ESG investing and ratings systems primarily focus on how environmental, social and governance factors can lead to material financial risks for businesses and shareholders. A recent report from New York University’s Stern Center for Business and Human Rights argues that this is a “conceptual error” and that frameworks should be overhauled to center a society-first lens.
According to the report, prioritizing shareholders over stakeholders is a “misguided” strategy because not all business practices that negatively impact the environment or society have negative financial impacts and linking ESG to financial gain can mislead value-driven investors. Additionally, the report said there are effective ESG policies that benefit society but have smaller returns on a shorter time frame.
Asset management firms and investors incorporating ESG factors into their decisions have primarily faced two forms of resistance, according to the report. The loudest has been a multi-pronged attack from the right wing of the U.S. political spectrum, consisting of cultural, legislative and legal broadsides against the principle. However, academics and other skeptics also question whether ESG investing, as currently positioned, aligns with the values it claims to and can help reach the climate and societal goals investors want.
Michael Goldhaber, the report’s author and a senior researcher at the center, said centering shareholders and businesses profits rather than their societal effects has led to fundamental flaws in the system.
“Environmental and social investing is about protecting the environment and society. It’s as simple as that,” Goldhaber told ESG Dive. “We need to go back to basics, go back to the ethical roots of the field.”
Goldhaber argues ESG funds should have narrower targets and more customizable goals for investors, with broader exclusions of companies, like those in the oil and gas industry or companies that pose other negative societal effects. He pointed to existing funds, like indexes of companies aligned with the Paris climate accords, as models. MSCI maintains one such index — as do others like HSBC and S&P Global — that BlackRock opened as an ETF portfolio in October after closing a pair of ESG funds the month prior.
The linking of environmental and social factors with governance, which investors had already come to recognize as factors affecting returns, helped create the current paradigm, the report said. Goldhaber also faults ethical investors for arguing that companies should invest in environmental and social issues because they are profitable. Consequently, ESG ratings have become a measure of “corporate goodness,” he said, and calls for regulators to require more transparency for companies’ and third-party ratings metrics.
Corporate sustainability and ESG reports have become common practice in recent years, though no two ratings systems are the same. A Stanford University report previously found 88% of investment professionals use third-party ESG ratings. Some of the variance in ratings structures is due to varying industry and jurisdictional priorities, David Ly, CEO of surveillance tech firm Iveda, previously told ESG Dive.
A Department of Labor rule that took effect in January allows retirement fund managers to consider ESG risk factors in investment decisions, as a potential element that may affect shareholder returns. The rule has so far withstood legal challenges by not requiring ESG to be considered.
Goldhaber acknowledges the environmental and social funds he proposes would be ineligible for investment from pension fund managers under the Employment Retirement Income Security Act of 1974, which requires managers to make decisions with the sole purpose of increase participant returns. However, he believes investors who want to take this approach should be able to authorize their asset managers to prioritize investments aligned with minimizing environmental and societal harms.
“There’s just a disconnect,” Goldhaber said. “The sole criterion should not be what is a financially material risk to shareholders. Because there are tons of business practices that are perfectly legal and scandal free and extremely profitable … that harm the environment or harm workers or harm communities.”
The International Sustainability Standard Board’s inaugural standards take a investor-focused approach to ESG disclosures and are showing progress as a global baseline for jurisdictions looking to require corporate disclosures. However, the European Union’s Corporate Sustainability Reporting Directive and Global Reporting Initiative requirements each take a double materiality approach like the one Goldhaber argues for.
GRI recently released additional standards for how companies should report their energy management use and plans for the climate transition and how they will minimize their impacts on the environment and support a just transition.