Is ESG the Future or A Replay of the 2008 Financial Crisis?

The sustainability ratings industry is under attack, and its flaws are making it easy

When, back in 2009, the world learned that the three leading financial ratings agencies, Moody’s, Fitch, and S&P Global, were earning lavish fees for conferring their AAA+ brand on exceptionally risky mortgage-backed securities (MBSs), many expressed (or at least feigned) outrage.

In effect, investment banks would pay one of the three credit ratings agencies (CRAs) to assess a bundle of soon-to-be toxic mortgage securities. Should an analyst for one of these firms dare to challenge the financial competence of their mortgage sausage making, the investment bank would just take its business to another CRA. This system of ratings arbitrage almost always produced the AAA+ result desired. And eventually, it also fueled the Global Financial Crisis.

Of course, the hands-off regulatory philosophy of the President George W. Bush administration didn’t help. It was the regulatory version of that wonderful scene in Casablanca when police inspector Louis Renault proclaims to be “shocked, shocked, to find that gambling is going on in here,” only to be interrupted by the croupier, who hands him his winnings.

Are ESG ratings a scam?

Some worry that a similar conflict of interest is at work with ESG metrics—the billion-dollar-a-year and growing industry of firms who rate the Environmental, Social, and Governance performance of corporations and real estate assets.

To be sure, the rise of ESG as an increasingly unavoidable hurdle for publicly traded companies to clear is a genuine revolution and is putting positive pressure on the corporate sector to look beyond the narrow goal of shareholder value to its impact on people, society, and the planet. Over the last five years, it has become a dominant investment strategy, its growth driven by activist investors (like pension funds and progressive billionaires) who are demanding action on climate change, income, or gender inequality; a younger, more progressive workforce to which corporations must cater in these days of tight labor markets; and increasingly, regulators, starting at the local level but now including the EU, the European Central Bank as well as the Securities and Exchange Commission (SEC).

That said, the Ukraine war, a sudden surge in energy prices, and issues around the transparency of ESG metrics have some questioning the long-term viability of ESG as an investment strategy.

So, who is right? To answer, let’s start with how ESG ratings work: A raft of firms, all wielding their own proprietary methodologies and algorithms, submit exhaustive surveys to corporations on an annual or semi-annual basis with questions ranging from fuel and water consumption to the diversity of the boardroom to how many times a month the CEO uses the corporate jet.

Slavery, child labor, or Xinjiang cotton in the company’s supply chain, income and racial inequality in its labor force, safety and transparency in the workplace—all of these factors, empirical and abstract alike—are self-reported back to the ratings firm, which then applies its special sauce and spits out a rating that can have a major impact on the company’s share price.

An entire new corporate cadre has emerged to deal with these complicated processes—Chief Sustainability Officers, ESG Stewards, Directors of Corporate Social Responsibility—and the importance of their work is recognized in their average salaries., a leading employment portal, pegs the average CSO salary in New York at $273,694. That may reflect the value the company and its investors put on stakeholder capitalism these days. Alternatively, it may also reflect a recognition of the reputational and regulatory risk a company runs in the second decade of the twenty-first century by getting sustainability messaging wrong.

Does ESG work?

But the fact that something is a good step does not mean it’s being implemented—or regulated—properly. As 2008 demonstrated, economic incentives can often taint allegedly empirical judgments to disastrous effect. One can argue that the impetus and market pressure applied to corporations these days to release data on their carbon footprint, racial and gender makeup, or pay equity can only be good for society—whether the ESG industry is wildly profitable or not. When the first ESG ratings firm appeared in 1995, Robeco SAM, the idea that this kind of data would meet investors' standards for “materiality” would have been laughed off the trading floor. Materiality, defined for us non-Masters of the Universe, basically means relevant to the company’s share price or future value.

Yet the leading players of the ratings industry reads like a Who’s Who of western financial giants: MSCI (the MS is Morgan Stanley); Sustainalytics, purchased in 2020 by market analysis firm Morningstar; Refinitiv, acquired in 2021 by the London Stock Exchange. The three financial ratings agencies that played havoc with the global economy in 2008 are major players, too: Trucost, swallowed up in 2019 by S&P Global; Moody’s ESG Solutions, which has at its heart 427 Research, which it bought in 2021; and, inevitably, Sustainable Fitch.

The Big 4 accounting firms and myriad law firms, risk and investment advisories are all getting into the act. And while a few non-profits and independents remain, the trend is clear. Big Finance is swallowing up the ESG ratings and research firms it once disdained.

