Welcome back to Spend Donate Invest! This is a podcast where we talk about ways to line up our values and our money. When we think about the things that keep us up at night. Whether that’s climate change, or homelessness, or the systematic oppression of our communities, we usually talk about how we can claim our power when we vote. Some of us might protest, or organize ourselves in other ways. But what about….our money?
Where do we bank, where do we shop, where do we donate?
These are the things I wonder about, and you might be wondering about it too. If you are, you can drop a line anytime and I’ll be happy to explore it on the show. The email address is spenddonateinvest at gmail dot com. Or you can use the voice recorder function on the show’s website which is at spenddonateinvest.world and I’ll transcribe your question and read it on the air.
We’ve covered so much in the past year. Questions have come in about trying to give up brands from companies who have values that are different than yours, trying to convince your partner to switch to a more socially responsible bank, and whether or not to give that person with a cardboard sign some cash.
And in case you aren’t already familiar, I’m your host! I go by GG, that’s short for Genet Gimja. I’m so glad you’re here today!
I’m really looking forward to today’s discussion, because I think it’s going to be surprising, interesting, and helpful! I want to talk about ESG investments. It’s all the rage among people who give a care about the world we live in, people like you and me.
For some investors, it isn’t enough to just make money, we care about how that money is being made. We want to invest according to our values. You might hear this referred to in many different ways. Some people call it:
Impact InvestingEthical InvestingSocially responsible investingSustainable Investing, orValues- Aligned investingSome people have come to call it ESG investing, which is not a great catch all name for this type of investing, and you’ll understand why by the end of this episode, I promise you in about 10 minutes you’re going to know more than most of the financial planners I’ve met at conferences and personal finance meetups, but that nickname, ESG investing, is increasingly common for when people want to refer to investing with your values in mind. The E stands for Environmental and the S stands for Social and the G stands for Governance.
So, whatever you call it, I usually alternate between values-aligned investing and socially responsible investing, whatever you want to call the type of investing you do when you care about more than just maximizing profits, historically, there were two phases that most people went through. In the olden days, and you can still do them now, but this is how ethical investing sort of started out.
First, you can do negative screening. You can screen out stocks that don’t line up with your values. The most common examples you’ll hear people talk about are firearm companies, tobacco, you used to hear people screening gambling companies out. Or pornography. Maybe your values are different, maybe what you really care about is excluding fossil fuel companies, the point is, this is the first and easiest approach to values-aligned investing. To screen out the companies that don’t align well with your values.
Second, you can do positive screening. This is where you add stocks for companies who are proactively doing good. Like maybe the company is a wind or solar energy company. Maybe this is a company who has taken a stand on how they treat human beings- their employees, the communities where they operate. These are companies that are proactively trying to do something to heal the planet and our people.
Nowadays, most of us invest in funds rather than picking individual stocks. And there are lots of socially responsible or values-aligned funds or again, that misleadingly nicknamed ESG Funds: The big investing platforms all have these types of values-aligned products now: from Blackrock, to Vanguard, to Merrill, etc. Because every day investors like you and me are super interested in these types of investment opportunities. More and more every day investors are starting to feel like they want to see that their investments line up with their politics, their ethics, or if they aren’t perfectly aligned, at least there isn’t a huge disconnect. This is awesome. It’s unfortunate that the shorthand name for these types of funds is sometimes “ESG Fund” but here we are.
And so you can log on to wherever you usually invest, and you can take a look to see what is included in the ESG fund that they offer, what has been excluded. You might see that they have more than one to choose from.
It could be that all companies are included in the fund, but more money is put towards the companies with higher ESG scores. Or it might be that only companies that surpass a certain ESG score are included in the fund. So you never know, it is good to click around and see what all is included in the fund.
ESG funds tend to charge higher fees than traditional fees. So when you are clicking on a fund to see what has been included, what has been excluded, you can also look at the fees. They are almost certainly going to be higher than the fees for a fund that doesn’t do any kind of ESG screening. And the reason that the investment platforms give for the higher fees is because they require extra work on their side, I’m skeptical of this, because it just seems like an extra line of code to add a criteria for ESG, but hey, what do I know. Anyway, look at the fees to make sure you’re comfortable with them.
And look to see if they are indicating what the ESG rating thresholds were to be included in the fund, keeping in mind that there is no standardized way to measure ESG, there are some popular rating agencies like MSCI and Sustainalytics. But even they can vary on the ESG ratings that they give the same company. And they can vary a lot.
It can be difficult to measure ESG, are you just looking at a company’s operations? What about their supply chain? What about their partners? Are they greenwashing their true environmental impact or are they really about that life?
And what exactly does ESG measure? Now here is where you’re about to learn, in 5 minutes or less, what the vast majority of people don’t know, and why it is so misleading to refer to “ESG” as a nickname for socially responsible or values-aligned investing.
