The False Promise of ESG

Wednesday, March 16, 2022

Originally published on March 16, 2022 in the Harvard Law School Forum on Corporate Governance

Elizabeth Demers, Professor of Accounting, University of Waterloo
Jurian Hendrikse, PhD Candidate, Tilburg School of Economics and Management
Philip Joos, Professor of Accounting, Tilburg School of Economics and Management
Baruch I. Lev, Philip Bardes Professor Emeritus of Accounting and Finance, NYU Stern School of Management

Photo of Elizabeth Demers

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.

Chart showing the MEAN ESG scores. ESG vs Social vs Human rights scores

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.