In our last blog post, we took a look at the details of the rankings behind ESG investments. In that post, several questions have emerged that we feel require further discussion. Let us explore in more detail the transparency of responsible investments and their potential for abuse.
One of the important takeaways of our previous post was that issues related to ESG ratings include a lack of standardization among rating agencies, a lack of transparency in the applied rating approach, and different focuses. In short, interpreting different scoring systems is quite tricky.
It is worth mentioning that different interpretations consider impact investing to be a much more exclusive concept. Knowing these details is not necessary for a general understanding of the topic, but it is interesting to note that not only are there no uniform systems in the field of ESG criteria but that interpretations of many other concepts in the topic also raise similar questions.
To have a better understanding of the problems that appear in practice, it is worth going one step further than ESG to approach the issue through the topic of impact investing. Impact investing is based on a simple idea: Investing in businesses that operate in line with our own principles/beliefs. Or, as described more professionally by GIIN (Global Impact Investing Network): “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” Meaning, impact investors promote social responsibility using ESG criteria and other social and economic approaches. So according to these explanations, impact investing examines the issues in a broader interpretation than ESG does. There are several aspects of impact investing that are often overlooked in the light of the popularity of sustainability, but it is important to be aware of them, such as:
- The return on impact investments is in many cases lower than on traditional investments. The reason is simple: Investments can easily offer higher profits when investors don’t have to pay for the damage they cause through, for example, carbon emissions or for the health impacts of air pollution. After all, if there were no trade-off between profit and impact, regular investors would already be investing in solving climate change, removing plastic from the oceans, or educating the poorest regions of the world.
- The expected social and environmental benefits are only predictions. It is difficult to identify in advance which social program will work.
Greenwashing conveys the idea that a company or some individual is providing misleading information about the environmental impact of their activities.
In addition to the cases mentioned, some dilemmas provoke more intensive reactions, such as the phenomenon that an investment labeled as “sustainable” or “socially responsible” is often just a marketing phrase. Industry trends are making it increasingly attractive for businesses to use the term “impact” when promoting their products, which they can do without any consequences, given the lack of regulation and standardizations in this area. With such ambiguity, however, there are growing concerns about green/impact washing, which could easily discourage potential investors and jeopardize the credibility of the industry.
Since the focus of our blog series is on ESG investments, let us look at some related cases through which this phenomenon can be demonstrated. With so many corporate scandals, one must question the authenticity of sustainability ratings. For instance, looking at the automotive industry, an increasing number of former ESG ‘champions’ are under investigation for involvement in massive, multi-year emission scandals. In the last decade, Bosch, Renault, Mitsubishi Motors, and Volkswagen had their share of massive scandals relating to environmental impact criteria, while previously all of them received awards and accolades for various ESG practices and/or promoting socially responsible investing.
The fashion industry is another area where finding loopholes is commonplace. Inditex and H&M are two corporations that emphasize their commitment to human rights in the name of corporate social responsibility, while they typically sub-contract parts of their manufacturing process to businesses in developing countries with less transparent supply chains.
Another example shows how ambiguous the interpretation of sustainability can be: Amazon, for example, registered 51.17 million metric tons of carbon footprint last year, with a 15% annual increase. Still, the company’s operation is often regarded as ESG-friendly by some experts, due to Amazon’s commitment to continuously reduce its carbon footprint and become carbon-neutral by 2040.
All of these examples show that responsible companies can easily look better or worse than they are, depending on the rating used. It is difficult to judge which investment products carry the true promise of sustainability. In the case of excessive promises and hype, defining investments with a social and environmental impact may lose their value.
With such overpromised investments, the investor may achieve a “feel good” state without actually doing any good and making an impact. It is apparent, therefore, that as long as there is no reliable, prescriptive, and verified methodology, it can be highly misleading what constitutes an ESG investment. With the growing number of cases of abuse, the whole idea can easily be reduced to just being a buzzword. So, what can be done to minimise misinformation and dubious corporate activities? The final part of our ESG blog series will be about the EU’s responses to the very issues raised here, the EU SFDR regulation that will enter into effect soon.