Why ESG sucks
About COP28
First, regarding COP28, general agreements have been made to move towards the following green economy in a practical way and with a clear roadmap, highlights include:
Triple renewable energy capacity by 2030
Double the growth rate of energy production efficiency to 4%/year (https://energy.ec.europa.eu/system/files/2023-12/Global_Renewables_and_Energy_Efficiency_Pledge.pdf)
Recognize the role of nuclear energy and commit to tripling capacity by some countries by 2050 (https://www.energy.gov/articles/cop28-countries-launch-declaration-triple-nuclear -energy-capacity-2050-recognizing-key)
GCF has received a record $12.8 billion in new funding commitments
Focus on other gases such as SO2 and methane
Especially do not emphasize phase out...
See more at: https://www.carbonbrief.org/cop28-key-outcomes-agreed-at-the-un-climate-talks-in-dubai/
There are also issues that I would like to see discussed more. Including Article 6 of the Paris Agreement on “Voluntary” Carbon Market (VCM) (https://carbonmarketwatch.org/2023/11/24/faq-everything-you-need-to-know-about-article-6- at-cop28/).
The lack of agreement in articles 6.4 and 6.2 shows that there is still no clear consensus on how to measure and report emissions. Effective and specific measurement is what is missing in replacing the ESG label that everyone is still using.
“The Article 6.2 and Article 6.4 negotiations outcome at COP28 is disappointing and sends the wrong signals to carbon market actors. The further delay of the Article 6.4 mechanism – which is expected to become a benchmark [for quality] – is very problematic.”
By the way, more on this nonsense of ESG label. Basically, my distaste toward the idea comes from the fact that a lot of it was stuffed into my head in business school. It was more like Greenwashing rather. Not a fan
About ESG
ESG rating system
First, we must recognize that there is no consistency in the rating system itself. This can be seen from the fact that each rating company has their own rating standards while presenting low correlation among them.
“We find that these ratings exhibit low convergence in their assessments of corporate social responsibility (CSR). This lack of agreement is not just due to announced differences in raters’ theorization of CSR; for example, if they measure performance relative to an industry group or in absolute terms. Instead, the low agreement implies all or almost all of the ratings have low validity.
This lack of consistency comes from 3 factors:
Scope – different rating firms has different assessment categories
Measurement – each categories have different evaluation methods
Weight – the agreed categories contribute different weights to the final result
What is particularly bothersome about this is the fact that the differences among the rating agencies come largely from scope (38%) and measurement (56%), which is more difficult to resolve than differences coming from weight. More importantly, is what the fact implies. The differences in measurement and scope means that each rating agency prioritizes a different aspect and evaluates those aspects differently.
More importantly, these agency rating methos is qualitative-based instead of quantitative which is subjective and unclear, prioritizing different things implies there is no consensus and there is no one defines what is good for the society. The consequence is: impairment of efficiency of capital allocation, meaning money does not flow to the right places, and managers do not have clear guidance to orient the company in a direction that is "good for society".
Some facts:
There are many companies that take ratings from many rating units to cherry pick using the highest rating :))
Tobacco company has higher ESG rating than Tesla:)
Confused investors -> The higher the ESG rating differences among agencies (low rating quality), the higher the risk premium -> raising cost of equity (This probably requires more controlled researches on cost of equity before and after the ESG rating) (https://www.ecgi.global/sites/default/files/working_papers/documents/gibsonkruegerschmidtfinal_1.pdf)
See more at:
rfac033.pdf
DoRatingsofFirmsConverge.pdf (duke.edu)
E in ESG
More specifically, we assess the question whether ESG is good for the environment. In short, the answer is no. The reason also comes from lack of objectivity and consistency in measurement. Which is why the progress in Article 6 in the COP28 was quite awaited.
Here are some facts:
High E score is associated with high CO2 + waste emission
Capital allocated toward the energy industry and other high-emission industries has not decreasing but actually increase
Better domestic environmental policy is associated higher E rating of firms within the country (consider the case of Mcdonald UK vs France. Doing the bare minimum according to the policy actually raise their rating). So why is there still a need for ESG?
To quote McDonald's MSCI 2021 rating report: “Carbon emissions” issue does not present a significant risk – weight of 0%
See more at:
https://www.oecd.org/finance/esg-investing-environmental-pillar-scoring-and-reporting.pdf
Full article: Scoring environment pillar in environmental, social, and governance (ESG) assessment ESG and back
ESG and returns
Another question is whether investing in ESG actually creates value and is it good for investors.
Value creation in corporation can be evaluated by looking at the followings: revenue growth, profit margin, investment efficiency and cost of capital
And here are some more facts:
There is no clear link between profit and loss ESG ratings
“If there is a consensus view derived from research evidence, there is a positive relationship, but these findings are fragile and sensitive to both how ESG and returns are measured.”
There is no clear link between ESG ratings and investment outcomes
“Filis and Mitrokostas (2015) using Bloomberg ESG scores for S&P 500 firms find a negative relationship between ESG and return on capital, although they find that imposing a non-linear relationship would create a U-shaped relationship”
A lower ESG rating can be associated with lower market value. However, these discount is only equivalent with outward cashflow due to fines from violations – again, enforcement of environmental activities can be done by the government, why bother with an ESG rating?
High ESG ratings do not result in significantly lower financing costs
Consider companies that operates well may have money to invest in ESG rather than investing in ESG improve its operation.
“Schreck (2011) tries to control for the issue of endogeneity, i.e. whether well-run firms are socially responsible or socially responsible firms are well-run firms, and concludes that there is no What is the relationship between profit and social responsibility?
See more at:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3557432
Conclusion
Like Dr Ho Quoc Tuan stated: "Knowing you have heart disease does not mean that inventing a trivial heart rate monitor will solve the problem. Not being able to measure is better than measuring trivially.”
To quote Prof Milton Friedman “There is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it complies with the rules of the game, that is, to engage in open and free competition without deception or cheating.”
That does not mean that businesses create harms for society, but that socially/environmentally responsible activities must come from the market. The general consensus of consumers on what is good mean there will be more effective measures for each E/S/G item. Hence, firms can operates effectively in the consensus of the market and capital are efficiently allocated.