The False Promise of ESG

Jurian Hendrikse is a PhD Candidate at the Tilburg School of Economics and Management. This post was co-authored by Mr. Hendrikse; Elizabeth Demers, Professor of Accounting at the University of Waterloo; Philip Joos, Professor of Accounting at the Tilburg School of Economics and Management; and Baruch I. Lev, Philip Bardes Professor Emeritus of Accounting and Finance at NYU Stern School of Management.

Millions of investors and countless fund managers direct their investments to companies that are highly-rated on the basis of their environmental, social, and governance (“ESG”) activities in an attempt to do good. The claim by ESG advocates, pundits, and many academics that highly-rated ESG companies and funds also deliver superior returns bolsters this move: Doing better by doing good. The best of all worlds.

But do ESG ratings really deliver on the promise? Are highly-ranked ESG businesses really more caring of the environment, more selective of the societies in which they operate, and more focused on countries with good corporate governance? In short, is ESG really good? The answer is no.

We demonstrate this by focusing on a group of companies that are now at the center of the world’s attention: businesses with substantial operations in Russia. Russia’s disregard for the environment, appalling social norms and behaviors, and extremely poor corporate governance are well-known and widely-documented. So one might reasonably expect that business involvement in such a country would detract from the ESG rating of the involved company. To our great surprise, this is not the case.

We examine the ESG scores and response to the Russian invasion of Ukraine for all European firms with a substantial presence in Russia, which we define as companies with Russian subsidiaries that generate more than US$100 million in sales and that have more than US$100 million in total assets. We focus on Russian subsidiaries of large European firms because these represent significant investments of economically important firms that are unambiguously identifiable from standard sources. We search the Amadeus database of Bureau van Dijk for firms that meet these activity thresholds and intersect this with Refinitiv’s EIKON database to generate a list of 75 non-financial European firms that have significant subsidiary activities in Russia with available Refinitiv ESG scores. On average these firms earned 6% of their sales in Russia.

Some startling observations emerge. First, as represented in the figure below, the average ESG scores of firms with substantial activities in Russia, a country that is well-known for its corruption and significant human rights abuses, is 78 out of 100. By comparison, the average ESG score of all other similar-sized non-financial European companies (i.e., those with sales in excess of US$2B) in the Refinitiv database is just 64. The average score of the Russia-invested group on the “S” (i.e., social) pillar dimension is 81 versus a comparable European peer group average of just 68. In terms of their human rights performance (i.e., a subcomponent of the social pillar), the firms profiting from Russian activities earn a whopping average score of 84 versus a much more modest 67 for their European peer firms. Remember, higher ESG scores are supposed to be indicative of more socially responsible corporate behavior, so according to Refinitiv, European companies with substantial subsidiary operations in Russia are, on average, significantly more “responsible,” both overall (i.e., on the basis of ESG) and on the “social” and “human rights” sub-dimensions, than comparable European firms with zero or more limited Russian operations in the periods leading up to the recent invasion.

A full 12 days after the invasion, a surprisingly high 28% of European firms had not taken even the most modest form of public action, such as the condemnation of Russia’s invasion or even the expression of a soft voice of support for the Ukrainian people. Even after intensified public pressure, as of today (March 15th) only 53% of the 75 firms have publicly announced significant action in the form of ceasing their subsidiary’s operations in Russia.

High overall ESG scores combined with slow (or no) meaningful action by many firms begs the ultimate question—how useful is a firm’s ESG score for predicting its response to the Russian invasion? The answer: not very.

We use duration analyses to investigate whether ESG predicts the timeliness with which companies announce their withdrawal from Russia. After simultaneously considering the firm’s size, profitability, and the amount of sales being generated in Russia, our analyses yield surprising overall conclusions: there is no statistical association between companies’ ESG scores and the timeliness of a meaningful response to the Russian invasion. If you’re an investor who has been picking stocks based on ESG scores under the assumption that your money is likely to be funding more socially responsible corporate behavior, particularly in periods of extreme crisis such as Russia’s invasion of a sovereign country, you should be very disappointed.

