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Validity and Regulation of ESG Investing Today

ESG Ratings Confusion

Although ESG has been around for more than twenty years (including earlier labels like SRI, Sustainability, and CSR), exactly what does ESG mean? It means different things to different people, making it challenging to analyze the industry.


There are all sorts of approaches to investment; from negative screening (excluding sectors such as tobacco or defense) to positive screening (picking sectors such as clean energy) to any strategy that promises to support one’s favorite social or environmental cause. These strategies may all be lumped under the ESG label.


For example, one rating agency might include toxic spills, while another may not include them. Even if two rating agencies agree on similar categories, they may measure them differently, with one evaluating labor via employee turnover and another via employee injuries.


Finally, they may use entirely different weighting schemes. Given all that can differ in the construction of the ratings, with no standardized definitions and methods, it is not surprising to find ESG ratings murky at best.


As demand for sustainable investing increases, more and more investors rely on ESG ratings. And, given the higher fees typically charged on ESG products, asset managers naturally have an incentive to label products ESG if they can. The trouble is that ESG ratings from different providers disagree substantially. Recent research shows that even among the six most prominent ESG rating firms, the correlation between their ratings is woefully low, ranging from 0.38 to 0.71 at best. For comparison, the correlation between credit ratings also issued by various rating agencies is typically 0.99.1


Who is doing the rating?

Hiding in plain sight is the fact that firms that rate ESG also have a vested interest in the success of ESG, a situation reminiscent of the Mortgage-Backed Securities/Collateralized Debt Obligation (MBS/CDO) markets in the early 2000s. Summarizing their extensive research, MIT commented, “we do not assume that ESG ratings provide accurate measurements. Instead, we assume that they measure ESG performance with noise.”



  1. Berg et al. (2021) and Gibson et al. (2019) documented large disagreement across major ESG rating providers in their evaluations of firms' ESG quality and performance.
  2. Tang et al. (2020) show that MSCI gave higher ESG scores to firms connected to it through institutional ownership than to other firms.
  3. Amel-Zadeh and Serafeim (2018) found 26% of investment professionals surveyed indicated concerns with ESG rating reliability although 82% use ESG data in the investment process. It goes on to state: "In this paper, we document widespread and repeated changes to the historical ESG scores of Refinitiv ESG." Several tests demonstrate that this data rewriting has important implications for ESG research and investment practice: While there is a positive link between ESG scores and stock returns in the rewritten data, we fail to observe such a relationship in the initial data."

Other MIT authors wrote the following. “Our analysis suggests that the score changes have in part been “data-mined” such that firms that performed better in a given year experienced ex-post upgrades in the scores for that year. Further, the data rewriting changes the results of predictive regressions relating ESG ratings to future stock returns: there is outperformance of stocks with high E&S/ESG scores in the rewritten data, but not in the initial data. We argue that our results reflect the incentive of the data provider to introduce a positive relationship between ESG scores and returns in the data, in order to demonstrate that their ESG scores are useful for data users developing ESG-related investing strategies”.3


What about Regulation?

Consider these recent headlines:

  • DWS, the big German asset management firm, lost €1 billion in market cap on a single day in August 2021 after it became public that the firm was under investigation by the U.S. SEC and German authorities that it overstated the ESG factors in its investment decisions. Greenwashing?4
  • An analysis by Morningstar found that more than 1,200 ESG funds representing more than $1 trillion in assets did not merit their ESG label and were stripped of their ESG classification.5
  • Vanguard announced it is resigning from the Net Zero Asset Managers initiative, one of the main financial alliances confronting climate change, whose members have committed to net-zero carbon emissions by 2050.6

These three news stories highlight the continuing debates and unresolved policy questions around ESG investing. They also illustrate what motivated the SEC into action recently with a set of new rule proposals on ESG disclosures.


None of this helps the credibility of ESG, the protection of investors, or the integrity of financial markets. Federal securities laws already exist against misstatements of any kind. Investment companies are required to disclose accurate information about how client assets are invested. The SEC is catching up and getting more aggressive against allegations of greenwashing.


On March 4, 2021, the SEC launched the Climate and ESG Task Force within the Division of Enforcement to develop initiatives to identify ESG-related misconduct. The Task Force seeks potential violations including material gaps or misstatements in issuers’ disclosure of climate risks, and disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.


Finally, the SEC has proposed new regulations that would set a common benchmark for how ESG products would be labeled, marketed, and reported. One proposed SEC rule seeks to enforce consistent ESG disclosures by requiring investment firms to give investors more information about how they carry out any ESG strategy. Another measure aims to restrict when asset managers can accurately add ESG and other green terms to their fund names. For example, to merit an ESG label, funds would need to invest at least 80% of their assets in ways that are consistent with ESG strategy.



Championing good stewardship of the planet and its businesses seems like a goal we can all get behind. However, the avenues to get there are the question. Is corporate ESG the answer? The Friedman Doctrine from 1970 makes the case for individual social spending vs. corporate consideration, where the primary purpose should be to maximize shareholder value rather than social issues.In other words, individuals are welcome to fund whatever social causes they desire with their own money, but not to the extent of involving the investment of other shareholders. Perhaps the answer lies somewhere in the middle.


Either way, clear visibility into ESG presents a challenge for investors. And the challenge should not be made more difficult by an industry—ESG—that knowingly or not, trades in ambiguity if not deception. As is often the case, the police (i.e., the SEC) are playing catch-up with ESG malefactors. Perhaps regulators will take heed of the weight of academic ESG research.


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[1] Review of Finance, Volume 26, Issue 6, November 2022, Pages 1315–1344

[2] Is History Repeating Itself? The (Un)Predictable Past of ESG Ratings
European Corporate Governance Institute – Finance Working Paper 708/2020, p.7
[3] Is History Repeating Itself? The (Un)Predictable Past of ESG Ratings, Florian Berg,, MIT,
[7] A Friedman doctrine‐The Social Responsibility of Business Is to Increase Its Profits
York Times, September 13, 1970, Section SM, Page 17.

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