Back in the early days, the industry positioned itself as a disinterested judge of sustainable performance and avoided the kind of conflict of interest that dogged the 2008 financial ratings agencies by avoiding direct commercial relationships with the companies they were rating. By and large, the early firms, inspired by the Millennium Challenge Fund and the United Nations’ Principles of Responsible Investment (PRI), were academic and analytical at heart, offering research for investors bent on avoiding corporate bad actors, and creating stock indices to track the performance of those wearing the white hats.

But those days are over. In the years since the Global Financial Crisis, ESG has gone mainstream and now consists of over 600 firms ranking from large to boutique players, almost all with their own “twist” that explains why they do it best. These firms no longer simply rate a company’s ESG performance but also consult on the risks companies should be looking out for, on the language they should use to report various metrics, launch investigations of supply chains in search of hidden risks like child or slave labor, design complex dashboards to track key indicators, and even advise on how to a company should best position itself as “Green” while, say, funding coal-fired power plants in East Asia.

By and large, the analysts who crunch the numbers within these ratings firms think of themselves as objective professional analysts—watchdogs constantly on guard against “greenwashing” who are harnessing the power of the market to name and shame those whose practices are destroying the planet. This clearly differs from the motives pursued by financial ratings agencies of 2008 vintage, who claimed to be disinterested analysts even though the fees they were paid kept them very interested indeed.

But the opacity and inconsistency of the ESG ratings industry’s proprietary methodologies, which are key to differentiating their product for marketing purposes, have opened up new areas for conflict. Bloomberg BusinessWeek, owned by the eponymous financial services giant which itself plays in the ESG ratings field, published a scathing piece positioned as an “expose” of MSCI, by far the largest and most influential of the ratings firms, accusing it of ignoring the actual impact that a given company has on the planet and basing its ratings instead on the risk to its business model and profitability posed by climate regulations, public opinion and other potential “ESG controversies.”

“No single company is more critical to Wall Street’s new profit engine than MSCI, which dominates a foundational yet unregulated piece of the business: producing ratings on corporate ‘environmental, social, and governance’ practices,” Bloomberg BusinessWeek reports. “Yet there’s virtually no connection between MSCI’s ‘better world’ marketing and its methodology. That’s because the ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.” Bloomberg backs these claims citing recent upgrades to McDonald’s ESG ratings, which rose 7 points despite growing carbon emissions and a poor record on recycling and plastics. MSCI, for its part, defends its methodology as the most relevant to the companies involved and to the investors who depend on their data.

What does ESG even measure?

Since the middle of the last decade, enormous pools of capital have flowed into investment funds branded as “Green” or “Sustainable,” labels their creators justify largely by citing the ESG ratings of the corporate securities within them.

In the ESG industry’s competitive environment, firms regularly claim to have the best ratings methodology or some secret technological edge. The disparate way these ratings are calculated results in some companies receiving wildly varying scores from different ratings firms, undercutting the credibility of the industry and opening a path for “ratings arbitrage” for those who decided whether to include a particular firm in an index or fund.

Some of this is subjective and may be difficult to solve empirically. Insiders call it the “taxonomy problem.” Can a natural gas company be sustainable? It’s a vital transition fuel, but it’s clearly carbon-based. What about makers of the Harpoon missiles Ukraine is using to defend its shoreline? How about a company like Tesla, pioneering electric vehicles but mining lithium and other alloys all over the planet and jetting its CEO around in high-carbon private aircraft? (Sustainalytics ranks Tesla at the 52nd position out of 71 companies in the automobile industry group, and MSCI also gives it middling grades, both citing governance issues and a lack of transparency under Elon Musk’s frenetic leadership). What about nuclear power plants? Are they green?

The inconsistencies are troubling global financial regulators, in particular, because the whole point of ESG ratings, from their standpoint at least, is to protect investors from fraud and greenwashing. Take the case of Wells Fargo, the California-based banking giant. Wells Fargo garners low ratings from many ESG data firms because of a history of deceptive business practices that led to steep fines when they were discovered in 2016. Yet, in 2020, the bank won an award from S&P for “sustained excellence” after it entered into a long-term supply contract with solar and geothermal energy firms.

The problems are well documented. Research Associates, an independent financial analysis firm, released a blind study of leading ratings firms in 2020 that found, “Many challenges face investors who are choosing an ESG ratings provider because of the sheer number and different types of providers available and the lack of correlation and consistency in ratings produced by the different providers.”

Assessing the vastly different scores earned by well-known companies, the report concluded it really came down to inconsistent methodologies.

