The Blueprint for Sustainability: What Makes an ESG Stock and why are the Criteria so Controversial?

Environmental, Social and Governance (ESG) stocks are the subject of widespread investor interest and are likely to be a favoured choice among retail investors for many years to come. However, it’s vital that research is conducted before buying into a stock that’s met the ESG criteria. 

The lure of winning appeal among environmentally conscious investors is sufficient for many firms attempting to become an ESG certified stock, whilst institutions have clambered to rebrand numerous ETFs as sustainability-focused funds. The push for environmental, social and governance recognition is so profound that it risks undermining the initiative itself.

(Image: NYU Stern)

As the data above shows, climate change investors have been found to significantly outperform their counterparts in terms of achieving positive results. We can also see that fewer climate change investors experience mixed or negative results in terms of their investments. 

(Image: Financial Times)

As the chart above shows, global ESG ETF assets have grown to more than $250 billion in value - a remarkable rise considering that less than $80 billion worth of assets existed when the Covid-19 began its emergence in early 2020. 

But what makes an ESG stock? Why is it important? And do investors need to be aware of the controversies associated with ESG criteria? Let’s take a deeper look at a complex model for measuring sustainability: 

The Importance of ESG Stocks

Investors, and particularly younger retail investors, have increasingly shown a willingness to seek out ESG-compliant stocks to build their portfolios. Due to this, brokerage firms and mutual fund companies have begun offering exchange-traded funds (ETFs) and various other financial services that claim to follow ESG criteria. 

Robo-advisors like Betterment and Wealthfront have used the lure of ESG ETFs to appeal to this new wave of investors, and according to a recent report from the US SIF Foundation, investors held some $17.1 trillion in ESG-compliant assets at the beginning of 2020 - an increase of more than $5 trillion in the space of only two years. 

Otherwise known as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI), ESG investments have grown to become a force to be reckoned with across retail.

The assessment criteria looks deeply at a broad range of behaviours surrounding company stocks which concerns their carbon footprint, the environmental risks posed by the business conducted, their relationships with other non-ESG-compliant businesses, company transparency, treatment of staff, and fair distribution of stock. 

Although the overall goal of ESG criteria is to ensure that companies are recognised for their positive impact on the environment and society around them. However, there are growing controversies surrounding the criteria itself, and the emergence of greenwashing, in which companies are falsely claiming to be ESG compliant when they’re actually carrying out damaging practices. 

Lack of Authenticity Among ESG Claims

According to a recent report by InfluenceMap, a UK nonprofit organization that evaluated 593 equity funds with more than $256 billion in total net assets, as much as “421 of them have a negative Portfolio Paris Alignment score, indicating the companies within their portfolios are misaligned from global climate targets."

Furthermore, 55% of the climate-themed funds also failed to match the goals of the Paris Agreement. The report found that these funds marked as low-carbon, zero-emission, and green energy were exaggerating their claims - with over 70% promising ESG goals falling short of their targets. 

"As the number of ESG and climate-themed funds has exploded in recent years, so too have concerns among investors and regulators about greenwashing and transparency," InfluenceMap analyst Daan Van Acker explained to Bloomberg. “The scrutiny does show serious scepticism about the authenticity of some ESG claims, but it also means intense interest in ESG concerns even if some efforts are fairly flawed or fall short.”

Maxim Manturov, head of investment research at Freedom Finance Europe, warns that investors must exercise caution in researching the stocks they want to buy in the wake of these fraudulent claims and the dangers of severe stock volatility that could accompany them. “Before making any investments, new investors need to know their risk tolerance. Some investments carry more risk than others, so it's worth thinking about preserving capital first,” Manturov noted. 

Deep Inconsistencies Within ESG Ratings

It’s also important to highlight a significant lack of consistency between ESG rating providers and the scores they give different stocks. Critics have highlighted this as a key shortfall of ESG ratings, claiming that the need for a more methodological standardization of ratings is needed across the sector in order to deliver greater levels of credibility. 

Here, it should be noted that in generating an ESG score, providers are often looking to value intangible assets and difficult-to-measure metrics. This means that inconsistencies to some extent should be expected. The prospect of inaccuracies emerging must be factored into the evaluation process by generating ratings to be perceived more as an indicator - rather than a de facto score. 

Adopting a more granular approach can be beneficial for clients and investors alike. This can help outsiders to better understand the relative strengths and weaknesses of companies in comparison to sustainability strategy and programmes across their respective industries. 

The wealth of information under each ESG criteria can be used strategically to guide the company and to help other organizations better understand where improvements can be made. This can help to bring greater transparency for retail investors and institutions alike, delivering a fairer investment landscape for all to participate in.