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Markkula Center for Applied Ethics

Is ESG Investing Ethical?

A computer screen with stock trading information.

A computer screen with stock trading information.

Sarah Cabral

Sarah Cabral is a senior scholar for business ethics with the Markkula Center for Applied Ethics at Santa Clara University. Views are her own.


Few today would argue that environmental, social, and governance (ESG) investing has no bearing on corporate decision making. From commitments to reducing waste, moving to wind power, increasing charitable donations, diversifying suppliers, hiring diversity, equity, and inclusion (DEI) directors, and implementing parental leave policies, ESG investing is impacting how businesses operate.

ESG investing is related to Socially Responsible Investing (SRI), which dates back to the 1800s when the Methodist Church urged congregants not to invest in alcohol, tobacco, firearm, and gambling companies. SRI investing became more mainstream in the late-twentieth century with funds divesting from companies involved in the Vietnam War or operating in South Africa during the apartheid era. Whereas SRI investment decisions are meant to punish companies viewed as bad actors in society, ESG investing rewards companies acting positively in the interest of shareholders and society. A landmark report in 2004 commissioned by the United Nations Environment Programme (UNEP), Who Cares Wins, stated that there is no contradiction between thoughtfully considering material ESG issues and fiduciary responsibilities thus opening doors for ESG investing. 

ESG investing reflects an approach to ethical decision making known as the common good framework. Those who appeal to the common good claim that we ought to cooperatively work towards establishing systems, institutions, and environments that benefit all stakeholders. However, critics of ESG investing argue that ESG funds financially underperform and do not seem to deliver better ESG performance. If the critics are right, then ESG investing cannot be said to promote the common good and can rightly be considered a sham

This overview of ESG investing aims to address the following questions: 1. Does ESG investing matter? 2. How are ESG factors measured and compared? 3. What are possible regulatory approaches to assure the accuracy of claims made by companies? and 4. How can ESG ratings and disclosures improve? 

The Future of ESG Investing

Despite Texas and Florida state lawmakers considering new legislation against ESG investing, ESG mutual funds have exponentially increased since 2012 and are expected to climb.  According to a recent survey by PwC, 81% of institutional investors plan to direct more dollars to ESG products over the next two years. PwC also projects that ESG assets under management in the United States will more than double from US$4.5 trillion in 2021 to US$10.5 trillion in 2026. Deloitte anticipates that ESG assets will make up half of all professionally managed assets globally by 2024 reaching US$80 trillion

Even with significant projected growth, one can still ask whether or not ESG investing matters. One of the more compelling arguments against ESG investing is that it is redundant. In other words, companies that want to maximize long-term shareholder value must be concerned with benefiting all stakeholders: investors, employees, customers, suppliers, and the community and environment. According to this view, when investment dollars flow towards companies focused on long-term rather than short-term profit maximization, those investments will inherently promote ESG factors. ESG compliance requires corporate resources that would otherwise be better utilized for stakeholders. However, regardless of this criticism, ESG investing is a market-driven phenomenon not a government initiative, and customers, in this case individual and institutional investors, have driven the demand for ratings and disclosure.

The Challenges Companies Face 

Companies engaged in ESG initiatives face a range of challenges, some of which are related to the particular size and industry of the company. For example, it can be difficult to achieve recognition for improvement in ESG categories without paying rating agencies, such as MSCI, ISS ESG, Sustainalytics, Refinitiv, FTSE Russell and others, for consultancy services. 

Another issue is that one individual factor can have an outsized impact on an overall rating. If a company is generally committed to ESG but downgraded for issues related to unionization, for example, then its overall rating can take a significant hit. This issue with ESG rating methodologies was spotlighted when Tesla Inc. fell out of the S&P 500 ESG Index in May 2022, despite the fact that electric vehicles have lower greenhouse gas emissions and a smaller carbon footprint than gasoline-powered vehicles. 

Additionally, ESG ratings incentivize the “showing” over the “doing,” so questions from corporate leaders arise such as, “Before we commit to X initiative, is it going to ‘count’?” This approach seems at odds with an employee-driven or grass-roots effort to do good. Most ESG ratings providers measure the environmental and social risks that impact financial performance rather than measuring initiatives that could be unrelated to the financial performance of the company. For example, Phillip Morris was added to the Dow Jones Sustainability Index (DJSI) in 2021, even though it sells 700 billion cigarettes a year. Similar arguments have been made about the inclusion of Pepsi and Coca Cola in sustainability indices, both of which receive favorable ratings from the major rating agencies.