“Provider 1 gives Facebook a top 10% Environmental rating, while Provider 2 ranks it in the bottom 30%,” the report says. “That’s because their environmental ratings measure quite different attributes, and each attribute has different weights.”

MIT’s Sloan School of Management concluded much the same thing, suggesting that these inconsistencies in differing methodologies make nonsense of the idea of rating a firm’s performance. For those interested in harnessing the market as an engine of change, this is terrible news: MIT Sloan notes that divergent signals from ESG ratings can even prevent progress. “Improving scores with one rating provider will not necessarily result in improved scores at another. Thus, ESG ratings do not, currently, play as important a role as they could in guiding companies toward improvement.”

Enter the regulators

The inconsistencies and potential conflicts of interest in the ESG ratings industry have sparked action from global regulators, but not necessarily because of their inefficient spur to measurable impact. Instead, the focus is on investors and the quality of data they have at their disposal to judge the ESG competency of a given firm.

The EU, as usual, is in the vanguard, choosing to focus on financial firms that issue “Green bonds” or make sweeping claims about the net-zero goals of the companies in their “green investment vehicles” in their marketing. The world’s first real effort to regulate such behavior, the Sustainable Finance Data Regulation (SDFR), which went into effect in 2021, threatens stiff fines for financial services firms engaging in greenwashing. So far, fines have not been issued, in part because the technical rules governing disclosure have been delayed by internal debate and will not be issued until July.

The EU’s approach was contagious, as it often is by dint of the size of the EU’s internal market. As was the case in 2016, when the EU’s General Data Protection Rule (GDPR) went into effect, activist regulators in the United States (California, New York) passed their own versions, and more importantly, multinationals felt compelled to modify the way they handled cookies, data tracking, and other shady practices in order not to lose access to EU customers. Since digital commerce really knows no national boundaries, the net result was that most corporations changed their practices for the entire globe rather than attempt to have one standard for the EU and another for, say, North America.

So, too, for SDFR. California passed a spate of laws in October, including one to regulate greenwashing. In the same month, New York passed laws to regulate greenwashing and the lack of transparency in supply chains, particularly in the fashion industry, which is notorious for the child labor and other ills feeding into its products.

At the national level, where regulation normally follows rather than preempts a crisis, regulators also are considering action. The US House of Representatives passed an ESG disclosure bill in June 2021, but it appears to stand little chance in the Senate, where an old-school skepticism of the entire sustainability movement tends to hold sway.

But Biden administration regulators are studying the issue, too. As one US financial regulator told me in April on condition of anonymity, “We’re quite concerned about being caught flat-footed. Everyone remembers how clueless (former SEC Commissioner) Chris Cox looked in 2008. So, we’re trying to get ahead of this.”

Kevin Donohue, a former SEC regulator who is now a Washington-based partner at the law firm Goodwin Proctor, told me the metrics industry is ripe for scrutiny. “I do think the ratings firms are eventually in for the same kind of scrutiny that Fitch, Moody’s, and S&P came in for after the financial crisis,” he said.

In May, the SEC put its foot in the water by proposing guidelines on how financial firms can market funds that claim to be following sustainable, green, or ESG principles. The rule would regulate how such funds are named and tighten the disclosure requirements for any firm soliciting investments on these grounds.

As for demanding more precision from the ESG metrics industry, the issue is on the SEC’s radar, but action seems stalled. Last September, the SEC’s investor advocate told Congress the country’s chief financial regulator intended to address two problems: the fact that information provided by companies for ESG disclosure “tends to vary in quality,” and the need to require companies to take climate risk and human capital management more seriously.

But the SEC is resisting calls to coordinate with the EU and other global regulators around standard definitions. Another SEC governor, Hester Peirce, has told Congress that “converging standards would be antithetical to our existing disclosure framework, which is rooted in investor-oriented financial materiality and principles-based requirements to accommodate the wide variety of issuers.”

The UK, now outside the EU’s regulatory net, is taking its own steps. The country’s Financial Conduct Authority (FCA) issued a warning in July to all ESG funds of the need to be more transparent. The UK Competition and Markets Authority (CMA), meanwhile, published a Green Claims Code and warning of an upcoming sweeping review of misleading green claims such as “all-natural,” “free trade,” or “GMO-free.” Together with the Bank of England, the ultimate watchdog of the UK’s large financial services industry, British regulators are considering rules that would require more disclosure from all companies on ESG matters, something the City of London is fighting behind the scenes.

Can ESG’s enemies destroy it?

