What Can We Learn from Tesla’s Exclusion from the S&P 500 ESG Index?

The credibility of “ESG” (environmental, social, and governance) indices and ESG ratings is again under attack, this time catalyzed by Tesla’s exclusion from the S&P 500 ESG Index. Elon did not hold back with his displeasure, and understandably so, given the enormity of Tesla’s success in the cleantech space, having shipped well over 2 million electric vehicles since inception.

In light of this discouraging development, I thought I would take this opportunity to shed some light on (1) why “ESG” benchmarking has become topical; (2) why the current ratings construct is flawed; and (3) what several promising startups are doing to tackle the problem.

Why should we care about ESG ratings in the first place?

• According to Morgan Stanley, achieving net-zero emissions will require $50 trillion in investment. More capital must be directed towards decarbonization if we want to have a shot at addressing climate change before it’s too late. The capital markets must play a crucial role in accelerating change.
• For the first time, there is incredible momentum behind sustainable investing from every investor persona. According to Morgan Stanley’s Institute for Sustainable Investing, the general investing population is increasingly bought in, with 49% of the general population interested in sustainable investing versus 23% in 2017.
• There has been rapid growth in “ESG-mandated” assets, particularly in the U.S. Between 2018–20, U.S. domiciled “sustainably” invested assets under management (institutional and retail) skyrocketed 42% from $12 trillion to $17 trillion (U.S. Forum for Sustainable and Responsible Investment).
• This trend is playing out not only because society is increasingly concerned about the disastrous effects of climate change but also because investors are now confident that they can generate impact alongside financial returns.

Exhibit 1: Morgan Stanley Survey: General Population + Millennials growing increasingly interested in ESG investing

Source: Morgan Stanley Institute for Sustainable Investing; Sample size: 800 U.S. individual investors with >$100K investable assets. Survey also included an oversample of 200 Millennials aged 18–37

• ESG ratings are intended to help investors easily identify assets that screen well on environmental, social, and governance factors. Most investors don’t have the time to research companies on their own to ensure that company practices align with their values. In this regard, ESG indices and ratings can play a beneficial role in mobilizing capital toward technologies, products, and solutions that are good for the world.
• Investors want access to better sustainable investing products, and wealth managers want access to better ESG data to improve the impact of their investments on behalf of clients.

Exhibit 2: Morgan Stanley Survey: Investors are increasingly confident that they can generate impact alongside financial returns

Source: Morgan Stanley Institute for Sustainable Investing; Sample size: 800 U.S. individual investors with >$100K investable assets. Survey also included an oversample of 200 Millennials aged 18–37

So, what’s wrong with ESG products today, and why are ESG rating agencies missing the mark?

There is a significant appetite for ESG investment products and proper ESG benchmarking. However, the largest exchange-traded funds (ETFs) are taking advantage of this trend to the detriment of all stakeholders. It’s no longer a secret that “greenwashing” has become rampant across ESG ETFs and other stock indices:

• I’ve heard that ~80% of ESG ETFs today have some exposure to fossil fuel producers and users.
• According to the former Chief Investment Officer of Sustainable Investing at Blackrock (10 trillion assets), there are many instances where funds and ETFs were rebranded as “green” with no discernible change to fund or strategies. That is the definition of greenwashing. For example, take a look at the composition of one of the more popular ESG ETFs (iShares ESG Aware MSCI USA ETF) shown below. Oddly, the top ten holdings include several companies that are average or below average on ESG by MSCI’s criteria. Also, the ETF contains holdings in at least five oil and gas companies.
• While there is significant interest in ESG investing, today’s products fall short by a wide margin and mislead investors.

Exhibit 3: Example ETF (iShares ESG Aware MSCI USA ETF)

Source: MSCI ESG Ratings

There are several concerns with how ESG ratings are constructed today. Below, I focus on three of them (credit to this article by Vladi Nikolov):

• Availability and quality of data: We can’t necessarily blame the rating agencies for not having access to accurate and sufficiently granular data, but this is one of the main culprits. Agencies (e.g., S&P Global, MSCI, etc.) tend to rely heavily on self-disclosures from the company, making it potentially easy for companies to “game the system” and say all of the necessary things to garner a high rating. There is also too much emphasis on management policies/declarations versus actual impact. As a result, it’s easy for companies to commit to specific ESG initiatives, but it doesn’t always translate to measurable results. For example, MSCI states that Tesla has no decarbonization target, and while it’s unclear if that is dragging down Tesla’s rating, that certainly could be the case. At G2, we are excited to see several startups (e.g., Watershed, Persefoni, and many others) deploy carbon accounting solutions that will help companies develop a comprehensive overview of their environmental footprint, all the way into the supply chain. Imagine if every company had the tools and methodologies to rigorously track Scope 1, 2, and 3 emissions and make the data transparent to investors. We would no longer have to take what companies are saying at face value; there would be actual accountability. For more on our views on carbon accounting, check out Francesca Whitehead’s blog post here.
• E, S, and G are very different from one another. Agencies generally lead with one top-line score which is meant to encapsulate a company’s performance across all three categories. However, just looking at top-line scores is flawed, as it detracts attention away from the specific areas where the company may be excelling versus underperforming. Case in point: I’ve included the ESG scores for Tesla from S&P Global and MSCI below. S&P has given Tesla an ESG score of “28” while MSCI has given Tesla a rating of “A”. It is surprising how little context the agencies provide around what these scores mean. While there is a score breakdown for S&P, it is unhelpful and leaves investors scratching their heads as to why Tesla is a “30” on Environmental while the industry average is “33”. How will the company know what it needs to improve on in order to screen better for ESG-minded investors? How will shareholders know where to put pressure on their company’s Board and executive team?

