The differences between individual and institutional investors considering ESG factors

Environmental, social, and governance investment practices distract investors and corporate management from maximizing long-term profitability, which is often achieved through innovation, cost control, and customer focus. By diverting attention away from priorities that align with increased productivity and toward a shifting array of inconsistently defined social-impact criteria, the ESG investment movement could be a long-term threat to continued economic growth.

But before expanding on this criticism, ESG deserves its due. Individual investors have, for decades, considered factors other than maximizing risk-adjusted returns. Personally, I never wanted to buy stocks in tobacco companies from the time I first had money to invest forty years ago. To the extent that ESG analysis assists individual investors (as opposed to fiduciaries) in selecting financial products that assist them in meeting their non-pecuniary goals, it is not all that worrisome.

Further, it is possible that insights derived from ESG orientation could lead to more prudent investments. For example, if we believe that climate change is going to cause sea-level rise that, if unmitigated, will inundate coastal real estate within a period that is relevant for investment purposes, it would be prudent to avoid Real Estate Investment Trusts that are heavily weighted toward oceanside properties. Whether environmental projections constitute useful news for investors depends on the reliability of climate and sea-level models, as well as the success or failure of mitigation measures that property managers and local governments might implement in response.

However, ESG proponents often cite such examples to justify moving away from conventional investment analysis. One must wonder how frequently or rigorously institutional investors model the impacts of ESG considerations on future cash flows. And it is this potential lack of rigor that makes the growing influence of ESG in modern investing troubling.

Predicting earnings before interest, taxes, depreciation, and amortization (EBITDA) and earnings multiples for equity investors, or default probabilities and recovery rates for fixed-income investors is already very difficult. Investors and the analysts they rely on often get these numbers very wrong. An example is when rating agencies messed up their projections of mortgage risk prior to the Great Recession of 2007-2009.

Now rating agencies, other analytical firms, and investors themselves are weighing in on a much wider set of metrics that often lack precise definitions, let alone clean data. Across third-party ESG-score providers, there are varying criteria for determining scores.

For example, Moody’s and S&P list the following elements of their “social” scores:

Moody’s	Standard and Poor’s (S&P)
Access and affordability	Access to Health care
Accident & safety management	Addressing Cost Burden
Bribery & corruption	Asset Closure Management
Community stakeholder engagement	Corporate Citizenship and Philanthropy
Customer activism	Financial Inclusion
Data security & customer privacy	Health Outcome Contribution
Demographic change	Human Capital Development
Diversity and inclusion	Human Rights
Employee health & well-being	Labor Practice Indicators
Fair disclosure & labeling	Living Wage
Human resources	Local Impact of Business Operations
Labor relations	Marketing Practices
Product quality	Occupational Health & Safety
Responsible distribution & marketing	Passenger Safety
Social responsibility	Responsibility of Content
Supply chain management	Social Impacts on Communities
Waste management	Social Integration & Regeneration
	Social Reporting
	Stakeholder Engagement
	Strategy to Improve Access to Drugs or Products
	Talent Attraction & Retention

Some of these concepts appear to overlap: For example, Moody’s lists “labor relations” while S&P mentions “labor practice indicators.” Other elements, such as Moody’s “demographic change” indicator or S&P’s “asset closure management,” do not appear to have a parallel in the rival’s rating scheme.

Under the circumstances, it should not be surprising to see a lot of divergence among ESG-score providers. In the chart below, I list ESG scores for Pfizer from Moody’s, S&P, and three other firms. The assessments range from dire (in the case of finance company MSCI) to celebratory (in the case of CSRHub, a web-based rating tool).

Complicating the comparison is the divergent scales different agencies use. Moody’s, for example, has ESG Credit Impact Scores (CIS) ranging from 1 (Positive) to 5 (Very Highly Negative). It also provides individual sub-scores on the E (environmental), S (social), and G (governance) components, respectively.

Rating or Analytics Firm	Rating or Score	Definition	Source
Moody’s	CIS-3	Moderately Negative	Link
Standard & Poor’s	30	Above industry means	Link
Sustainalytics	25.2	Medium Risk	Link
MSCI	1.5	Implied Rating of “B”, a junk rating category	Link
CSRHub	92	Scores higher than 92% of companies in the rated universe	Link

But even if analysts could all get on the same page, large-scale ESG investing poses an even greater concern: misdirection of capital. As aforementioned, it is difficult to determine the future profitability of any given firm. As a result, capital is often allocated to firms or projects that fail to produce the type of return that might reasonably be expected. For every successful company, there are often many competitors with skilled management teams attempting to serve a similar market that fail. 

While critics of capitalism might dismiss this circumstance as a market failure, it is more properly understood as an experimentation process necessary for economic advancement. Or, in the words of Joseph Schumpeter, a process of “creative destruction.” No one can predict with certainty which businesses and product plans will succeed; we must learn through trial and error.

But if investable funds are not even chasing profitability, many more dollars are likely to be invested in companies pursuing product plans that do not gain support from the market or suffer from ineffective execution.

Meanwhile, startup founders and management of existing companies will likely receive market signals that steer them away from the task of efficiently meeting customer needs and toward other priorities. They may conclude, for example, that it is better to focus on diversity, equity, and inclusion than to make product improvements, causing them to expend more of their scarce resources on the former than the latter.

Individual investors should be free to consider ESG when deploying their own capital, even though it may not be economically efficient for them to do so. But this idea should not scale to the activities of large investment fund managers with billions of dollars in assets. Not only do their decisions have a much greater impact than those of virtually all individual investors, but they have a fiduciary responsibility to manage the funds with which they have been entrusted in the best financial interests of those whose money it is or, in the case of retirement funds, will be.

Like many movements in America’s past, the ESG investment movement has taken a reasonable idea and stretched it beyond reason. If institutional investors continue to deploy funds according to shifting criteria other than long-term profitability and rely on imprecise metrics while doing so, they will likely undermine the ability of the U.S. economy to grow and thereby improve our standard of living.

A version of this commentary was first published in National Review.