Editor’s note: This explainer was commissioned by subscriber Pradeep Thopae. We always encourage our subscribers to write in and ask for Big Stories on subjects of their choice. So be sure to reach out to us at talktous@splainer.in. 

First, a guide to sustainable investing

The phrase is thrown about indiscriminately—and applied to all kinds of financial investments. There are roughly three ways to put your money to “good” use—and ESG is the least aggressive among them:

• Impact investing targets funds at companies who actively promote change—and maximise social good.
• Socially responsible investing (SRI) will not put money in a variety of industries that are viewed as harmful. For example: alcohol, tobacco or fossil fuel companies.
• ESG investing looks at how the company performs across three areas: Environmental, Social and Governance—and invests in companies with high scores. These funds typically do not eliminate certain sectors unlike SRI—or favour companies just because they’re trying to create positive change.

Unpacking ESG: The three areas are assessed as follows:

• ‘Environmental’ looks at the company’s carbon footprint, waste management, land usage etc. 
• ‘Social’ focuses on how it impacts society—via labour practices, product quality, safety standards etc.
• ‘Governance’ is about how the company governs itself. These include the diversity of the board, the gap between executive and employee pay and overall transparency and ethics. 

The higher the score, the better the company’s ratings. 

The many myths around ESG investing

The scoring system isn’t quite as straight-forward as it seems. There is typically confusion around four key points. 

One: ESG investing is more about minimising risk than doing “good.” These scores don’t look at whether the company is making a positive impact. As an expert in sustainable finance expert emphasises:

“There is a fundamental misunderstanding of what ESG ratings are—and I think that's causing the tension. They don't provide an indication of really how the company is impacting the broader world.”

Also this: There is nothing that prevents a fund from investing in lower-ranked companies—if, say, they have plans to improve: “Because of this flexibility and potential for customization, investors often don't have to choose between their morals and their own bottom line, but can incorporate both considerations.” But this is also why investors who want to avoid big tech companies like Meta have a hard time finding an ESG fund.

Two: ESG scores assess whether the company’s practices in these areas pose a risk to itself—and its investors. And this is a big reason why ESG funds are very popular. They’re often safer and more stable:

“The Morgan Stanley Institute for Sustainable Investing released a white paper in 2019, comparing the performance of traditional funds and sustainable funds between 2004 and 2018. It found that the latter had significantly decreased downside risk, a measure of how the asset performs in worst-case scenarios, like times of turbulence and volatility. The paper also found that on average, sustainable funds experienced a 20% smaller downside deviation—which is a measure of risk and price volatility—than conventional funds.”

Since these companies are less vulnerable to “reputation, political and regulatory risk,” it leads to a more stable cash flow and increased profitability.

Point to note: This isn’t always true—and less so over the past year. For example, the world’s biggest ESG exchange-traded fund—BlackRock Inc’s $20.9 billion iShares ESG Aware MSCI USA—lost 25% of its value this year. In India, the “morally-upright” ESG funds have underperformed—offering an average return of 1.25%.

Three: Each company is ranked against others within its own sector. This is also why Tesla was dropped from the S&P 500 ESG Index—while Exxon was not:

“[O]il and gas companies are rated separately from automotive companies or technology companies. Exxon stacks up fairly well relative to others in the oil and gas category on many measures. But if you compared Exxon to, say, Apple, Exxon would look terrible on its total greenhouse gas emissions.”

Tesla—which does very well on environmental criteria—ran into trouble because of its ‘social’ and ‘governance’ components: “S&P listed allegations of racial discrimination, poor working conditions at a Tesla factory and the company’s response to a federal safety investigation as reasons for dropping the company.”

Four: There is no single, standardised way to measure ESG scores—and each fund has its own proprietary algorithm and system:

“Because every ESG data provider uses a different set of criteria to assess a company's ESG performance, it makes it very hard for investors to get a clear picture of how different companies score in regards to their ESG performance.”

There are at least 140 such funds that offer scores in the US—and at least nine in India. And a company that is kicked off one index—example, Tesla—may still be part of another fund, in this case, MSCI ESG Index. 

Also this: The criteria themselves can be fuzzy:

“For example, when companies say they derive a portion of energy from renewable sources, they could mean either just electricity, or include fuels used in production. These are also interpretational issues—if one company reports increasing sexual harassment complaints, and another reports no complaints year after year, does it mean the latter is doing better, or is it a reflection of a more open culture of reporting in the former?”

And this: Typically, investment managers decide which components of ESG to emphasise. So a tech company’s carbon footprint may be more important than its governance or social practices. And the final score is highly subjective: “There’s a range of green and so … something that is ecological for you, may not be ecological for someone else.” The chart below gives you a sense of the sheer range of variation:

Scandals to note: All of this fuzziness has led inevitably to greater disillusionment—and growing allegations of “greenwashing.” Deutsche Bank was recently raided by German police for overstating its use of sustainable investing criteria to manage their customers’ investments. Investigators claim they found “sufficient indications” that ESG standards were applied only “in a minority of investments.”

Meanwhile in the US, the Securities and Exchange Commission (SEC) is finally going after companies that make inflated or fraudulent ESG claims—specifically, Goldman Sachs which has four funds that have clean-energy or ESG in their names. Last year, the SEC warned investors that there are a number of fund holdings “predominated” by companies with low ESG scores.

The bottomline: When it comes to putting your money into the stock market—whether for profit or to do good—the age-old maxim holds just as true: Buyer beware!

Reading list

Business Insider has the best overview of ESG investing. Bloomberg News is best on ESG’s recent fall from grace. The Conversation explains why Tesla was kicked off the S&P ESG index—while Exxon was not. Harvard Business Review argues that it's time to give companies standalone climate ratings. Economic Times has the best overview of ESG investing in India. Mint looks at why Indians are more reluctant to invest in ESG funds.