The industry is capitalizing on enormous public demand for genuinely responsible investing options, but it is diverting this otherwise powerful force for good toward a false solution that only makes matters worse.
Asset managers advertise ESG investment funds as a way for everyday investors – especially young people – to align their money with their values. In recent years, millions of people have shifted their retirement savings from traditional index funds to those carrying the ESG label. Their rising popularity is fueled by industry executives and marketing materials that claim they are helping investors “build better portfolios for a better world.” Unfortunately, they don’t.
The process through which companies’ ESG ratings are determined and then used to tailor investment portfolios has funneled enormous amounts of capital to companies that look good on paper, but have terrible real-world impact. This is in part because the ESG ratings on which the whole industry is based only reflect information that the ratings agencies consider “financially material” – factors that could materially impact the profitability and value of a company – not information about its real-world impact on communities, workers and the environment (as most people believe it to be).
But that’s not the only problem.
ESG ratings can also mask serious human rights abuses and other destructive corporate behaviors because of how they are calculated. Ratings firms take hundreds of indicators and thousands of data points about a diverse range of environmental, social and governance issues and amalgamate them, using a proprietary methodology, into a single score on which a company’s ESG credentials are judged. That means a company implicated in land grabbing or sourcing materials produced with forced labor can offset that bad behavior and improve its ESG rating by, for example, launching a new recycling program or improving the diversity of its board.
Far too often, the end-result is greenwashing.
The firms that translate ESG ratings into benchmarks for investment portfolios (ESG indexes) – including MSCI, FTSE Russell and S&P Dow Jones Indices – have become the gatekeepers of trillions of dollars in capital. These firms have enormous leverage to improve respect for human rights among companies seeking a spot on their indexes. And they have a responsibility to exercise that leverage under the UN Guiding Principles on Business and Human Rights, but they’re not.
The low bar for securing a place in ESG funds does more than direct “responsible investment” to the wrong place. It makes it harder to hold some of worst corporate offenders accountable. The “ESG” stamp of approval undermines the efforts of communities and human rights defenders to secure redress for corporate abuses by making investors less likely to engage and use their leverage to compel action. We know this from first-hand experience in our casework.
We are calling for regulation and reform of the ESG investing industry to end false labeling and ensure that ESG ratings and the investment products tied to them are aligned with international human rights standards.
In the meantime, we will continue to call out #ESGreenwashing wherever we see it. Because we cannot let the movement toward real corporate accountability get hijacked by a fraudulent industry selling false solutions to some of the biggest challenges facing humanity.
Companies benefiting from this so-called “responsible investment” include weapons dealers arming the regime, tech firms serving the military-controlled national police force, and others that direct profits and resources to the military, allowing it to violently crush dissent and maintain its grip on power.
The rising demand for responsible investment options holds enormous promise as a driver of better corporate conduct. But the ESG investing industry that is servicing that demand is fundamentally flawed. As a result, it rewards bad corporate conduct and undermines accountability to international business and human rights standards.
The industry needs to be regulated and fundamentally reformed to end #ESGreenwashing and return it to the original values-based intent of the socially responsible investing movement that it captured.
We are calling on policy makers to institute these seven reforms to make responsible investment mean what it says and to realize its promise of building a better world:
The International Sustainability Standards Board, announced at the COP 26 climate summit, is developing “a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.” This framework should be based on the principle of double materiality, which pays equal heed to the risks and impacts of corporate activities on people and the planet as it does to how ESG issues affect the company’s value. Corporate reporting on human rights, and the external assessments conducted by ratings firms, must be divorced from financial considerations and aligned with the International Bill of Human Rights and the expectations of businesses under the UN Guiding Principles.
Testimony from rights-holders, including workers and communities affected by a company’s operations should hold more weight than a company’s own reporting, which is highly incentivized to portray an air-brushed account of its negative impact. This can be accomplished in part through an auditing and assurance system that prioritizes the perspectives of rights-holders.
The social auditing industry, which is itself highly flawed, must be regulated to ensure that it is staffed by qualified specialists whose independence and impartiality are not compromised. Regulation must include legal consequences for ESG auditors who do not exercise due care in certifying the veracity of company disclosures.
Regulators should require ratings firms to break down ESG scores into separate and distinct categories of environmental, social and governance issues.
All companies should be assessed against the same global standards of responsible business conduct, rather than graded on a curve against industry peers, as is the current practice.
That junk rating should stand until the harm has been remediated, regardless of any grand policy pronouncements that the company makes.
When there is credible evidence that a company is implicated in serious violations, index providers should in collaboration with asset managers use their leverage to demand remedial action and remove companies that fail to repair the harms.
Myanmar Energy Ties Are Flying Under the ESG Radar — Bloomberg — December 21, 2022
Call for US Greenwashing Rules to Extend to Human Rights — ESG Investor — August 25, 2022
The limits of responsible investing — Capital Aberto — March 13, 2022
Happy birthday to Europe’s sustainable finance directive — Financial Times — March 11, 2022
ESG Funds Scolded for Investing in Myanmar Arms Suppliers — Bloomberg — March 9, 2022
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