The twentieth century is not taking this lying down, however. For all the legitimate concern about the lack of global standards, there is a legion of enemies of the ESG movement happy to manipulate its shortcomings. This, by and large, is not an effort to “fix” what’s misfiring in the ESG ratings world. It is an effort by ideologically driven foot soldiers to put a stake through its heart.

The lightning rod for this effort is Larry Fink, CEO of the world’s largest asset management firm, BlackRock. Fink is a vocal proponent of ESG’s “double-bottom line,” the idea that not only is it right to use such metrics as a way to avoid funding the worst actors on environmental, social, and governance issues, but also a way for investors to identify companies who will outpace their rivals as the world transitions to net zero. His annual shareholder letter has the aura in some quarters of the twenty-first century’s version of papal encyclicals of previous eras.

When BlackRock’s former chief ESG officer, Tariq Fancy, penned a diatribe in USA Today pointing out some very real problems with the way ESG is driving investment decisions, it was seized upon by those who fear a slide toward “stakeholder capitalism” as evidence of heresy in the Temple of Capitalism. In fact, it was not, and Fancy has gone out of his way to say so since he was elevated to the Pantheon that includes Ayn Rand, Milton Friedman, and Arthur Laffer.

In fact, Fancy is trying to fix the system, not destroy it, by pointing out that the focus on avoiding bad actors and applying inconsistent standards isn’t going to maximize the movement’s leverage.

To BlackRock and other financial giants, he wrote more recently in a post on Medium, “[m]ost of the time it means building investment portfolios that exclude objectionable categories, such as ‘divesting’ of fossil fuel producers in an apparent attempt to fight climate change. Unfortunately, there’s a difference between excusing yourself of something you do not wish to partake in and actively fighting against something you think needs to stop for everyone’s sake. Divestment, which often seems to get confused with boycotts, has no clear real-world impact since 10% of the market not buying your stock is not the same as 10% of your customers not buying your product.” And, he adds, when you sell stock based on such principles, someone is buying it on the other end.

Nonetheless, Fancy is in, and Fink is the skunk at the Predator’s Ball these days. “Rather than push companies to pursue higher returns, they’re trying to impose their political agenda on corporate America,” a Feb. 17 Wall Street Journal editorial charged. “CEOs and corporate boards can find themselves on the wrong end of a shareholder vote if they refuse to accommodate BlackRock’s policy preferences on climate and “stakeholder capitalism.” Hail, Caesar, er, Larry.

The Ukraine War has thrown another twist into the mix. Defense contractors, previously anathema to many ESG investors, look quite different in an aggressive war scenario. And Big Oil and others who have seen markets channel investment elsewhere in recent years have sensed an opportunity in the spiraling energy prices and policy moves to lessen Europe’s dependence on Russian energy sources. West Virginia, for instance, has threatened to ban Blackrock and other ESG proponents in the financial sector from doing business with the state, including investments from the state’s public employee pension funds. West Virginia may elicit a shrug from Wall Street, but if Texas follows suit, it’s game on.

What ESG critics object to most about the concept is its rejection of the idea that a company’s sole purpose in life is to maximize shareholder profit. This concept is derived from Friedman’s seminal 1970 op-ed in The New York Times, “The Social Responsibility of a Business is to Increase Its Profits,” kind of the Ur moment of the idea of a rising tide lifting all boats. ESG metrics, when functioning properly, expect a company to integrate into its thinking “minutiae,” as The Journal editorial puts it, like the carbon emissions, fairness and diversity in its workforce, its impact on the communities it operates in, policies on preventing plastics pollution and, well, the survival of the human race.

As the size, trajectory of growth, and influence of the ESG ratings industry shows, these rants are the modern-day equivalent of Lear screaming into the tempest. That ESG is flawed and still evolving is undeniable. But then, that same line could be applied to many things which have lately been exposed as less robust than previously assumed: the global economy, epidemiology, and American democracy, to name just a few. That doesn’t mean we give up on them.

Those pointing out ESG’s shortcomings are doing us all a favor. But they should not be confused with those trying to destroy the movement, and intelligent people need to be on guard against their appropriation. “Adam Smith’s ‘invisible hand’ still exists, so free trade capitalists can relax,” writes Eric Israel, a veteran sustainability analyst who helped found KPMG’s Global Sustainability Practice and PwC’s Conflict Minerals Practice. “What is different now is the realization that self-interest also includes improving society. This is no longer just a political process but has also become an economic factor... This initiative aspires to come up with a set of dimensions to build a new social contract that honors the dignity of every human being.” In some quarters, sadly, that sounds a lot like communism.