A Lawsuit Waiting to Happen: The Use of Non-Financial Metrics by the Investment Industry

By Bryce Tingle. He is the N. Murray Edwards Chair in Business Law, University of Calgary.

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• Environmental, Social and Governance (ESG) scores are sold to investment fund managers to assist them in making investment decisions. The scores are generated by a large industry of third-party firms and embedded in ratings, rankings, and indices.
• The various elements in ESG scores stand in contrast to the traditional financial metrics relied upon by previous generations of investors.
• Can investment fund professionals, who manage the wealth of other people, legally rely on ESG data in making their investment decisions? Over 88% of fund managers overseeing US$3.16 trillion of investment funds purport to use these ESG scores, a problem if the scores are inaccurate.
• A decade of careful investigation in dozens of empirical studies has found:
  • ESG funds market themselves as advancing environmental and social objectives, but the ESG ratings those funds depend on are explicitly not about protecting the earth and society from the impact of corporate behaviour, but protecting the corporation from society.
  • Turning the welter of complex criteria into the simplistic ratings sold to investment funds requires judgement calls about what is material for a company or industry, and how to weigh various factors in coming up with a final score.
  • ESG ratings of the same company vary widely from one rating agency to another, demonstrating low validity and suggesting the ratings are not measuring anything real.
  • ESG ratings fail to predict future environmental and social performance, such as the exposure of a company to government fines, labour actions, or pollution violations.
  • ESG ratings of companies do not predict future operating performance or the trajectory of stock prices.
  • ESG ratings do not correlate with reduced investment risk.
  • Corporate disclosure of ESG-favoured information seems, ironically, to be connected to less ethical and more self-interested managerial behaviour.