I’ll link a couple of explainer videos if you want more detail from both MSCI and Sustainalytics. I’ll give you a high level explanation here, in order to be assigned an ESG rating, a company is examined and some analysis is done to estimate how much risk exposure they have, how much risk their profits are exposed to depending on their industry, or where in the world they operate.
Then, an analysis is done on how well they are managing that risk. And they get a rating. A risk rating. There are 3 categories;
E is for environment. These are the questions that will be asked. How can environmental factors risk the company’s profits? Do they use ingredients that come from nature? Maybe they make and sell granola bars. Do they need to grow ingredients? Do they need to put the final product onto boats to get them to the customer? Are they careful in managing those risks? Do they have sloppy practices in sourcing the ingredients or shipping their products that could put their profits at risk and therefore put your investments at risk? If the answer is yes, they will get a lower E score.
S is for social. This is the next component of the ESG rating. For social, the questions that will be asked are: How can employee factors risk the company’s profits? Do their employees keep getting hurt on the job so much so that the company’s profits could be at risk? That will affect the ESG rating. Do they keep having product recalls that actually affect their profitability? Or do people still keep buying their products even with the product recalls? If it affects their profitability it will affect their ESG rating. And yes it is weird that product safety would go under Social, but that’s just another weird thing about ESG. Also in this social category, the questions that will be asked about a company to determine their score would include data breaches, do they have data breaches to where it actually affects their profitability? If so, it will lower their ESG rating on the Social category.
There’s one left, G is for governance. So this is primarily about the company’s board. Is there something about the way they pay the board that could lower the company’s profitability? If so, that will affect their ESG rating. Could their profitability be affected by how transparent they are about paying their taxes? These will affect the G rating on their ESG rating.
I want to use the word “risk" as many times as possible during this discussion because that’s the word that gets left out of almost every ESG conversation. You’ll also notice the way I was asking the questions about the company to get at their ESG score. I was asking “could their profitability be hurt by….?”
My frustration with ESG is that it is discussed as though it is a measure of how well a company treats the environment, how well they treat their employees, and how well they govern themselves. That is not what ESG measures. ESG does not measure how wholesome a company is. ESG does not measure if a company is a good corporate citizen. High ESG scores don’t mean that a company is helpful to our environment or society. A high Environmental score does not suggest that the company is green, that they are striving to reduce emissions, that they recycle. Not at all. ESG is a risk rating. How risky is your investment from an environmental standpoint? Do you hear the distinction? The evaluation is on whether your money will be safe, not whether the environment will be safe.
ESG was designed so that you could look at two companies who might have similar profitability and to pick where your money is safer. ESG is answering the question of which company will have higher operational costs and litigation? Yeah sure, both companies are equally profitable, but one of the companies is riskier, so your money isn’t quite as safe.
This is dramatically different than how you’ll hear less informed investors talk about ESG, they’ll say, you know, I really care about the environment, so I really look at that E score to make sure it is high before I invest. But, that’s not what a high E score means. It doesn’t mean that the company is a good steward of the environment. A high E score means, your money is probably safe here based on an analysis that has concluded that they probably won’t get into a lawsuit about their environmental operations. They probably won’t have an expensive environmental disaster that they will have to pay for. ESG is measuring how risky it is for you to put your money with that company. Not how well the company minimizes its environmental destruction.
So the ESG raters look at a company and they look for actions they are taking which might put your investment at risk. Are they sloppy with how they move stuff around, could they have an oil spill. Are they real lax about their IT infrastructure, could there be a cyber security hack that could put your investment at risk? Is their board known to be corrupt? Could one of the executives steal a bunch of the company’s money which would then put your investment at risk?
When you listen to the executives at MSCI and Morningstar Sustainalytics talk about why they started the ESG ratings in the first place, they say, point blank and this is a quote that “Sustainable investing is top of mind for investors who want to manage risk in their portfolios” but it’s like no, that’s actually not what investors are worried about, they are worried about the risk to the environment! And to our people. By the way. that quote was from Laura Lutton, the Director of ESG Risk Products at Morningstar Sustainalytics. I think this is what bothers me, that ESG was created to measure how safe a company’s profits are, and yet it has been branded as a measure of goodness. I don’t even know if that was the original intent to give this false halo, I don’t know if the creators of ESG meant to trick people into thinking it was a measure of goodness, maybe it was one of those situations where investors were misunderstanding intent but the creators didn’t correct them, because it was hugely popular and making a lot of money. I had a friend that was at a career fair once looking for a job, and the recruiter he was talking to thought he had said he was a student at Harvard University and even though my friend clearly realized the recruiter had misheard him, he was like well, I mean, it’s not my fault he misheard me, I’m not going to correct him! LOL
If you do a deeper dive onto the MSCI website, like I did, eventually you will find the tiny disclaimers about what ESG ratings are and what they are not. Here’s what I found, in their words, buried deep on their website, and I’ll put a link in the show notes.
