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The era of ESG fraud

New rules will push ESG investing to be more transparent and more rigorous.

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  • Tim McDonnell
By Tim McDonnell

Climate reporter

Published
June 18, 2022
Image copyright: Quartz

Hi Quartz members,

The greenwash police are racing to Wall Street, sirens ablaze.

Last week it was revealed that the Securities and Exchange Commission is investigating Goldman Sachs for possibly overstating the environmental, social, and governance (ESG) credentials of some mutual funds. It’s the latest move in a broader crackdown by US and European regulators on the ESG investing industry. The SEC launched an ESG investigation of Deutsche Bank last year, which was followed by a police raid on the bank’s Frankfurt headquarters in May. The SEC also fined BNY Mellon $1.5 million for “misstatements and omissions about ESG considerations.”

These investigations all revolve around the question of whether and how the firms consider ESG criteria—everything from carbon footprint to board diversity—in selecting which company stocks to include in ESG-labeled investment funds. Since ESG funds are one of the hottest items on Wall Street—their value reached $2.7 trillion in 2021—there’s been a rush to slap an ESG label on everything, sometimes without due diligence.

But the investigations also are a warning from the SEC about a deeper problem: that ESG considerations, even when dutifully applied, mean something different to everyone and do an especially bad job of measuring climate impact. That explains how S&P’s ESG index fund, for example, can hold half a dozen oil and gas companies but drop Tesla, the world’s top electric vehicle maker. Over the last two months the SEC has rolled out draft rules that will govern how public companies disclose climate data and how fund managers use it for ESG labeling, placing an ESG overhaul at the center of president Joe Biden’s climate agenda. The idea is that with tighter ESG rules, more money will flow into genuinely climate-friendly companies (that won’t help Tesla, however, unless it can resolve issues related to safety and working conditions).

While those rules grind through the bureaucratic approval process over the next several months, the SEC is using existing fraud regulations to crack down on lazy ESG practices and send a message that the most egregious greenwashing has to stop. That should make fund managers think twice about how they use ESG labels—but is unlikely to diminish the appetite for green and socially responsible investing.

“I don’t think it’s going to slow down,” said Katelynn Bradley, a former official in the House of Representatives Financial Services Committee. “This is all based on investor demand, and I don’t see that changing at all.”


The backstory

  • WTF is ESG? One of the biggest problems with ESG is that it needs to boil a vast amount of data about a company’s strengths, weaknesses, operations, personnel, risks, and opportunities into a single rating. Different firms count different criteria and give some things more weight than others. “What if you have an oil and gas company with the best parental leave ever?” said Ken Rivlin, an environmental and financial regulation attorney at the law firm Allen & Overy. “Or an organic hemp sneaker company with terrible workplace conditions? At what level is it meaningful or productive to make these kinds of judgments? It’s not really clear.”
  • Elon’s big beef. That ambiguity has turned ESG ratings into a “scam,” Tesla CEO Elon Musk said in May. He’s not wrong that ESG ratings in general do a poor job of reflecting some important kinds of positive impact—avoided greenhouse gas emissions from gas-fueled cars, in Tesla’s case. But they did catch Tesla’s poor track record on safety issues and working conditions. ESG ratings also tend to reward companies that publish a lot of internal data, which Telsa scores poorly on. The SEC is developing rules to make more climate-related disclosure mandatory, which could level the playing field.
  • ESG doesn’t cut emissions much. Major carbon emitters can still receive a glowing ESG rating, and specialized funds like ESG-labeled ones are permitted by law to carry up to 20% of their value in non-ESG assets. As a result, many big ESG funds are only slightly less carbon-intensive, in terms of CO2 per dollar of revenue, than the market average.

Numbers for your next conversation

  • 121: Number of new ESG funds launched in 2021, up from 73 in 2020.
  • $2 trillion: Contraction in the ESG investment market in Europe after regulators there issued early anti-greenwashing rules in 2018.
  • 0.35: Points out of 100 that are based on financed carbon emissions in S&P’s ESG rating method for banks (i.e., a bank with a huge carbon footprint would stand to lose only 0.35 points out of 100 on its ESG rating).
  • 40%: The threshold proposed by many economists for the share of a company’s total carbon footprint coming from customers and suppliers, beyond which the SEC should mandate public disclosure of those emissions.
  • $1.8 billion: Fees earned by asset managers in 2021 for managing ESG funds.

What to watch for next

  1. Final rules. A public comment period on the climate disclosure rule closed on June 17; the ESG fund rules are still open for comment. Both may be finalized by the end of the year, and will almost certainly face litigation from high-carbon business groups.
  1. Fines. In the meantime, more firms are likely to get caught in the SEC’s dragnet. But Bradley said the pace of enforcement actions may fall off once the new rules are finalized and the most blatant fakers made an example of. “They’re not going to go after companies that make a good-faith effort to comply with the rule,” she said.
  1. Whistleblowers: The SEC probe of Deutsche Bank was prompted by allegations by Desiree Fixler, the company’s former top asset manager, that its ESG analyses were based on flimsy data. BlackRock also had a vocal ESG defector, former chief sustainable investment officer Tariq Fancy. But SEC enforcers aren’t waiting for the phone to ring, Rivlin said: “They’re reading disclosures and surveilling the market, not just waiting around for tips.”
  1. ESG performance. Some big ESG funds are underperforming the market average this year, in part because they tend to be heavy on big tech companies, whose share prices are tumbling. Share prices for oil and gas companies, meanwhile, are surging, but are usually underweighted in ESG funds.
  1. Catching up to Europe. Europe is a couple of years ahead of the US on developing ESG standards, and the SEC’s new rules don’t exactly match them. That could be a big headache for firms with business in both regions, Rivlin said: “It’s a goat rodeo, which is a polite phrase for something else.”

One 🎯 thing

Missing the target. As hot as ESG investing is, it’s not stringent enough to stop companies from hiding behind bogus climate strategies. According to an analysis this week led by the University of Oxford, 65% of corporate net zero targets (which have been set by about 702 large public companies globally) aren’t backed up by a credible plan to deliver emissions cuts on time. The quality of these plans may improve once the new SEC rules let investors take a better look under the hood.


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Thanks for reading! And don’t hesitate to reach out with comments, questions, or topics you want to know more about.

Have a socially responsible, fraud-free weekend,

—Tim McDonnell, climate and energy reporter

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