Investors (including individual investors and institutional investors, such as pension funds, mutual funds, and hedge funds) use ESG scores to measure companies’ performance in terms of their environmental impact, treatment of employees, and corporate governance practices.
Over the past few years, ESG scores have become the go-to metric for measuring companies’ ESG (Environmental, Social, and Governance) efforts; however, some critics argue that ESG scores cannot accurately measure companies’ environmental and social impact.
This post discusses why ESG scores may be inaccurate and explains why investors should ignore these scores.
Reasons Why ESG Scores May Be Inaccurate
1: ESG Scoring Criteria Are Not Standardized
There are no universally accepted standards on how ESG criteria are defined and measured. This lack of standardization means that investors do not always know what factors a rating agency considers when assigning an ESG score. Moreover, some companies may provide incorrect or incomplete data, which can cause rating agencies to assign an inaccurate ESG score.
2: ESG Scores Are Inconsistent
ESG scores are compiled by different rating agencies, including ISS, MSCI, and Sustainalytics. These rating agencies use different methodologies to assess companies and assign scores.
Some agencies focus on certain issues, like human rights or climate change, while others take a more holistic approach. There are no standardized methodologies for calculating ESG scores, making it difficult for investors to compare ESG scores across companies.
3: ESG Scores Can Be Misleading
Some rating agencies assign ESG scores based on companies’ self-reported data, which can sometimes be biased.
Some companies try to make themselves attractive to investors by highlighting certain sustainable practices while glossing over others, resulting in an inaccurate representation of their ESG performance.
Even worse, some companies may engage in greenwashing (the practice of claiming that a company is more green, ethical, or sustainable than it actually is) to make themselves appear more sustainable than they really are.
When companies depict themselves more positively than they are, they are more likely to receive a high ESG score, which can mislead investors into believing that they are sustainable when they are not.
4: ESG Scores Can Promote Bad Companies
ESG critics argue that ESG scores can elevate companies whose practices negatively affect the environment and society.
Companies can receive high ESG scores even though they are not sustainable. This occurs when a rating agency assigns an ESG score based on a company’s performance in one area, even though the company has fallen short in other areas.
For example, some rating agencies give precedence to a company’s governance practices, while others place a greater weight on environmental performance. The choice of weighting can determine an ESG score, which is why some “bad” companies rank higher than those that uphold ethical and sustainable practices.
5: ESG Scores Are Counterintuitive
ESG scores do not always align with the goals of socially conscious investors. It is normal for you to expect a low-emitting company to receive a high E (Environmental) score and a high-emitting company to score poorly in E (Environmental) metrics, right? Well, that is not always the case.
Under frameworks like MSCI, high-emitting companies may lose profits if stricter climate regulations are set in place. For such companies to keep their ESG scores high, they need to vouch for politicians who do not support strict climate regulations.
Success for such companies’ ESG ratings is electing a legislator that allows high emissions with few to no consequences so that the companies can continue to dump tons of greenhouse gases into the atmosphere and make a profit.
ESG scoring systems can influence behavior in a way that worsens the problems investors are hoping to improve.
6: ESG Scores Focus on a Narrow Set of Issues
ESG scores focus on a limited number of issues, such as carbon footprint and climate change, while overlooking other important issues, like biodiversity and product safety. As such, these scores may not capture the real picture of a company’s ethical practices and sustainability.
Take ESG Scores With A Grain of Salt
ESG scores are inaccurate and should be ignored by investors. At first glance, ESG scores seem like a valuable metric for investors; however, they can be inaccurate or inconsistent due to a lack of standardization, can be misleading because they are based on self-reported data, can promote bad companies because there is no consensus on which issues should be weighted more heavily than others, and they tend to focus on a narrow set of issues.
Investors should ignore ESG scores, and if they must consider ESG scores when making investment decisions, they should supplement those scores with other tools, such as recent news or annual and quarterly reports.