Investors who trust ESG funds for a positive impact have a crucial blind spot, and it puts the $35 trillion industry's promises in doubt

If you own stocks, chances are good you have heard the term ESG^[1]. It stands for environmental, social and governance, and it’s a way to laud corporate leaders who take sustainability – including climate change – and social responsibility seriously, and punish those who do not.

In less than two decades since a United Nations report^[2] drew attention to the concept, ESG investing has evolved into a US$35 trillion industry^[3]. Money managers overseeing one-third of total U.S. assets under management said they used ESG criteria in 2020^[4], and by 2025 global assets managed in portfolios labeled “ESG” are expected to reach $53 trillion^[5].

These investments have gained momentum in part because they cater to investors’ growing desire to have a positive impact on society. By quantifying a company’s actions and outcomes on environmental, social and governance issues, ESG measures offer investors a way to make informed trading decisions.

However, investors’ trust in ESG funds may be misplaced. As scholars in the field of supply chain management^[6] and sustainable operations^[7], we see a major flaw in how rating agencies, such as Bloomberg, MSCI and Sustainalytics, are measuring companies’ ESG risk: the performance of their supply chains.

The problem with ignoring supply chains

Nearly every company’s operations are backed by a global supply chain^[8] that consists of workers, information and resources. To accurately measure a company’s ESG risks, its end-to-end supply chain operations must be considered.

Our recent examination^[9] of ESG measures shows that most ESG rating agencies do not measure companies’ ESG performance from the lens of the global supply chains supporting their operations.

For example, Bloomberg’s ESG measure^[10] lists “supply chain” as an item under the “S” (social) pillar. By this measure, supply chains are treated separately from other items, such as carbon emissions, climate change effects, pollutants, and human rights. This means all those items, if not captured in the ambiguous “supply chain” metric, reflect each company’s own actions but not their supply chain partners’.

Even when companies collect their suppliers’ performance, “selective reporting” can arise because there is no unified reporting standard. One recent study found that companies tend to report environmentally responsible suppliers and conceal “bad” suppliers, effectively “greenwashing” their supply chain^[11].

Carbon emissions are another example. Many companies, such as Timberland^[12], have claimed great successes in reducing emissions from their own operations. Yet the emissions from their supply chain partners and customers, known as “Scope 3 emissions^[13],” may remain high. ESG rating agencies have not been able to adequately include Scope 3 emissions because of a lack of data^[14]: Only 19% of companies in the manufacturing industry and 22% in the service industry disclose this data.

More broadly, without accounting for a company’s entire supply chain, ESG measures fail to reflect global supply chain networks that today’s big and small companies alike depend on for their day-to-day operations.

Amazon and the third-party-supplier problem

Amazon, for example, is among ESG funds’ largest^[15] and favorite^[16] holdings. As a company bigger^[17] than Walmart in terms of annual sales, Amazon has reported emissions from shipping that are only one-seventh^[18] of Walmart’s. But when researchers for two advocacy groups reviewed public data on imports, they found only about 15% of Amazon’s ocean shipments^[19] could be tracked.

In addition, Amazon’s figure does not reflect emissions generated by its many third-party sellers and their suppliers who operate outside the U.S. This difference matters: Whereas Walmart’s supply chain relies on a centralized procurement strategy, Amazon’s supply chain is highly decentralized – a large percentage^[20] of its revenue comes from third-party suppliers, about 40%^[21] of which sell directly from China, which further complicates emissions tracking and reporting.

Another important ESG metric concerns consumer protection. Amazon prides itself as “Earth’s most customer-centric company^[23].” However, when its customers have been injured by products sold by third-party sellers on its platform, Amazon has argued that^[24] it should not be held liable for the damage, because it functions as an “online marketplace” matching buyers and sellers. Amazon’s foreign third-party sellers are often not subject to U.S. jurisdiction^[25] so can’t be held accountable^[26].

Yet major ESG rating agencies do not appear to reflect the supply chain implication on customer protection when measuring Amazon supply chain performance.

For example, in 2020, MSCI^[27], the largest ESG ratings agency, upgraded Amazon’s ESG rating from BB to BBB, reflecting its strength in areas such as corporate governance and data security^[28], despite its consumer liability risk^[29].