Overall, our analyses reveal that the former Ukrainian finance minister, Natalie Jaresko, was fully justified in calling out so-called “virtuous” (high ESG) firms for not walking the talk of socially responsible corporate behavior. Our evidence suggests that Russian-invested European firms that have higher overall ESG scores, and even those with higher “social” and “human rights” scores, do not move more quickly to exit their Russian operations in response to Russia’s invasion of Ukraine. If ESG scores are going to remain meaningful and fulfill their promise of enabling socially responsible investing, they need to do a much better job of reflecting the rated firm’s activities in suspect countries that are known for widespread corruption and human rights abuses.

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  1. Roy Niekerk
    Posted Thursday, March 17, 2022 at 8:15 am | Permalink

    Hello Jurian,

    Read this article with great interest.
    Currently I am doing a masteprogram with TIAS and we recently had the topic ESG.

    Your article raised some questions:

    – First of all, the article suggests some surpise about companies with high ESG being active in Russia. However, isn’t that the principle of ESG? That your standard should not be dictated by the country you’re active in?
    – Is the response of companies to this conflict (condmening war activities) being considered in ESG metrics at all?
    – If yes, wouldn’t the fact that companies have not adequatly responded, lead to very low ESG scoring in the next quarter. And consequently, the conclusion is that ESG works after all?

    I am curious to know. Prof Caeldries explained us the principles of ESG and explained there are today ~130 different methods. However, I have not yet been involved in practically applying it.

    My question is mainly for my own study interest, but I would be happy if you could explain a bit more.

    Kind regards,

    Roy Niekerk
    [email protected]

  2. Kurt Schacht
    Posted Thursday, March 17, 2022 at 10:01 am | Permalink

    This is a somewhat silly and counterproductive analysis. Just as is blaming the ESG movement for being unprepared for oil price shocks. Or even less thoughtful reasoning, that ESG caused these NRG price jolts in this instance. ESG does not fix everything, it is not a light switch process nor is it any sort of first or second line response to military action not seen in over 80 years. It is a tragic story with lots of villains, ESG is not one of them.

  3. Mayra Rodriguez Vall
    Posted Thursday, March 17, 2022 at 12:50 pm | Permalink

    Good piece Jurian. I wrote about ESG and banks trading Russian assets a few days ago. Here it is in case it is of interest.

  4. Sarah Wilson
    Posted Thursday, March 17, 2022 at 4:47 pm | Permalink

    Kurt is far too polite. “Work” like this does a great disservice to the academic community and the tremendous multidisciplinary work on development economics, sustainability and international relations which informs ESG approaches which despite the earnest desire of some is not a one size fits all methodology.

  5. Joe MacDonald
    Posted Monday, March 28, 2022 at 6:11 pm | Permalink

    This article is spot on. In the much anticipated CEO letter by Larry Fink, this year titled The Power of Capitalism, he states that “Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not “woke”. Which of course is a colloquial term meaning alert to injustice in society, especially racism. I teach at an Ivy League school, and if I said that, I’d be dismissed. So much for “S” in ESG. Further, 421 out of 593 ESG equity funds have portfolios misaligned with Paris climate targets, and 72 out of 130 climate funds are also not in line with Paris goals. The facts speak for themselves.

  6. Mark Williamson
    Posted Tuesday, April 12, 2022 at 2:31 pm | Permalink

    Understand the investment community is a marketing machine. ESG is just a modernized version of socially responsible investing. Both in general are miss understood by the investor and largely a marketing ploy to attract new investment. When you buy a stock in any company (outside of an IPO) the money goes to the seller of the stock, not the ESG company. What good does that do? You would be better off buying poorly rated ESG companies and using your shareholder voting power to change how they do business.