation's profitability.
MSCI then credited McDonald's for the "installation of recycling bins at an unspecified number of locations in France and the U.K." This improved MSCI's rating for McDonald's regarding "risks associated with packaging material and waste." Prior to installing the recycling bins, McDonald's faced "potential sanctions or regulations" in those countries.
Bloomberg looked at 155 companies that received upgrades from MSCI between January 2020 and June 2021. There was only one case where MSCI cited a reduction in climate emissions as the primary reason for the upgrade. In 51 cases "MSCI highlighted the adoption of policies involving ethics and corporate behavior—which includes bans on things that are already crimes, such as money laundering and bribery." In another 35 cases, MSCI upgraded companies "for employment practices such as conducting an annual employee survey that might reduce turnover."
In other words, it's possible to categorize nearly any company as valuing "ESG" issues. That's why "almost 90% of the stocks in the S&P 500 have wound up in ESG funds built with MSCI’s ratings." It is a virtually meaningless designation.
Another BlackRock ESG fund, ESG Aware, is very similar to the S&P 500. The only significant difference is that ESG Aware, which has an "environmental" seal of approval, is "more heavily weighted in 12 fossil fuel stocks than the actual S&P 500." The other difference is that BlackRock charges higher fees for ESG Aware than its S&P 500 index fund.
Fink remains an ESG enthusiast. "BlackRock is a leader in this, and we are seeing the flows, and I continue to see this big shift in investor portfolios," Fink said last October.
Individual investors and others are being deceived. And now the federal government is calling for reform.
The SEC's Proposed Fix
On May 25, the SEC Chairman Gary Gensler announced a proposed rule that would "establish disclosure requirements for funds and advisers that market themselves as having an ESG focus." The rule aims to ensure "that investors have consistent and comparable disclosures about asset managers’ ESG strategies so they can understand what data underlies funds’ claims and choose the right investments for them."
The proposed rule would "require funds that say they consider ESG factors to provide investors with information in the prospectus about what ESG factors they consider, along with the strategies they use." ESG fund also would need to "disclose relevant metrics." For example, funds that say they take climate issues into account "would be required to report the greenhouse gas emission metrics of their portfolios."
Those who benefit from the status quo are already attacking the proposed rule. The Investment Company Institute (ICI), which represents the investment industry, has called the SEC's proposal "unworkable." ICI argues that it is impossible to disclose, for example, the greenhouse gas emissions of companies in an ESG fund because some companies don't make that information publicly available. Which raises the question: Why are investment firms marketing funds as environmentally conscious and then including companies that don't release any data about greenhouse gas emissions?
Michael McGrath, an attorney that represents investment firms, says that the proposed rule "presumes that the only way an environmentally-conscious fund would operate is as a fund focused on climate change." In reality, a fund would not have to disclose the emissions of the component companies if they "expressly state they don’t take carbon emissions into account at all." McGrath wants to preserve a fund's ability to suggest it is climate-friendly without backing up those claims with data.
Even though this is still a proposed rule, the SEC has already begun to crack down on particuarly egregious greenwashing by enforcing the general prohibition against misleading investors. Last month, the SEC "fined BNY Mellon’s investment adviser division $1.5 million for allegedly misstating and omitting information about environmental, social and governance (ESG) investment considerations for mutual funds that it managed." BNY Mellon "suggested in documents that all investments in the funds had undergone an ESG quality review, but that was not always the case, the SEC said." While the $1.5 million fine is trivial for a major financial company, it puts the industry on notice that the SEC is taking greenwashing seriously.
