The Problem With ESG Investing
(Last Updated On: 1. March 2023)
The criticism of ESG investments is increasing. Many experts criticize the rating system or the rating agencies behind it. They state that ESG does not analyze the sustainability of companies. Instead, they claim, the goal of ESG is to make good business through supposedly green investments. But where exactly is the problem of ESG, and what solutions could be used to avoid ESG criticism in the future?
The ESG criteria are intended to assess investments concerning to their sustainability. This should make sustainable investments more comparable for investors since the verifiable criteria make it possible to evaluate a company. But what sounds good in theory has many problems and disadvantages in practice.
The criticism of ESG and the accusation that exactly these green investments are only feignedly sustainable are getting louder. Instead, critics say, it is misleading investors. Corresponding ESG investments are also repeatedly suspected of greenwashing and thus getting into the focus of supervisory authorities.
ESG Methods: How Are The ESG Criteria Applied?
The various ESG criteria are used by rating agencies. These collect and interpret the relevant data and information from companies on their sustainability performance. However, the agencies use different methods that apply the individual criteria according to completely different approaches.
The main methods include the so-called positive screening, the negative screening, and the so-called best-in-class selection:
With positive screening, companies are selected for ESG investing that meet certain environmental, social, and corporate governance requirements above average.
If negative screening is applied, the fund issuer sets certain values that a company must meet to be considered an ESG investment. If a company does not meet these values, an investment is excluded.
The best-in-class approach selects the best company from the relevant industry for the respective ESG investment. These are the companies that have received the best scores in terms of their social and environmental impact. This does not exclude sectors that are harmful to the climate, the environment, or unethical. Only the worst-case company is rewarded with an ESG recommendation.
Why Is There Criticism Of ESG?
I’ve briefly shown you three different methods, and here is the problem. The ESG criticism is mainly triggered by the different approaches and methods in evaluating sustainability. The term sustainability still has not yet been clearly defined in the financial sector, giving fund providers a free hand in applying the criteria.
Due to the lack of a standard in ESG investing, providers can set the criteria themselves. This is why companies from the oil and gas industry, for example, always manage to get into green investment products. As ESG investing is also becoming increasingly relevant in the media, several studies have been made about it. And the results were pretty disillusioning. For example, this study testified that a clear majority of ESG funds violated several criteria as exclusion of arms trade. In addition, investments are repeatedly made in fossil energy.
The main problem is that there is a lack of standardization and regulation. This makes it impossible for investors who want to do ESG investing to trust the ESG ratings. It must always be expected that some ESG criteria will not be fully met or not met at all. In addition, the ratings of the individual agencies often differ. While rating agency A gives the grade “poor”, agency B gives the grade “good”.
These differences in the valuations create additional uncertainty among investors that makes it clear that the criticism of ESG investing is not entirely unjustified.
Investing In Alternatives Instead Of ESG Investing
The criticism of ESG investments makes many investors look for alternatives. Because very few private investors are willing to do intensive research to check whether the respective ESG products are really sustainable. So how can you really invest in green assets without much effort?
Instead of ESG investing and investing in ETFs, alternative asset classes on the private capital market are also available for sustainable investments. There, investors can choose between a wide range of investments, so they can find the suitable investment for them and at the same time, actively promote the change to a sustainable economy.
The possibilities for investors are already great, and the offer is constantly growing due to the increasing demand. However, investors should not just look for a suitable green investment but also rely on a reputable provider. Let’s take a look at a couple of such alternative green investments:
This can be a solar investment of a specific project where you provide capital and thus propel the expansion of renewable energies. You set a term at the beginning and get back the money you invested at the end. During the term, you will also receive a return with an annual fixed interest rate.
With venture capital, you usually invest over a very long period in young and fast-growing companies that focus on development of climate technologies. You invest in a broad portfolio with various companies and participate financially in company success.
Forest investments can also generate profits while protecting the environment at the same time. A sustainable forest offers many sources of income and improves biodiversity and the climate. In addition, a forest investment is considered very stable in value and thus provides an anchor of stability for an investor’s portfolio even in volatile times with political turmoil.
How Can The Problem Of ESG Criticism Be Solved?
Solving the problem of criticism of ESG investing requires pressure from investors on the one hand and legal regulations on the other. As everywhere, demand determines supply. If investors avoid the ESG products affected by greenwashing, the pressure on the providers to bring real sustainable investments to the market, would increase.
At the same time, however, specific regulations and guidelines by politicians are unavoidable. Investors can only invest without hesitation if there are clear legal rules. Maybe this proposal by the EU Commission would bring some trendsetting changes. Then consumers should be better protected from unreliable or false environmental statements. But of course, it remains to be seen whether this will actually be helpful.
Final Words: Is ESG Investing A Good Approach?
The ESG rating is a first step in the right direction because it also takes sustainability criteria into account when making an investment. Nevertheless, the criticism of ESG is justified, and the implementation of ESG criteria is not enough. The way things are going now, ESG investing is not made to save the planet but to make as many profits as possible. Providers simply have too much scope and often abuse personal responsibility. In the long term, however, investors will also lose confidence in the fund issuers.
Anyone who wants to invest sustainably currently has only two choices: to do their own intensive research with the respective application of the ESG criteria or look for alternatives. And currently, alternative investments in the private capital market have better positive effects on the environment and our planet.
For these reasons, it makes sense for many investors to invest in specific projects whose business model is essentially sustainable. This could be renewable energies, for example. Alternatively, an investment in venture capital funds is also suitable, in which investments are made in start-ups that develop future technologies focusing on the climate and the environment. This can be, for example, green fuel for ships and airplanes or alternatives to meat. And of course, there is also a possibility of ESG investing in individual stocks that really care about the environment.
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