The holes in holistic ESG indices

Choices over inclusion in benchmarks of goodness are dubious in nature

Image: Scott Steinhardt

A near replica of this article was published this week in the Financial Times. You can find the original here.

Suppose you had to balance each of your acquaintances’ pros and cons — were they generous, quick to anger, patient with children? — and choose the “best”. The idea is off-putting, and the thought of assigning individuals a “score” encompassing their every character trait is extremely off-putting.

S&P Global has run into this sort of minefield in crafting its S&P 500 ESG Index. This is a selection of the best (corporations, of course, not people) in which Tesla, which has done more to reduce fossil fuel consumption than arguably any other company, was excluded, and ExxonMobil made the list.

The problem is not that S&P made the wrong choices — it’s the dubious nature of any such choices. Thus we have an index purporting to respect organized labor in which Amazon and Starbucks, which are fighting to crush union drives, are included, while firms supplying arms to Ukraine are potentially scotched 

ESG investing has, of course, taken Wall Street by storm. Well over $2tn has been invested in funds offered by a host of firms purporting to promote the environment, social good and enlightened governance.

Many ESG funds are narrowly targeted. There are funds comprised of low-carbon stocks, funds that exclude tobacco, funds adhering to Catholic values and to Sharia law. They telegraph their mission plainly just as do traditional ones specializing in high-tech stocks or banking.

But this is not where the ESG industry is headed. The action now is in so-called holistic indices that attempt to assess corporations’ every attitude or behavior and boil it down to a single metric. Call it the goodness standard.

One issue with holistic indices is the sheer number of categories. S&P Global’s Corporate Sustainability Assessment, a road map of what it assesses, runs to 253 pages, little of it reading like an Ian McEwan. “We just implemented [a new screen] in the last two months,” Reid Steadman, global head of ESG and innovation, noted. “Views of sustainability are evolving.”

The challenge is magnified by the incoherence of weighing so many disparate qualitative factors against each other. There is simply no objective way to balance an exemplary record on labor relations or gender pay equity against a high carbon footprint (the trees don’t care).

A further problem is the subjective nature of assessments. S&P determined that nuclear power was not “renewable”; some would disagree. It pays attention to human rights but did not exclude Apple, which counts China as a major supplier. It considers not just corporate deeds but reputations.

Given the malleability of such terms, there is confusion over what it is trying to measure. Steadman says, reductively, “we are trying to measure the companies that meet the minimum criteria for sustainability”. Elaborating, he says, “We look at their environmental, social and governance in a holistic way.”

The S&P 500 ESG Index aims to carve out a portion of the familiar S&P 500 that represents best of breed in the same underlying industries. ExxonMobil scored higher than Big Oil competitors. Tesla was bounced partly because of claims of racial discrimination and poor working conditions, as well as its response to autopilot-linked fatalities. Yet the process is hardly free of human judgment. S&P’s methodology “strives to account for all relevant ESG issues” and weight them according to financial import, a subjective business.

Was Tesla easy to boot because its chief executive, Elon Musk, has frequently offended progressive taste? S&P says its methodology does not allow for such prejudice. If not bias, then perhaps groupthink. S&P monitors media reports and screens for “company controversies”, suggesting that conformity is not among the traits that work against inclusion.

The firm conducts scores of conversations with wealthy investors and institutions to understand how notions of sustainability are evolving. A “vigorous debate” preceded a new restriction against arms suppliers. “We are trying to reflect the market’s position,” Steadman says.

He says the shift toward holistic indices reflects an increasing sophistication among investors. To this writer it looks like laziness. If weapons offend you, avoid them. The same for oil or a failure to diversify. To outsource ethical judgments to a one-size-fits-all marketer is to settle for the appearance of sustainability, what industry critic Tariq Fancy labelled a societal placebo. It is less courage than conventionalism.