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Ethics of Ethical Investments - ESG under the Lens

Shiv Sankar is a second-year student and George Daniel George is a third-year student at National Law University Odisha.

ESG investing is a socially responsible investment technique that prioritises a company’s impact on a set of environmental, social, and governance norms for company operations, its stakeholders, and the planet in addition to financial rewards. ESG investing originated from investment philosophies on sustainability which later expanded its branch to socially responsible investing. The early ESG methodology concentrated on eliminating firms from portfolios that had a negative impact. Moving a step further, the current technique favours notable companies that are pitching favourable contributions to ESG elements by recognizing environmental and social issues as essential elements of strategic positioning. Many investors and policymakers have taken notice of the staggering growth of ESG investing and potential returns since, amid the market volatility created by the COVID-19 pandemic, many companies with good ESG track records displayed lower volatility than their non-ESG competitors.

Due to the staggering growth of ESG, there is a lacuna that policymakers and regulators have to fill because based on recent findings, rating agencies are not acting in good faith while preparing the ratings for companies. During the 2008 financial crisis, rating agencies played a significant part in the downward spiral that caused the United States housing bubble to burst. These rating agencies assist both parties and governments since they cover information gaps about investment products. Rating agencies also play an essential role in the financial system since they assist investors in determining the quality of economic goods. This rating fiasco could result in a slew of unprecedented events, such as a bubble burst or a crash.

If these companies continue selling products that do not have a true value, then the whole idea of ESG investing gets tampered with, and it just results in paving the path for marketing these products.

The ESG Bubble

The worldwide ESG industry is valued at roughly $40 trillion, and estimates show that by 2025, it will be worth around $50 trillion. Countries all over the world are surging into this investing strategy, and the catalyst for this growth has been the consistent returns even in volatile markets. The growth in figures demonstrates that both investors and companies are heading in the right direction in terms of sustainability.

There are various rating agencies and a few dominate the landscape making the data regulated. MSCI’s dominance in the domain of ESG ratings is immense; estimates suggest that 60 percent of all retail investors’ money has gone into sustainable or ESG funds built on MSCI’s ratings. However, the majority of retail investors do not understand what goes into ESG fund ratings and what all substantiates the ratings. As these ratings are primarily unregulated it is not possible to set a standard rating procedure for different companies. MSCI ranks the company based on an aggregate score that is turned into ratings that resemble credit ratings. Hence MSCI is accountable for what it rates as it represents a heavy fraction of the data that investors rely on. According to the Bloomberg Investigation, of the 150 companies they investigated, which also got the rating upgrade, half of the companies got their rating upgrade without any particular change but for merely standing still because MSCI changed its methodology and tailored the ratings where the factors were playing out in the company’s favour.

When McDonald’s was under the lens, a company that has an aggregate carbon emission that is more than the whole country of Norway or Portugal got its ESG ratings improved in April 2021. MSCI rating report upgraded it from a BB to BBB, by reducing the weight of emission from a mere 5 % to 0% and instead replacing it with a new initiative that the company launched around recycling bins that were installed at select locations in the UK and France just because there was a case of heavy littering in the streets where the fast-food giant was present, as there was a threat of regulation.

Following the Paris Agreement in late 2015, JP Morgan Chase decided to bet against green drive and acquired more bonds for fossil fuel companies, resulting in higher fees than any other bank in the world. However, JP Morgan recently self-described green credentials that were mentioned in the rating assessment, which included the formation of a committee on green projects. The green bonds were valued at $14.6 billion. This measure led MSCI to improve its rating from BBB in December 2020. The report and assessment made no mention of the bet against green energy.

According to the companies which were subject to Bloomberg’s investigation, half of the 150 companies that achieved rating upgrades did not report their greenhouse gas emissions, which should be the foundation for the entire ESG investment strategy. The factors that triggered the upgrade to the ESG elements were Boards Structure, Data Privacy, and Corporate Behaviour.

As a result, investors who are focusing on funds that would benefit the environmental aspect of the ESG rating may unknowingly lead to an increase in the carbon footprint of their pensions and other investments. The promise of returns may result in cancelling out the true purpose of ESG. But the aura MSCI and other rating agencies created with unregulated data that looks similar to credit ratings actually drives in the opposite direction of where most investors are looking - sustainability.

Position of ESG in India

SEBI, over the past few years, has induced several regulatory changes in this matter, including a shift from ‘Business Responsibility Report’ to ‘Business Responsibility and Sustainability Report’, which mandates companies to disclose their financial statements and plans to channel the ESG space. The regulatory body also brought up new norms for mutual funds that focus on ESG investing. Recently, SEBI released a consultation paper on ‘ESG Rating Providers for Securities Markets’ where it is proposed that a regulatory framework for ESG Rating Providers (ERPs) be implemented. The paper clearly states the issues faced by the investors when using ERPs including “transparency, consistency, and potential risk of conflict of interest and attempts to achieve through regulation better interpretability, comparability, and reliability.”

There is a major conflict of interest between the ERPs and the entities they rate, according to SEBI, because ERPs that rate entities on ESG criteria also provide consultation services to help them address the concerns. The regulatory body proposed that ERPs maintain a robust policy to identify, disclose, and mitigate possible conflict of interest issues in order to solve this conundrum. SEBI further stated that they are not allowed to assign ratings to their affiliated organisations or securities. Furthermore, the staff in charge of awarding the rating should be kept separate from the rating provider's other services, such as ESG advice. Their reporting lines, as well as their compensation structure, should be set up to prevent any potential conflict of interest.

Critique and Conclusion

In theory, ESG should work, and it is one of the most efficient ideas to tie the loose ends that the companies make while they are running behind profits. ESG rating is largely unregulated, and the methodology used by these rating companies is not standard. Several forms of studies have been conducted to expose the issue of the current ESG grading system. It jeopardises the true objective of ranking. The goal of any ranking is to provide the correct message to all stakeholders, which is not the case under the present system. Without any reformative actions taken by companies to create a sustainable future, getting the ratings upgraded is simply a marketing technique to lure and mislead investors, which will result in a downfall for both investors and the environment.

Meanwhile, the Swiss Finance Institute of Finance published research claiming that ESG is already a bubble that may burst. “The doing-well-by-doing-good conviction driving ESG investors around the world is nothing more than an illusion of their own making, according to a controversial new study. Research from the Swiss Finance Institute argues stocks highly rated on environmental, social and governance metrics have outperformed in recent years all thanks to the trillions of dollars flooding the sector. The fundamentals of socially responsible investing have played no role in driving these returns.”

In conclusion, as in any industry, profit-minded investment managers align with rising trends to ensure their offerings appeal to a growing segment of the market. That can certainly contribute to a market bubble, but it does not guarantee one. Although the rapid growth in demand for ESG investments over the past couple of years may resemble bubble-like activity, market dynamics will ultimately determine how the situation plays out. Therefore, the regulators and watchdogs should be capable of protecting the investors from misleading claims.

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