When ESG and Reality Collide

Perhaps the most consequential of frustrations in adopting ESG principles is the frequent disconnect between the ESG scores of companies and their actual corporate behavior

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    When ESG and Reality Collide

    When ESG and Reality Collide

    Even as ESG principles are increasingly adopted by investors, portfolio managers and companies, growing pains breed continuing frustration. Perhaps the most consequential of these frustrations is the frequent disconnect between the ESG scores of companies and their actual corporate behavior.

    A recent analysis, “Are ESG Ratings Informative About Companies’ Socially Responsible Behaviors Abroad? Evidence from the Russian Invasion of Ukraine,”1 reviewed the relationship between companies’ ESG ratings and their Russian exposure (and disclosures of such exposure) and their post-invasion response.1

    When investors consider a company’s social responsibility it involves a range of factors, from diversity and governance issues to labor treatment and environmental responsibility. Nevertheless, most investors would expect a company with a high ESG score might have limited exposure to Russia, one of the most corrupt nations on earth2, or at least fully disclose that exposure. At a minimum, an ESG investor would expect a highly-rated company to immediately end any Russian relationship in the wake of an unprovoked, immoral invasion of a neighboring country.

    Highly-Rated ESG Companies Fall Flat

    The above-cited research paper found that of the seven different ESG rating agencies evaluated by the authors, none assign a meaningfully lower ESG score to companies with Russian exposure, while five rating agencies assigned significantly higher ESG scores to the group of firms with Russian activities.

    More disturbing was that these companies scored higher on Social and Human Rights measures, despite Russia’s poor record on social and human rights issues.

    Moreover, the firms with higher ESG scores did not have higher levels of disclosure on their Russian involvement.

    The paper also examined how quickly companies exited or suspended Russian operations post invasion. It found no correlation in ESG scores to the likelihood or speed of any withdrawal or suspension.

    ESG Presents Tough Business Decisions

    When a company decides to adhere to the principles of responsible behavior, it may find that difficult decisions await them, as evidenced by recent domestic social issues and the Russian invasion.

    These decisions often involve balancing a tangible financial cost (e.g., lost profit of exiting from Russia) versus the difficult-to-quantify cost of reputational harm. Sometimes that exit is an easy decision (even if expensive), like it was for the scores of companies that exited Russia, McDonald’s being one of them.  The fast-food conglomerate recently announced its exit of Russia after 32 years, closing approximately 850 stores, citing ethics with the humanitarian crisis in Ukraine as a primary reason.3

    Other times, like with China (whose record of human rights, worker rights and intellectual theft is poor), the cost of an exit is far too high for most companies to act on moral principle alone.

    And, in other times, it can create real head scratchers, like the large beverage company that immediately withdrew support of holding MLB’s All-Star game in Atlanta in protest of Georgia voting laws, but dithered in withdrawing from Russia post invasion.

    Sources:

    1. Are ESG Ratings Informative About Companies’ Socially Responsible Behaviors Abroad? Evidence from the Russian Invasion of Ukraine; Social Science Research Network; July 13, 2022; https://deliverypdf.ssrn.com/delivery.php?ID=513103103009125004111105091092105074097042014048023025121113072117000100113097064124027012010041026121034095068031120124120014017009044015049102025124070094029092068065013083112115090085089096095001120074124025004119097066113093024119113079016104031083&EXT=pdf&INDEX=TRUE
    2. Transparency International; Corruption Perceptions Index ; https://www.transparency.org/en/cpi/2021/index/rus
    3. McDonald’s is leaving Russia, after more than 30 years; NPR; May 16, 2022; https://www.npr.org/2022/05/16/1099079032/mcdonalds-leaving-russia

    Please reference disclosures: https://blog.americanportfolios.com/disclosures/

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