These gaps are also concerns for ratings of companies such as 3M, ExxonMobil^[30] and Tesla^[31].

Other countries are adding pressure

Currently there is no unified reporting standard, so different companies may cherry-pick certain ESG performance measures to report to boost their sustainability and social ratings.

To improve consistency, the next step would be for ESG rating agencies to redesign their methodology to take into account what may be environmentally harmful and unethical operations across the entire global supply chain. ESG rating agencies could, for example, create incentives for companies to collect and disclose their supply chain partners’ activities, such as Scope 3 emissions.

In June 2021, the German Parliament passed the Supply Chain Due Diligence Act^[32], which will become effective in 2023. Under this new law, large companies based in Germany will be responsible for social and environmental issues arising from their global supply chain networks.

This includes prohibitions on child labor and forced labor, and attention to occupational health and safety throughout the entire supply chain. Those who violate the law face a fine of up to 2%^[33] of their annual revenues.

The European Union’s new Sustainable Finance Disclosure Regulation^[34], which went into effect in March 2021, adds pressure in a different way. It requires funds to report details on how they integrate ESG characteristics into their investment decisions. That has led some money managers to drop the phrase^[35] “ESG integrated” from some of their assets, Bloomberg reported.

Without similar laws in the U.S., we believe ESG rating agencies could fill an important gap. To be sure, surveying a company’s entire supply chain’s ESG performance is far more complex. Yet by tying all the ESG dimensions to a company’s supply chain end-to-end operations, rating agencies can nudge corporate leaders to be responsible for actions across their supply chains that would otherwise be kept in the dark.

[Over 115,000 readers rely on The Conversation’s newsletter to understand the world. Sign up today^[36].]

References

1. ^{^} ESG (theconversation.com)
2. ^{^} United Nations report (www.unepfi.org)
3. ^{^} US$35 trillion industry (www.bloomberg.com)
4. ^{^} one-third of total U.S. assets under management said they used ESG criteria in 2020 (www.ussif.org)
5. ^{^} $53 trillion (www.bloomberg.com)
6. ^{^} supply chain management (carey.jhu.edu)
7. ^{^} sustainable operations (scholar.google.com)
8. ^{^} global supply chain (papers.ssrn.com)
9. ^{^} recent examination (papers.ssrn.com)
10. ^{^} ESG measure (www.oecd.org)
11. ^{^} effectively “greenwashing” their supply chain (dx.doi.org)
12. ^{^} Timberland (www.bloomberg.com)
13. ^{^} Scope 3 emissions (www.msci.com)
14. ^{^} lack of data (www.scoperatings.com)
15. ^{^} largest (ssir.org)
16. ^{^} favorite (www.ft.com)
17. ^{^} bigger (www.businessinsider.com)
18. ^{^} one-seventh (www.businessinsider.com)
19. ^{^} 15% of Amazon’s ocean shipments (www.pacificenvironment.org)
20. ^{^} a large percentage (www.statista.com)
21. ^{^} 40% (www.barrons.com)
22. ^{^} Kmatta via Getty Images (www.gettyimages.com)
23. ^{^} Earth’s most customer-centric company (www.aboutamazon.com)
24. ^{^} argued that (static.reuters.com)
25. ^{^} often not subject to U.S. jurisdiction (www.jdsupra.com)
26. ^{^} can’t be held accountable (www.barrons.com)
27. ^{^} MSCI (www.msci.com)
28. ^{^} corporate governance and data security (www.fool.com)
29. ^{^} consumer liability risk (www.modernretail.co)
30. ^{^} ExxonMobil (greenalphaadvisors.com)
31. ^{^} Tesla (www.forbes.com)
32. ^{^} Supply Chain Due Diligence Act (www.loc.gov)
33. ^{^} fine of up to 2% (www.loc.gov)
34. ^{^} Sustainable Finance Disclosure Regulation (www.spglobal.com)
35. ^{^} some money managers to drop the phrase (bloomberg.com)
36. ^{^} Sign up today (theconversation.com)