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 Market Mysteries of the week

   Was it fair to kick Tesla out of the ESG index?  

Answer:

S&P dropped Tesla from it's S&P 500 ESG Index. People freaked. The rationale from the index provider seems logical. Elon Musk’s explosion and the broader reaction demonstrate his (and most people’s) confusion about what ESG really means.

What is ESG?

Let's shout this from the rooftops:

ESG does not equal sustainability

. As we've covered before,

Environmental, Social, and Governance ratings aren't a reliable indicator of how "good" a company is

. They're not intended to be. Large financial institutions like MSCI, S&P Global, and Sustainalytics created these metrics to help investors understand the non-financial risks to a company's profits. They are

intended to identify how the world impacts the company, not the other way around.

For instance, an ESG rating given by MSCI that measures "

water stress

" looks at whether or not the locality has enough water to support the company's operations, not whether the company is consuming a damaging proportion of the community's local water supply. 

As we've mentioned before,

ESG ratings are also unregulated, inconsistent, and arbitrary

. Ratings vary widely across providers for many reasons. We've highlighted before that

the core problem is in the data.

Corporate reporting of various environmental and

social issues is mainly voluntary, unregulated, and lacking standardization

. So ESG rating agencies are forced to make a lot of assumptions and normalizations of data themselves to fill the gaps.

On top of that, each rating agency arbitrarily prioritizes and weights criteria differently. Investors are left with wide variability in the meaning of an ESG score by company and rating provider. How do ESG indexes work?Indexes are numbers created to help investors track things. Just like any index - humidity index, body mass index, whatever. In this case, we're talking about the S&P 500 Index, created by S&P Global to help investors follow the changes in the value of America's biggest 500 companies. An index fund, like the Vanguard S&P 500 ETF, would invest in the stocks of all of the 500 companies tracked by the S&P 500 index.The S&P 500 ESG Index takes on slightly different criteria. The company wanted to make an index that mirrored the S&P 500 index but excluded the companies that ranked lower on its ESG criteria (like Tesla). The most important thing to understand is that the index provider intends for the ESG-version of its index to move in line with the regular version of the index. The makeup of the companies included in the ESG index has to have a proportional diversification to the standard index, meaning the industries have to be similarly diversified. So S&P's ESG rankings are industry-relative, meaning a fossil fuel company like Exxon can have a high ESG score and be included in the ESG index as long as it has the lowest ESG risks among its industry.  

Why did Tesla get kicked out if Exxon is in there?

ESG ratings are all about risks.

Investors hate uncertainty. So ESG rating providers are hyper-focused on identifying companies that responsibly manage potential risks. So

, these

ratings can often give more credit to reducing negative risks

than to the creation of positive environmental or social impact. 

Many of the most significant measurable risks are liability for fines, lawsuits, or regulations. Companies like Exxon can

get a lot of credit for proper disclosure and taking steps to minimize potential penalties

. It’s hard to avoid news about Tesla’s CEO Elon Musk, but if you’re unfamiliar, he’s one to

exhibit unconventional and unpredictable behavior

that one would typically associate with risk. The management inconsistency, paired with a

lack of disclosure

, a history of

safety issues for its workers

and

customers

, and r

acial discrimination lawsuits

, lead to a reasonable financial risk. Following Tesla’s exclusion, S&P Global released details about the rating change, highlighting Tesla’s

“lack of a low-carbon strategy” and “codes of business conduct.” 

Also, despite its business model propagating carbon-efficient electric vehicles, Tesla has been ranked as a

top toxic air polluter

and faced

improper waste investigations

from its two biggest manufacturing facilities. 

Since these ratings are

not about measuring the positive environmental impact of a company’s products

,

Tesla’s poor management of potential legal and financial risks from social and governance issues limits its possible S&P ESG rating.

S&P Global also highlighted that

Tesla’s rating declined relative to peers in the automotive industry

. So until Tesla regains ground on other automakers, it will likely stay excluded.

Should we care about ESG ratings while investing?

They are just more data points. 

Focus on understanding the companies you're investing in. Despite the ads you see from every investment manager, the reality is that there just isn't an easy way to invest based on your values at a fund level. When you invest in a fund, you're still investing in companies. No company represents a singular value. No company is perfect. One company might be an ideal business for reducing emissions but still be terrible to its workers. Stay diversified or invest in specific companies you believe in.

At Share Scoops, we don't think it should be some handful of financial companies who decide whether a company is doing enough for the environment, its workers, or its community. It should be all of us. Read your scoops and let your vote be heard.

💙 The Share Scoops Team

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