Exhibit 4: MSCI ESG Ratings (Tesla)

Exhibit 5: S&P Global ESG Ratings (Tesla)

• Lack of consistency among rating agencies in how ESG ratings are derived. According to a 2020 MIT study, the correlation among six agencies’ ESG ratings for 25 firms was on average 0.61. This is rather low in comparison to credit ratings from Moody’s and Standard & Poor’s which is 0.99. There needs to be greater consistency in how various agencies evaluate companies for these scores to be relevant. For that to happen, we need greater alignment from all stakeholders (rating agencies, investors, publicly-traded companies, government agencies, NGOs, etc.) on measurable ESG factors.

Exhibit 6: MIT Study shows that ESG ratings are inconsistent across the main rating agencies

Source: MIT (Aggregate Confusion: The Divergence of ESG Rations, 2019)

How do we address this problem?

At G2, we’re spending a lot of time learning about companies that are taking a new approach to ESG data reporting, ratings, and indexing. Similar to how Bloomberg leveraged computers and other technology to revolutionize financial and market data in the 1980s, we think there is scope for one of the new entrants to revolutionize ESG data using AI/ML. The exhibit below compares offerings from the traditional/incumbent ESG data firms versus what some of the newer, more AI-driven players are doing.

Exhibit 7: ESG Data Reporting Market Landscape

Source(s): Harvard Law School Forum on Corporate Governance, Company Websites, G2 Venture Partners

I’d emphasize a few main differences between the incumbent versus newer solutions:

• Traditional firms are too reliant on corporate disclosures, whereas newer players are attempting to leverage AI/ML to create ESG benchmarks using unstructured data from a diverse set of third-party sources (media, government, academia, etc.). This approach has its flaws too, but it’s at least a step in the right direction in terms of accountability.
• As discussed, traditional firms focus on a top-line rating (e.g., “AAA”) without drilling into the specifics. This is particularly noteworthy in Tesla’s case. From my perspective, Tesla is one of the most “green” companies ever built. Perhaps they lack in social and governance factors (I have no view on this), but it doesn’t seem fair to dismiss Tesla as not sustainable because they may have deficiencies in other areas. Newer ESG data firms are allowing investors to customize their scores and weigh various categories (e.g., carbon footprint, labor management, corporate governance, etc.) differently.
• Traditional firms typically maintain an annual rating cycle versus newer firms which provide frequent updates. Companies are constantly announcing new products, altering their strategies, and investing in new initiatives. A static annual rating doesn’t do much good for the investment community.

The largest asset managers are also growing increasingly excited about the newer entrants. The likes of Clarity AI, Arabesque, and others are already trusted by some of the biggest asset managers in the world (e.g., Blackrock, Allianz, etc.).

Lastly, I wanted to highlight companies that are building consumer wealth platforms tailored toward ESG investing because I think is a promising angle. While it’s early, I believe retail investors will eventually gravitate towards investment platforms focused on thematic or “values-based” investing. Consumers are gradually shifting away from investing in companies purely for wealth creation. As illustrated in the Morgan Stanley survey, consumers increasingly care about the sustainable impact of their investments. Millennials are the drivers of this paradigm shift, and that’s important because, over the next two decades in the U.S., baby boomers are expected to transfer $30T in wealth to younger generations. The likes of Clim8 Invest, Carbon Collective, Inyova, Cooler Future, Ethic, and others are rolling out specialty investment platforms that help investors screen, select, and monitor sustainable investments.

Exhibit 8: Taxonomy of Sustainable Investing Approaches (Oliver Wyman)

Source(s): Oliver Wyman (ESG impact framework); G2 Venture Partners

Bottom line: It’s obvious that the ESG rating construct is broken today, but that shouldn’t discourage us from benchmarking companies on environmental, social, and governance factors. Instead, we should look to an emerging crop of companies that understand the root of the problem and are coming up with innovative solutions that will paint a more accurate picture of how companies are actually performing across factors that we care about. It’s important that we get this right so that the capital markets can become a bigger catalyst for positive change.