[Maeil Business News] ESG ratings play too great a role as a determinant
Professor Youngju Nielsen (Faculty Chair of AI MBA, Associate Professor of Finance) has written a column about the stock market on MK News (Maeil Business News).
One thing that suddenly started to look like a loser after doing well is ESG: Environment, Social, and Governance. Skepticism over ESG ratings loomed large, starting with the greenwashing scandal of the German asset management company DWS. This was followed by the removal of Tesla in May this year by ESG evaluators S&P, to which Elon Musk tweeted, “ESG is a scam. It is weaponized by phony social justice warriors.” This sparked a series of tweets against ESG. In addition, the low rate of return on ESG funds which underperform compared with benchmarks has not mitigated this situation.
So is ESG a scam, as Musk rants? First, let's consider the essence of ESG before judging whether investing in companies that are working hard on ESG increases returns. No one would disagree that the implementation of ESG by companies is very desirable, and that the world should accept it without question in the future. The recent controversy is over how to evaluate it, that is, how to ascribe points. In the end, too much depends on ratings and ranking.
ESG ratings are derived from ESG rating companies' evaluation criteria, as with credit rating agencies. ESG ratings are first used by investment companies that sell ESG funds based on the ratings, and the second use could be promotional.
Let's study an example of what affects scores. Most evaluation companies include an item on the Board of Directors to assess governance scores. The female director ratio is often considered here. Then, can it be said that the higher this ratio, the better the governance structure? Is a company with two females out of four directors better than one with three out of eight? This may affect total scores.
As another example. Business Week referenced McDonald's ESG scores in a December 2021 article. McDonald's greenhouse gas emissions in 2019 were higher than Portugal’s or Hungary’s, and increased by 7% compared with the past four years. Still, McDonald’s ESG ranking rose because the evaluation company removed carbon emissions from the criteria as they did not consider carbon emissions a risk or a critical factor for appraisal.
Many poorly explained instances stem from ESG evaluation methods. Accordingly, U.S. and European regulators are taking action to solve this problem. This year, the European Securities and Market Administration (ESMA) began investigating how ESG is evaluated and ranked, and the Financial Times (FT) reported feedback in July.
Noteworthy feedback reports possible problems with transparency, error correction, and timing of feedback on the evaluation method and data, and the ESMA says it will continue to monitor whether regulations should be created.
Many evaluation institutions explain that ESG ratings, by definition, are a standard for institutions and experts who understand the evaluation items they used, and who pay fees knowing how the scores were calculated. In a sense, the ESG ratings are a business source, and the idea of precisely regulating them may be unreasonable.
In the end, it seems that monitoring will take place as much as in credit rating evaluation. The biggest current problem is that companies communicate with the public through the media as if they were absolute standards, so it is necessary to protect ordinary consumers understand neither ESG ratings accurately nor the bases for rankings.
Original article in Korean: https://www.mk.co.kr/opinion/contributors/view/2022/07/655174/