Environmental, social and governance ratings, coupled with the Biden administration’s subsidization of electric vehicles, are facilitating the misallocation of capital toward firms controlled by the Chinese Communist Party. ESG ratings are encouraging the politicization of retirees’ life savings and bolstering China’s stranglehold on the global energy sector.
There is no universal agreement on how to define ESG. The European energy market is an example of its fickle nature. According to Bloomberg, “European-based ESG equity funds have been increasing their investments in firms like Shell Plc and Repsol SA since Russia’s invasion of Ukraine upended the energy markets.” ESG’s traditional exclusion of carbon-intensive companies suddenly shifted in order to ameliorate the supply crunch on oil and gas.
ESG ratings agencies such as S&P Global, Sustainalytics and MSCI evaluate companies’ ESG scores differently. Human biases and artificial intelligence biases have contributed to “divergence” in rating methodologies. Sustainalytics and MSCI “often disagree” on the degree to which a company is environmentally conscious. The ratings are subjective, immaterial and lack concrete indicators that outline the true financial performance of a company.
Sen. Pat Toomey (R-Pa.) sent letters asking for more information from the agencies on how they calculate their ESG ratings. The letters state that “many ESG ratings firms consider information that is not material or financially relevant under federal securities laws.”
Some academics have echoed Toomey’s inquiries by calling for ratings agencies to be more transparent. One article from the “Review of Finance 2022,” concludes that “rating agencies should become much more transparent with regard to their measurement practices and methodologies.”
The state of Utah has been leading the charge to depoliticize ratings. A letter sent by the Utah delegation to S&P accused the firm of giving “Chinese state-owned China Petroleum & Chemical Corporation a higher ESG score than ExxonMobil and Chevron, despite human rights violations by the Chinese.”
The subjective ESG ratings are facilitating the allocation of capital to Chinese companies with questionable business practices. The S&P China A 300 Sustainability Screened Index includes China Merchants Bank, which was accused of lending discrimination against African American neighborhoods in New York.
The index, which includes a Chinese battery manufacturer called Contemporary Amperex Technology Co. Ltd., is enabling the CCP to consolidate swaths of the electric vehicle supply chain. It was recently reported that a Chinese state-owned firm, Luoyang Guohong Investment Group, which already has a 24.68 percent stake in CATL, is partnering with CATL’s subsidiary to acquire a stake in cobalt producer CMOC Group. After the reported transaction is complete, “Luoyang Guohong will have a 20.8 percent interest in Sichuan CATL, which in turn owns the stake in CMOC.”
ESG is the financial sector’s response to government policies that artificially prop up the EV sector through subsidies and tax credits.
The Department of Labor has blacklisted supply chains for lithium-ion batteries used in EVs. The batteries have been added, “to a list of goods made with materials known to be produced with child or forced labor under a 2006 human trafficking law.” Cobalt, which is used in the batteries, is “a mineral largely mined in the Democratic Republic of Congo, where children have been found to work at some mining sites.” The Labor Department explicitly reported on the “terrible conditions to produce cobalt for lithium-ion batteries.”
The Inflation Reduction Act offers tax credits on new EV batteries that require the use of critical minerals, including cobalt, that are largely mined outside of the United States. From 2024-2026, EVs that go into service must have batteries that are constructed using critical minerals that are increasingly extracted or processed in the United States. However, the bill never requires 100 percent of the value of the critical minerals to be U.S.-based. This exposes the U.S. taxpayer to funding an EV supply chain that relies on child labor and forced labor.
Fitch Ratings admits that the tax credits embedded in the Inflation Reduction Act are incentivizing battery producers to issue more debt and raise capital — encouraging the misallocation of capital.
ESG companies “may have lower climate-related risk, but that reduced risk translates into lower expected returns” for retirees and investors.
Ratings firms should be required to prove that their rating methodologies complement their customers’ fiduciary duty to their clients and only include products that consider the expected future financial returns of a company — not ancillary ESG factors.
Congress needs to continue to investigate ESG ratings firms and index funds, pursue increased oversight and, if prudent, draft legislation to root out irrelevant information that inhibits a company from maximizing financial returns and life savings.
Bryan Bashur is a federal affairs manager at Americans for Tax Reform and executive director of the Shareholder Advocacy Forum.