Interest in environmental, social, and governance (ESG) issues has surged among investors, as has demand for sustainable funds that often rely on ESG ratings.

“In the past, ESG was much more Europe-driven, and European companies were at the forefront,” Steven Fox, CEO and founder of Veracity Worldwide, told Yahoo Finance at the 2021 Concordia Summit (video above). That changed during the pandemic, he said, “and we would say in the last 18 to 24 months, there's suddenly been a sea change among U.S. companies with a real interest in ESG issues.”

ESG investors rely on companies’ voluntary disclosures and tend to navigate incoherent ranking systems that attempt to apply a rubric to disparate metrics, sectors, and jurisdictions.

“It's easy to rely on rankings," Fox said. "The problem is that rankings have many limitations and shortcomings, and there's lot of ink that's been spilled on that topic."

He suggested investors dig deeper into the nuances of their ESG holdings to better understand the context surrounding corporate ESG policies.

“It's what we would call ESG intelligence as opposed to just having ESG rankings,” