ESG means Environmental, Social & Governance. SDG means Sustainable Development Goals. SDGs are set by the UN. Most SDGs have ESG implications. ESG rated companies have become popular in investment portfolios. This is because the ESG standing of a company is a proxy for long term value, say the boosters of ESG based investing. The retail investor, by necessity, outsources research on ESG to professionals and invests in funds with a sustainable focus. The funds are meant to investigate the sustainable claims of many companies. Instead of doing so themselves, they rely on outfits like MCSI and Sustainalytics to choose the portfolio companies.
Much like the ratings agencies whose triple A rated bonds cratered as the financial crisis hit in 2008, these ESG raters do not and cannot stand by their scores when non-sustainable practices at firms with high ratings are exposed. Similar to those rating agencies who also got paid by their targets to rate the bonds that they issued, there is often a conflict of interest at the heart of these ratings. The scores are often proprietary and employ models and methods, including survey based results which rely on the enterprises to self-report. Self-reporting has never been a good method to rate enterprises or individuals.
Sustainable Development Goals
After laying bare the debate about ESG based investment strategies; some efforts to improve the quality and depth of the data and hence make the scores more objective are discussed. Some of these proposals use the blockchain to secure the truths about the business attested by programmatic or other verifiable metrics. A combination of methods probably works best, with suspicious activity getting investigated further, including the use of shoe leather.
The Skeptics
The US Labor department regulators recently released a proposed new rule, to clarify the ERISA guidelines as being concerned purely with pecuniary results. The new rule says that ESG ratings should not be used as a criteria for investment. Since this affects all investments by pension plans, it has a great influence on investment strategy and climate in the US; since pension plans control a huge chunk of investment. This new rule could be a huge problem for portfolio managers who are in charge of pension funds.
Another idea that has gained prominence when talking about the superior pandemic performance of ESG rated companies was that ESG ratings have nothing to do with it. A well respected analyst has asserted that ESG ratings do not have anything to do with the better performance of ESG rated companies; since the difference in performance during the pandemic is due to the fact that energy companies and airlines who have poor ESG ratings cratered in first weeks of the pandemic. You can certainly apply this narrow logic to the performance metrics focused on a specific crisis. However, nothing can be said about the wider alpha generated by better ESG metrics. Indeed the better performance of ESG companies during the pandemic can be thought of as being generated by their resilience, better credit ratings and being relatively sheltered from black swans like the pandemic.
One more example is a company called Boohoo in the UK. Boohoo had received good ESG ratings from the ESG rating agencies which earned it a place on some portfolios in ESG funds. When news broke that their supply chain included vendors that underpaid their workers, the stock dove. These revelations resulted in its removal from the ESG funds. This points to the lack of depth in the rating; for a fashion brand suppliers matter. This is a case of a company receiving higher grades than they should have, because of the lack of proper due diligence.
ESG Proponents
The head of State Street Advisors
Measuring ESG
There was some talk in the ESG community that using the SDGs to measure ESG performance would be better, since they are finer grained and may be actually measurable. There are 17 headings there rather than just three in ESG.
For carbon emissions and other types of environmentally destructive activities where there can be a measure of objectivity, independent auditors and public data can bridge the transparency gap. The IWA has created a Carbon Emissions Token that includes several measurements and assertions. Nominally this would be on the blockchain so that the various parties who issue and monitor the token can assert to the measurements.
Another effort in the climate & accounting SIG in Hyperledger to setup utility emission channels will use public eGrid data, published by the EPA, along with the customer’s utility bills to calculate the emissions attributable to their energy consumption can be used to rate enterprises on their emissions profile. This uses a blockchain to capture this information from multiple parties. All of this point to the original use case for the blockchain to be a non-repudiable source of ordered documents.
Other ESG factors are harder to measure, especially the social and governance aspects. The ESG rating agencies who use a host of factors to calculate the ESG ratings will have to use many more automated methods using publicly available data; including some from blockchain anchored data stores. These methods will get better as time passes and ESG ratings will no longer be questioned as proxies for long term performance.