“ESG ratings are designed for one purpose: to measure a company’s resilience to financially material environmental, societal and governance risks. Our ESG ratings provide a window into one facet of risk to financial performance. They are not a general measure of corporate “goodness,” a barometer on any single issue or a synonym for sustainable investing.“
I can say it even more concisely than that. ESG ratings tell you how safe your money is, not how socially responsible the company is.
It has been proven that ESG investments tend to do as well or better than traditional investments. And because you now know what the vast majority of investors don’t know who toss around that ESG nickname without really understanding it, you know that this makes perfect sense. Of course a company with a higher ESG score is going to do as well or better than a company with a low ESG score. ESG is measuring risk to a company’s profitability. And high ESG companies are less risky. They aren’t taking big chances that will end them up in hot legal or regulatory water. They aren’t taking the big risks that could end in a big oil spill, which could end up costing them expensive fines, lawsuits, a hit to the public’s perception of the brand, lower interest in buying their stocks. A worse ESG score indicates that a company is out here playing a riskier game. So of course they will face higher capital costs, more volatility in general.
If you step away from ESG ratings, and think about companies that are actually more socially responsible. So these are companies that are trying to do right by the environment, trying to do right by the people that work there, etc. I have read some analysis that those companies tend to do better financially. For example, there are links between higher diversity of the leadership and the profitability of a company. I'm going to link a paper that draws out that link between gender diversity and firm performance in the show notes.
I’m going to end with a wish. My wish is that someone out there please develop a widespread scoring system to evaluate how harmful a company is to our planet and to our people. I’d like to be able to use it to compare companies within and across industries. I’m not asking you to tell me how profitable the company is, I want to know how harmful the company is.
And I get that there’s some subjectivity to that, maybe I care about the climate crises and somehow you still don’t believe in climate change. I get that. That’s fine, we will disagree on some things, but make the tool, and then just be clear about how you came up with your scores. What are the specific questions that you are asking about each company? And where do you get the data?
When they come up with ESG ratings they use publicly available data. Companies don’t have to do a full accounting of here’s what our emissions are, ya da ya da, I don’t know that raters could even fully trust that if it did come from the companies unless there was some sort of regulatory body that could confirm that they aren’t greenwashing the data, it is a true indicator of their carbon emissions, for example. So raters just take the publicly available data and use that to come up with the ratings. And that includes data like recent scandals that the company has had.
So if you’re out there listening, and this is your field, please come up with something that actually measures a company’s harm on the planet and our people.
I am sure that a lot of every day investors don’t know that ESG is a measurement of how risky their investment is, but I am also concerned that even the fund managers might not know this. And I know that investors, especially young people that are starting to think about their investments, are going to be interested in investment options that actually address the risk to our planet rather than the risk to our money. So please, if you are someone who can do this, please, we can’t keep thinking of our money and our societal impact as being two completely different goals.
But in the meantime, if you are going through an evolution like I have been for the past few years of really starting to question where I am investing, and trying to figure out how to bring it into closer alignment with my societal and environmental values, I think we need to do what we can for now, while we push for systemic changes. I don’t want you to get analysis paralysis and let perfection be the enemy of progress. Most of my listeners are listening from America, we don’t have social safety nets that might exist in other countries. In our country, we need to figure out how we’re going to not work until we die, so we have to invest our money. We can’t let our money sit doing nothing while we search and keep searching to try to find the best, most socially responsible investment opportunity. Let’s invest it somewhere for now, while we continue to look for places to invest that are closer and closer to our values.
Alright, thanks to those of you who stuck around for this impassioned clarification of what ESG is and what it isn’t. I left a lot of links in the show notes today so you can do a deeper dive. I’d love to know if you have any other questions about ESG, how you’re hearing your friends and family talk about it.
If there’s another topic you’re interested in, please send an email anytime. The email address is spend donate invest at gmail dot com. If you’re new, check out the back catalog, there are dozens of episodes on all kinds of ways to think about your money and your beliefs, whether they are about our planet, our communities.
Please share this episode with someone who you think might appreciate a concise, clear, easy to understand explanation of ESG. I think that’s it for this week, let’s talk again soon!
Links
MSCI ESG Ratings Explained
https://www.youtube.com/watch?v=79rZm7FCkOU
Sustainalytics What is ESG?
https://www.youtube.com/watch?v=VwGmtThiwII
An Institutional Approach to Gender Diversity and Firm Performance by Letian Zhang
https://www.hbs.edu/faculty/Pages/item.aspx?num=55194
What MSCI’s ESG Ratings are and are not
https://www.msci.com/our-solutions/esg-investing/esg-ratings/what-esg-ratings-are-and-are-not