Finally, there is a widespread recognition of the need for greater consistency regarding definitions and measurements. Rating agencies use different methodologies which often result in assigning poorly correlated rankings to the same company, even when rankings are separated out by category. A further complication is that rating agencies also use dissimilar scales. For example, MSCI uses a 7-point scale from AAA to CCC, in which the AAA rating is the best, while Sustainalytics uses a scale of 1 to 100, in which lower numbers are associated with lower financial risks, resulting in a positive rating. 

Possible Solutions

1. Government Regulations: EU and the UK as a Model

The European Union regulates the financial market for sustainable investments through its Sustainable Finance Disclosure Regulation (SFDR). The regulations are meant to improve transparency regarding sustainability claims and to prevent greenwashing, by requiring asset managers to classify their investment products. The framework came into force in March 2021, and firms must classify their investment products under one of the three articles: Article 6, 8, or 9. Even funds that are categorized as “non-ESG,” which fall under Article 6, must still disclose how investment decision-making considers sustainability risks. Article 8 funds are those that “promote” ESG characteristics. In other words, these are funds that consider ESG factors in the investment decision-making process. Article 9 sets measurable ESG “objectives,” and funds must identify the investment strategy used to meet the sustainable investment objective. Additionally, an Article 9 Fund must be assessed against the principle of “do no significant harm.” If the Article 9 Fund has an explicit objective to reduce carbon, it must refer to an EU Climate Transition Benchmark. The regulations include new mandatory templates for reporting disclosures related to Article 8 and 9 funds, in order to increase consistency in reporting. These regulations have had an impact, as evidenced by EU asset managers removing the ESG label from $2 trillion worth of funds after regulations were announced but before they were enforced. 

This shows that the market can be self-correcting simply due to an awareness of impending regulations. However, Morningstar Inc., which acquired Sustainalytics in 2020, determined that 23% of Article 8 Funds do not merit the Article 8 classification. Therefore, while the SFDR regulations are providing more oversight of the sustainable investments market, additional regulations will be forthcoming. Even now, the European Securities and Market Authority is considering regulations targeting ESG rating agencies.

In June 2022, the United Kingdom’s financial services regulatory body, the Financial Conduct Authority (FCA), issued support for the government’s consideration of bringing ESG data and rating agencies within its “regulatory perimeter.” This month, the FCA announced that it established an ESG advisory committee to aid in the board’s execution of ESG-related issues. The committee will keep the board informed of new ESG topics and guide the board on how it should pursue an ESG strategy in line with statutory objectives and regulatory principles. Already the FCA has begun cracking down on greenwashing. As of October 2022, the FCA is requiring that ESG strategies be categorized as “impact,” “aligned,” and “transitioning” in regards to decarbonizing and in reference to objective criteria. This is in line with the government’s goal of reaching net-zero by 2050. In terms of rating agencies, the FCA does not currently view differences among rating providers as overly problematic, as long as the rating firms are transparent about their methodologies and data and provide oversight of risk and control. 

2. Policy Developments in the US

Currently, the US does not require ESG disclosures at the federal level. However, in March 2022, the Securities and Exchange Commission (SEC) proposed a rule that would regulate climate reporting for publicly traded companies. Up until now, information on climate-related impacts to a company’s bottom line have been reported voluntarily and in an inconsistent manner. This measure would make disclosures more standardized and reliable. The SEC views greenhouse gas (GHS) emissions as a commonly used metric to understand climate-related financial risks, and the proposal requires companies to report direct GHG emissions, indirect emissions from purchased electricity, and emissions from their value chains. The timeline and any relevant exemptions will be based on the size and status of the company. In March 2021, the SEC also announced the creation of a Climate and ESG Task Force in the Division of Enforcement, which does not have legislative responsibility but can hold companies accountable to existing rules. 

While some have criticized the SEC for only being concerned with the financial impact of ESG initiatives, the role of the SEC under the U.S. Securities Act of 1933 is to ensure transparency regarding corporate financial statements. It was not established by Congress to regulate ESG claims generally speaking. The more cautious approach taken by the SEC is preferable to actions taken in the EU and UK, despite many people in Congress and academia urging the SEC to take a considerably broader view of its jurisdiction in matters relating to ESG. There are three reasons to prefer the current approach of the SEC: 1. It is premature for the SEC to come up with one list of ESG disclosures that companies should make. Investors have not yet determined a definitive list and the SEC could prevent useful and ongoing private sector debate. 2. The SEC must remain committed to the materiality principle upon which it was founded, and it is unclear which ESG disclosures are materially significant. 3. The SEC has no legislative mandate to prompt fund managers and companies to pursue ESG goals. In contrast, Congress, composed of elected representatives, has this law-making ability. There is currently a bill, The ESG Disclosure Simplification Act, that has passed in the House. Should this bill and others like it become law, the SEC would have the legal basis to create more ESG regulations.

