Financial products that employ environmental, social and governance (ESG) or “sustainable” themes are becoming increasingly attractive to investors. Globally, $22.9trn in professionally managed assets are under responsible investment strategies – up 25% since 2014, according to the Global Sustainable Investment Alliance.
But recent events have raised serious doubts about the claims, methods and practices that result in a company receiving the coveted ESG-compliant badge, which is awarded after passing an ESG scoring process that is above and beyond standard due diligence.
The trigger event was the massive scandal involving Volkswagen cheating on emissions tests, which broke in 2015 but had actually been going on since 2006. VW is facing billions of dollars in fines from the US government as well as lawsuits from institutional investors and asset managers.
But it is not only VW. Fiat-Chrysler is facing a lawsuit from the US government, which alleges it also used illegal “defeat devices”, to help evade emissions tests.
Then there is Renault, which French prosecutors are investigating on suspicion of emissions test cheating allegedly going back to the 1990s, and Daimler, which US and German authorities are both looking into for similar reasons.
It is necessary to mention auto components supplier Bosch, which paid a $327m settlement arising from its alleged role in the VW scandal but faces another lawsuit and allegations that it conspired with specific automakers to develop and conceal the emissions defeat devices.
Also accused are General Motors and Peugeot. Why single out Europe and the US? Last year, Japan’s Mitsubishi Motors admitted that it had also cheated on fuel-efficiency tests, using fuel economy testing methods that did not comply with Japanese regulations for 25 years.
What did these companies have in common, besides belonging to the auto industry? Awards and accolades for various ESG practices and/or inclusion on ESG or socially responsible investing (SRI)-type indices, which were touted as validation of superb governance in the annual reports that investors read.
ESG – really a safer bet?
One fund manager, who uses ESG checks in her investment strategy, shrugged off the emissions scandal by explaining “We do not screen for fraud”. Another manager seemed to agree, saying Volkswagen governance weaknesses could not be detected by ESG teams exactly because it involved fraud.
Absurdly, the managers are saying that fraud has no link to corporate governance. Yet governance is the very source of fraud and as such is the key to the label of distinction. The E and the S are determined by the G.
Volkswagen: An honoured steward of ESG
From VW’s Sustainability Report 2011:
To be awarded the green badge, ESG scoring puts the company through a second layer of vetting after standard due diligence. What emerges are champions in governance, less risky and more environmentally aware than the universe of companies out there – safer bets which passed enhanced scrutiny – or at least that is what is implied in marketing ESG to investors.
To put it diplomatically, that message is misleading. The emissions scandal was a warning that something is fundamentally wrong with the ESG scoring process, which failed to find a hint of any weak links that could lead to bad behaviour.
The scandal was huge. It was a bold and cynical (and apparently easy) exploitation of ESG status. It was not caused by a rogue employee. Nor was it a one-time event, a tweak of data or some other minor transgression committed by a single company – something that would be nearly impossible to screen for. It was a multi-year, concerted effort to develop and use software that hides actual vehicle emissions, which in VW’s case was up to 35x the allowable standard. It involved top management and engineering teams, most likely across the many companies that are under investigation.
Failure to admit failure
Auto industry dynamics had nothing to do with the scandal. Vehicle manufacturers are no more prone to fraud than companies in any other competitive industry. Moreover, Toyota, a key player, is not involved in the scandal.
Excuses should be put aside. The ESG scoring process failed on a grand scale.
Yet there is no discussion around the inadequate methods and practices used in ESG scoring and what exactly the status represents. Is the scoring a box-ticking exercise to award the badge or is there a significant difference in corporate governance between a company that is ESG-approved and one that is not?
Emissions-gate makes it fair to question what value the ESG label actually provides, aside from helping the companies, the ESG fund management firms and the investors appear virtuous.
Prudent investors should ask an ESG fund manager: How have your screening methods changed after the emissions scandal?
