ESG Scores Are Broken
Conflicting scores, arbitrary weighting, and zero correlation with performance
Tesla is ranked worse on ESG than ExxonMobil. McDonald's scores better than some renewable energy firms. If that sounds absurd, it’s because it is.
ESG ratings often rely on very sophisticated methodologies. But not a single ESG scoring methodology manages to produce meaningful datapoints without publishing a gargantuan portion of ridiculous garbage on the side.
Companies receive wildly different ESG scores from different rating agencies. There’s no real convergence and no clear definition of what ESG even means.
Different data providers weigh environmental, social, and governance factors differently.
This results in situations like the one in late 2022, when Tesla got booted from the S&P ESG index, while oil companies remained on it.
ESG scores, unfortunately, often reward PR spin over real impact. Companies can score higher by just reporting more data—not by actually doing anything better.
Many ESG scores are laughable
As a result of all this, ESG scores often lead to ridiculous results:
In May 2022, Tesla was removed from the S&P 500 ESG Index over concerns related to racial discrimination claims and crashes with its autopilot vehicles.
ExxonMobil, the largest U.S. oil and gas producer, remained a prominent constituent of that same ESG index. Why would a fossil fuel giant be favored over a company producing sustainable products?
A prominent ESG ETF, with ticker symbol EFIV, had approximately $89.41 million, or 5.17% of its assets, invested in fossil fuel stocks.
Major technology companies such as Microsoft and Alphabet consume gargantuan amounts of energy for their AI products. Their demand in data center power is projected to rise by 160% until 2030. Yet, tech firms receive excellent ESG ratings.
ESG Scores Were Never Designed for Investors
Here’s the thing: ESG scores were never created to predict financial returns—or, for that matter, sustainability impact.
Most ESG scores are compliance tools. If your company scores well, your CEO won’t be jailed.
Using these scores as investment signals is a bit like investing in your uncle’s company because he’s a sweet guy—not because he actually has any business acumen.
In addition to this, ESG ratings favor companies that disclose more data—overwhelmingly these are large conglomerates that can afford to gather and publish this much data. This does not mean that smaller companies with out the same data capacities are actually less sustainable; they’re just less able to tick off boxes in a compliance exercise.
Finally, ESG scoring methodologies are complex at best and opaque at worst. There’s no simple methodology to know how they’re calculated. Contrast this to credit scores, where the methodology is very clear and reflective of reality!
To be fair, there is indeed some research to suggest that correlations between good ESG scores and good financial performance exist. Nevertheless, the reality is too muddy and multi-faceted to be used as-is by investors.
What Should Investors Do Instead?
ESG scores are broken. Investors who rely on them are making bad decisions. If you care about sustainability in investing, you need a better approach.
So. What should investors use? After all, there’s a need for real sustainability signals. Flawed ratings are a tool from the past.
The good news: There are better ways to integrate ESG into investing.
The bad news: It requires going beyond the scores.
On Thursday, I’ll break down exactly what to look at instead.
Wangari’s Curated Reads
From ESG to OMG, says
. (I’m appalled that I didn’t come up with that headline myself!) It’s a pretty short but comprehensive take on the state of ESG today. One thing in particular struck me: ESG, at the end of the day, is about adaptability to change. I couldn’t have said it better.- asks: Are ESG funds subsidised by their non-ESG siblings? It seems, to some, that ESG funds have gotten a preferential treatment by asset management firms and hence outperformed non-ESG ones. This might not be true, because within the study period green stocks were perhaps simply outperforming brown stocks—something that may or may not happen again. Worth a read!
Mainstream sustainability is a bust, says
in a provocative piece. The way he sees it, green technology, green labels, and so on only assist us in consuming more of our precious planetary resources. What we really need, he writes, is a cutback on overconsumption. I have my doubts, but it’s certainly thought-provoking!