ESG claims in relation to advertising are regulated by the Federal Trade Commission (FTC), which is responsible for enforcing truth-in-advertising laws. In April 2022, the FTC issued its largest civil penalty against Kohl’s and Walmart for falsely advertising rayon products as “made from bamboo.” The penalty was $5.5 million and requires the companies to stop using deceptive advertising involving environmental claims. 

Finally, in November 2022, the Department of Labor issued a rule allowing retirement plan fiduciaries to consider ESG factors when selecting investments. The rule legitimizes the consideration of climate-related financial impacts in investment planning and removes restrictions on ESG investing put in place under Republican leadership. Although ESG has become politicized and cast as an idea that is at odds with good business practice, a review of 1,000 research papers published between 2015-2020 finds primarily a positive or neutral correlation (71%) between ESG and financial performance. However, ESG disclosure on its own does not often correlate with positive financial performance, underscoring that performance-based ESG measures are those worth pursuing.

3. The Search for a “Gold Standard”

With the rating agency industry so fragmented, some may hope for a “gold standard” to arise from the mix. It is unclear which rating system will ultimately become the most widely accepted over time and whether one system is to be preferred at all. However, there has already been significant consolidation within the industry, with at least twenty mergers and acquisitions among ESG data providers since 2013. Until more consolidation reduces the variability of method and data, Florian Berg, a researcher at MIT Sloan, found that relying on complementary data from multiple rating agencies yields the best results. Berg employs different modeling techniques to find the highest correlation between ESG and financial performance. The MIT Sloan Sustainability Initiative launched the Aggregate Confusion Project to solve the problem of noisy ESG data through research. Another strategy to improve the usefulness of ESG data would be for ESG rating agencies to offer subscores for the “E”, the “S”, and the “G.” This would allow investors to more easily compare companies by category and understand how an overall ESG rating is related to particular subscores.

In regards to self-disclosure, the Sustainability Accounting Standards Board (SASB), a non-profit organization, began in 2011 to develop standards for sustainability that are financially-material. The creator of the framework, Dr. Jean Rogers, explains, I wanted SASB to develop standards that would enable sustainability fundamentals to be available right alongside financial fundamentals, such that investors could compare performance on critical social and environmental issues, and capital could be directed to the most sustainable outcomes.” SASB standards are now the most-used sustainability reporting standards among the 1,000 top companies by market capitalization in the United States. While one may be suspicious of the accuracy of ESG reports generated by the company itself, rating agencies use corporate disclosures based on the SASB standards to develop tools, analytics, and resources for the capital markets.

4. Assess the Most Material ESG Issues to Your Company 

What sets SASB standards apart from others is that they offer guidance on corporate disclosure of material sustainability information. For 77 industries, the SASB generates a “materiality finder,” a list of issues that are material to that specific industry. There is research that shows companies that have good ratings on material sustainability issues are more likely to outperform firms with poor ratings. This is opposed to companies that have good ratings on immaterial sustainability issues. After identifying material issues for the industry of which the company is a member, a company can next identify material issues for its customer’s industry and supply chain industries. VentureESG released a SASB materiality Whitepaper and toolkit for Venture Capital firms to perform materiality assessments. Part of the recommendation is for companies to identify material issues not listed by SASB through researching these sources: 1. News and social media, 2. Market research reports, 3. NGO and country assessments, and 4. Technology assessments. 


ESG ratings and disclosures are only growing in significance to investors. While the ESG rating agency industry is currently highly fragmented, there will likely be further consolidation within the industry and increasing government regulations and enforcement. Until then, companies and investors should focus on 1. ESG performance-related measures as opposed to mere disclosures, 2. Utilizing complementary ratings from multiple agencies, and 3. Improving on sustainability issues materially significant to the industry. For improved financial performance and the promotion of common goods, companies must do more than pay lip service to the idea that ESG factors matter. ESG investing is ethical when it reflects corporate actions genuinely undertaken for the benefit of all people, investors included. At its best, ESG investing challenges us to consider the role each member of society can play in furthering our common goals. At its worst, it is a distraction rewarding those that game the system with the avoidance of real moral scrutiny. 


Jan 9, 2023

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