In January, Tesla, a company with a market capitalization of more than $1 trillion, announced “breakthrough” 2021 profits of $5.5 billion. But there is trouble in the company’s supply chain. The batteries in electric cars like the ones Tesla manufactures require cobalt, a mineral found in abundance in the Democratic Republic of Congo (DRC). While electric vehicles are important in the effort to combat climate change, there are credible reports of serious human-rights violations at informal cobalt mines in the DRC, including widespread exploitation of child labor and safety hazards in deep, unstable tunnels. Despite its reliance on these troubling supplier practices, Tesla is a popular stock pick by mutual funds and exchange-traded funds that are marketed as promoting responsible capitalism by focusing on environmental, social, and governance (ESG) goals. Does Tesla deserve to be treated as an ESG champion?
ESG investing has grown rapidly over the last 15 years focused primarily on climate change. Asset managers like BlackRock and Vanguard now seek to attract investors to funds marketed as socially responsible while still offering attractive returns. The value of assets invested in this manner topped $35 trillion globally in 2020, an amount that is expected to rise to $50 trillion by 2025, representing almost one-third of all projected assets under management.
Leading asset managers aren’t waiting for the development of credible “S” standards.
Many companies are included in ESG funds because they have made commitments to reducing carbon emissions and/or they don’t fall into one of the categories of “sin stocks,” such as manufacturers of alcohol or firearms. But in many instances, asset managers don’t pay adequate attention to social problems that flow from a company’s core business, such as poor labor practices in their global supply chains. Most asset managers also fail to take advantage of their voting power as shareholders to help shape better corporate social practices.
Reacting to these and other shortcomings in how most ESG funds are structured, some critics dismiss the entire concept of socially responsible investing, viewing it as little more than an exercise in “greenwashing.” My colleague at NYU’s Stern School of Business Hans Taparia argues: “The bar for what constitutes a good corporate citizen is abysmally low.” As an example, he cites technology companies such as Alphabet, Amazon, and Facebook, which “tend to be among the largest holdings for ESG funds. They often get high ESG ratings because they are predictably low producers of greenhouse gas emissions.” Though much of his critique is valid, it would be a mistake to give up on ESG altogether. If ESG ratings were grounded in more accurate assessments of corporate responses to both social and environmental challenges, and investors were engaged with companies to address these issues, ESG investing would have great potential. We know this because investor demands for reduced carbon emissions have spurred meaningful change. Similar pressure now needs to be applied to exploitation of workers and other social problems.
One of the flaws of existing ESG investment options is that they rely on measures of corporate social conduct (the “S”) that are poorly defined and don’t provide an accurate assessment of how companies treat their outsourced workers or the impact of their products on consumers or communities. Despite this lack of reliable “S” metrics, leading entities that provide ESG analysis to major asset managers are rushing to consolidate ratings systems. Last fall, the International Financial Reporting Standards Foundation (IFRS) facilitated the merger of three major sustainability organizations, including the Sustainability Accounting Standards Board (SASB). IFRS is highly influential. Its accounting standards have been formally adopted by 144 countries. What the IFRS now seeks to do is develop a comparable ratings framework for ESG, in what it calls a “global sustainability disclosure standard-setter for the financial markets.”
The danger in this move to consolidate ESG ratings is that neither standard-setting bodies like IFRS nor large asset managers like BlackRock and Vanguard have developed approaches to “S” that reliably assess corporate social conduct or engage actively with companies to improve their performance. While the desire to consolidate disparate ESG ratings systems is on its face laudable, the process currently underway is likely to lock in inadequate “S” standards rather than develop assessments that are useful to investors.
Leading asset managers aren’t waiting for the development of credible “S” standards. This is why so many companies like Tesla, with questionable social performance, are included in ESG funds. One wonders how BlackRock, Vanguard, and other major investment firms are actually evaluating social risks. Too often, it appears that they are aggressively marketing ESG-branded investment funds while often outsourcing ESG assessments to a handful of third-party firms that rely on ill-considered criteria and insufficient data. While these funds have growing influence with corporate management, when and how they are using this power to advance the interests of their ESG clients is often unclear.
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I asked Vanguard and BlackRock about these issues. A Vanguard spokeswoman responded that its “indexed ESG funds include company conduct screens that target social issues—such as human-rights matters, labor issues, board diversity, and/or equal opportunity practices.” Vanguard said that this screening is done “by third-party index providers.” BlackRock did not respond to my inquiry.
Existing ESG analysis suffers not only from the lack of granular metrics but also from the absence of an overarching framework for the “S,” something comparable to the way that climate change has helped to frame the “E.” Some current frameworks define the “S” as referring to racial and gender diversity in the workforce or on corporate boards. Others focus on consumer health and safety, or data privacy, or the wellbeing of a company’s directly hired employees. To be fair, even if there were a consensus on appropriate factors, social issues are difficult to quantify. Machines can determine a company’s carbon footprint. It is far more challenging to assess the treatment of workers across a company’s global supply chain or how a social media platform amplifies harmful content online.
To compensate for weak standards and inadequate data, most efforts to capture the “S” focus on company policies, not performance. A 2017 survey conducted by my colleagues at the NYU Stern Center for Business and Human Rights looked at 12 ratings frameworks devised by organizations such as SASB, the Global Reporting Initiative, and the Dow Jones Sustainability Index. The report found that these frameworks alone relied on 1,700 social metrics, 92 percent of which measured internal company policies and systems, not outcomes or performance.
If ESG investing is to fulfill its promise of encouraging better corporate behavior, it needs a better “S” framework. In an October 2021 report, the NYU Stern Center made the case for placing greater emphasis on “the quality of low-wage work and the extent to which outsourcing practices are contributing to lower-paying, precarious jobs.” It called for companies to compile and make available “more and better data relating to employment practices, especially for outsourced labor.” Companies that manufacture products abroad have long outsourced the responsibility for protecting workers to their suppliers. At present, we have little data or widely accepted analytical tools to assess the human impact of corporate strategies that include aggressive and abruptly changed production targets and extreme cost-cutting measures.
Devising ESG measurements that rely on more meaningful corporate disclosure and analysis of how workers are treated will not be easy. But until we have such measurements, IFRS and other standards-setting organizations need to stop pressing so hard to consolidate the current systems into a consensus version based on flawed criteria. For their part, major asset managers should stop marketing investment offerings with an ESG label that mischaracterizes their understanding of the social impact of companies in their portfolios. Instead, all of these investment sector actors ought to work with companies to determine what good social practices entail and then engage with them in the admittedly difficult task of crafting industry-specific social standards and metrics. Governments also have a role to play, requiring companies to make public far more data on their operations—information that companies either don’t compile at present or that they view as proprietary.
Until this happens, the rush to consolidate current ESG measurement systems will result in companies like Tesla being highly rated without having their social impact seriously tested.
Michael Posner is the Jerome Kohlberg professor of ethics and finance at NYU Stern School of Business and director of the Center for Business and Human Rights. Follow him on Twitter @mikehposner.
Reprinted with permission from Forbes.