Why was Volkswagen in ESG and Sustainable Investing Funds?

Responsible investing must come clean about Volkswagen. Too many funds rated it highly on Environmental, Social and Governance (ESG). Collateral damage will run well beyond the car sector. Already, the scandal has tarnished the brands of Volkswagen and Germany, with their reputations for trust and engineering excellence. But it is not just about mis-selling cars. Investors should be asking questions too.

The focus should now be on Environmental, Social and Governance Investing (ESG), along with funds and index products that use these criteria.

Volkswagen was rated as one of the best ESG companies, included in key products that claim to offer investors portfolios of the best-behaved companies. Now confidence has been shaken in the notion that being a “good” company must mean an outperforming investment. Terms like “responsible investing” and “sustainable” may need to be re-defined.

Can ESG even be measured accurately? There is a danger of relying on company reports that can be self-serving or misrepresent. The desire to promote ESG has run well ahead of the investment industry’s ability to measure it. The Volkswagen scandal should drive an opportunity for the ESG movement to reassess its claims and improve its practices. It is a broad church that now needs to get more specific, particularly on governance.

ESG is meant to deliver long-term investment benefits, as well as improving society. The claims go beyond simply making asset owners feel good. The spin suggests that companies scoring well on ESG face less strategic risk, and should perform better. The appeal is not to investors’ altruism, but their pockets.

There is now a lot of money backing ESG as the future of investment. Not only have indices and ETFs been set up that buy only these “good companies” and package them for investors. Increasingly many conventional active investors are trying to integrate the concept within their investment analysis and decision-making. A recent CFA Institute survey of investment professionals worldwide showed that 73% of them take ESG into account in their investment analysis and decisions. But the same poll highlights the need for third-party verification, given the dangers of relying on company reporting and promises.

The movement is entering the mainstream with more research now being done to create a robust methodology. Academic evidence to date is mixed, although studies may not fairly capture the long timescale in which ESG might make its biggest impact. There is an understandable lack of detailed historic data, as some of the concepts are new.

Recently advocates have claimed evidence that there is some relationship of shorter-term performance to the direction of improvement in ESG. But for something that is argued so strongly, it is surprising that the evidence is not overwhelmingly in favour.

Perhaps it is a concept that many investors simply want to believe in. It seems beyond debate the companies should be sustainable and everyone should invest responsibly. It seems growth in ESG has been based largely on the argument of what should be, rather than hard historic evidence. But the role each factor plays in the ESG case is complex.

The simplicity of just three letters is persuasive, but we may not yet have found how to identify the companies that in the long term do the most social good. Getting the right measures for ESG matters.

Simply scoring companies on a box-ticking exercise for diversity, disclosure and environmental impact may not get to the root of the problem. It is too easy for the companies that make the most noise about caring for the environment to get favourable treatment. Volkswagen’s annual report stated its intention to become the global economic and environmental leader in cars, and talked of its focus on setting new ecological standards.

The biggest companies are typically more skilled at the sort of expensive reporting that scores on ESG, but they may actually have the greater risk. Volkswagen is not the only major company where rhetoric has run ahead of reality.

Volkswagen scored in ESG as the cheerleader for environmentally-conscious car owners. Yet its undemocratic voting structure seemed not to penalise it. Four controlling groups have over 70% of the votes, yet own less than half the equity. Effectively, the free-float of 37% was entitled to less than 10% of the votes. That looks like a recipe for an unquestioning and complacent board.

Worryingly, the concept of favourable voting rights for longer term investors appears a core belief of those who seek better company stewardship, and could be enshrined in EU legislation. The EU’s Shareholder Rights Directive may reward long-term shareholders with additional voting rights or other enhanced benefits. When opinion on what constitutes good governance is divided, how can stewardship be rated? Disproportionate voting rights might either reward long-term holders, or just lead to cosy long-term relationships. Which of these is more likely matters a lot for implementing ESG.

Governance may prove to be the key to getting other sustainability factors right. Shareholders need bold sceptics in the boardroom. Those directors can ask questions and drive change in a way that is not possible for shareholders. Repeatedly, lack of accountability of boards has been linked to nasty surprises. The Co-Op, Tesco and Glencore are just perhaps the highest profile examples of this.

Volkswagen and other recent scandals should be a warning bell for sustainable investing. To be truly effective, hard evidence is needed to relate scoring on good governance with real world results. And much better verification is needed of company ESG claims. ESG has arrived in the mainstream. But it must now explain how it will prevent the Volkswagens of the future from gate-crashing ESG funds and indices.

A version of this article was published as a Financial News Op-Ed on October 5th 2015.

Image credit;Volkswagen, fair use, all rights reserved.