Climate investing: Are ESG ratings holding back green growth?

ESG ratings are supposed to encourage investment in greener companies, but accusations of greenwashing and controversies are mudding the waters

ESG assets have grown to more than $40 trillion – totalling about one third of investments globally. But there's a controversy over ESG ratings. Getty Images

Green investing is not delivering for climate change in many sectors, senior banking figures say, laying the blame on environmental, social and governance (ESG) rating standards.

Chuka Umunna, JP Morgan's head of Europe, the Middle East and Africa ESG and green economy investment banking, spoke this week about structural issues facing banking when it comes to delivering the green economy.

“Our job is to enable and facilitate … the transition. We are not in a position to deliver the transition,” he told an event in London. “We need to build a funding model for green tech companies.”

Figures from the global funds network Calastone show that nearly £2.5 billion has flowed out of ESG-focused investment funds since May of this year.

Since the beginning of the year, the S&P Global Clean Energy Index, which covers companies investing in renewable energy, has fallen by 25 per cent.

To some extent we can blame the pandemic – during and immediately after the Covid lockdowns, investment flows into the better-rated ESG companies and funds soared. A record £537 billion moved into sustainable funds, up from £449 billion in 2020, according to Refinitiv.

Hortense Bioy, global director of sustainability research at Morningstar, points out that while investment has continued to flow into ESG funds in Europe, albeit at a slower rate, in the US, the trend is towards outflows.

“Factors contributing to the decline in inflows in Europe include persistent inflation, climbing interest rates, and fears of recession,” she told The National.

“In addition to these macroeconomic factors, the political backlash against sustainable investing in the United States also continued to weigh on investor demand for ESG products.”

Much of the stock market action switched to more traditional sectors like oil and mining, where the new ESG fund managers could not follow, given the parameters of their investment funds.

Ratings and reality

Companies can parade their ESG credentials in the form of ratings, similar to the credit ratings afforded by the likes of Moody's and Fitch, and fund managers can use them to assess the suitability for inclusion into their funds.

It's difficult to argue that ESG ratings don't matter at all – in the Middle East, 90 per cent of sovereign wealth funds and 22 per cent of central banks have adopted ESG policies, according to the recent Invesco Global Sovereign Asset Management study.

Kenneth Pucker, professor of practice at Tufts University, and Andrew King, professor in management, strategy and innovation at Boston University, pointed out in a paper for the Harvard Business Review that “ESG funds are not going to save the planet” and winning the battle against climate change will cost in the order of $3.5 trillion over the next years.

“Unfortunately, these trillions are not the same trillions that are presently invested in assets managed according to many forms of ESG investing,” they wrote.

“Those are dedicated to assuring returns for shareholders, not delivering positive planetary impact.”

Daniel Cash, an associate professor at Aston University in the UK and the ESG Ratings and Regulations lead at Ben McQuhae and Company in Hong Kong, told the The National that ESG ratings “operate on what is known as a ‘single materiality’ basis, meaning they are concerned with how a business/product can cope with external non-financial risk, not how the business/product affects the environment around it”.

This may seem like an academic distinction, but it led to Elon Musk taking to X – or Twitter as it was then – to complain that tobacco companies and oil producers had higher ESG ratings than his company Tesla.

Tesla was given an ESG score of 37 out of 100 by S&P Global, while Philip Morris, which makes Marlboro cigarettes, scored an 84. Tesla also scored lower than Shell and Exxon.

Supporters of the ratings pointed out that while Mr Musk's electric car maker scored highly on the environment scale, its overall rating was dragged down by lower scores in social and governance.

'Risks of greenwashing'

As such, a strong sense of confusion has emerged in the ESG ratings world. Analysts say this is not surprising given that there are no international standards and often the methodologies used to reach ratings are less than transparent.

Trust, therefore, becomes a major issue.

“The rise in green and sustainable-focused bonds, and general ESG-focused investment, means the risks of greenwashing and capital misallocation is, for the system, uncomfortably high,” said Dr Cash, who advocates an oligopoly of ESG ratings agencies that adhere to a set of clear international standards.

“Investors, as a homogenous group (that does not exist because it is so diverse) would, theoretically, want fewer ESG rating agencies to choose from, not more. This is because the strength of the signal that a rating provides is diluted with more players rather than fewer – this is what we call a natural oligopoly,” he added.

Lindsey Stewart, director of investment stewardship research at Morningstar, told The National it's “time of change for the ESG rating industry”.

“They have up until now provided a useful and digestible means of incorporating ESG factors into decision making, but it would appear that investors’ needs are becoming more complex and diversified,” he said.

“That in turn has fuelled demand for more granular ESG information, in preference to having everything boiled down to a single score or grade.”

The single scores that are awarded in the credit world are calculated off the back of audited financial figures, but in the ESG ratings arena, the grades are the result of a more nuanced and subjective process.

Regulators react

The controversy in the ESG ratings industry has caused regulators to sit up and take notice, given the levels of influence that ratings can bring to bear on trillions of dollars' worth of investments.

The UK Treasury is thought to be considering expanding the remit of the Financial Conduct Authority covering ESG ratings.

In July, the authority launched a three-month consultation for a voluntary code of conduct for ESG data and ratings providers.

Back in June, the European Commission made proposals that would eventually see ESG ratings companies come under the auspices of the European Securities and Markets Authority, following the issues raised about the ratings.

While regulators have made proposals and launched consultations, ESG ratings remain an area of controversy. Any new regulations would “take time” to implement, according to the authority's director of ESG, Sacha Sadan.

In the meantime, market participants are stuck with what Ms Bioy feels is a “love and hate relationship with ESG ratings”.

“Despite all of the issues and criticism, corporates pay a lot of attention to ESG ratings,” she said.

“It’s important to highlight that most asset managers use their own ESG research and scoring models to make investment decisions.

“They use underlying ESG data and scores, rather than overall ESG ratings.”