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ESG funds can have a positive impact on investors, but they have a critical blind spot that makes it difficult for them to trust the promises of the $35 trillion industry.

ESG funds can have a positive impact on investors, but they have a critical blind spot that makes it difficult for them to trust the promises of the $35 trillion industry.

Looking down on a worker at a computer in a large warehouse

Chances are you’ve heard of the term if you own stocks. ESG. 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 that two decades, a United Nations reportESG investing was first mentioned. US$35 trillion industry. Supervision of money managers one-third of total U.S. assets under management said they used ESG criteria in 2020, and by 2025 global assets managed in portfolios labeled “ESG” are expected to reach $53 trillion.

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. Researchers in the field of supply chain management sustainable operations, 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.

Supply chains are often ignored.

Nearly every company’s operations are backed by a global supply chainThis is made up of information, workers, and resources. To accurately measure a company’s ESG risks, its end-to-end supply chain operations must be considered.

Our recent examination 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 lists “supply chain” as an item under the “S” (social) pillar. This measure treats supply chains separately from other items like carbon emissions, climate change impacts, pollutants, or 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.

Carbon emissions are another example. Many companies, such as TimberlandThey have achieved great success in reducing their own emissions. Yet the emissions from their supply chain partners and customers, known as “Scope 3 emissions,” may remain high. Scope 3 emissions are not properly included by ESG rating agency due to a lack of dataThis data is only available for 19% of companies in manufacturing and 22% in service industries.

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 problem with third-party suppliers

Amazon, for example, is among ESG funds’ largest favoriteHoldings As a company biggerAmazon is a better seller than Walmart in terms annual sales. However, Amazon has reported emissions from shipping that are just 1% of what Walmart is reporting. one-seventh of Walmart’s. Researchers from two advocacy groups looked at public data on imports and found that only about 5% of them were correct. 15% of Amazon’s ocean shipmentsCould 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 percentageAbout 80% of its revenue comes directly from third-party suppliers 40%Many of these products are shipped directly from China, further complicating emissions tracking and reporting.

Looking down on a worker at a computer in a large warehouse
Although retailers are skilled at tracking goods in supply chains once they arrive, the potential impact on the climate or workers in other countries can often be overlooked by them.
Kmatta via Getty Images

Consumer protection is another important ESG metric. Amazon prides itself as “Earth’s most customer-centric company.” However, when its customers have been injured by productsSold by third-party sellers on its platform, Amazon has argued that 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 so can’t be held accountable.

Yet, the major ESG rating agency do not seem to reflect the supply chain implication of customer protection when measuring Amazon’s supply chains performance.

For instance, 2020 will be the year of the swan. MSCI, 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 securityDespite its shortcomings, consumer liability risk.

These gaps are also an issue for rating companies like 3M? ExxonMobil Tesla.

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Other countries are also adding pressure

There is currently no standard reporting format. Companies may choose to report specific ESG performance measures to improve their sustainability and social ratings.

ESG rating agencies need to change their methodology in order to be more consistent. This would allow them to consider what might be environmentally harmful or unethical operations throughout the 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.

The German Parliament passed the German Constitution in June 2021. Supply Chain Due Diligence ActThis law will take effect in 2023. This new law will make large German companies responsible for environmental and social issues that arise from global supply chains.

This includes the prohibition of child labor and forced labor as well as attention to occupational safety and health throughout the supply chain. Violations of the law can lead to severe penalties. fine of up to 2%They are worth approximately 5% of their annual revenue

The European Union’s new Sustainable Finance Disclosure RegulationThe, which took effect in March 2021 adds another layer of pressure. It requires funds to report details about how they incorporate ESG characteristics into investment decisions. This has led to some money managers to drop the phrase “ESG integrated” from some of their assets, Bloomberg reported.

We believe ESG rating agencies can fill a significant gap in the U.S. without having to comply with similar laws. 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.

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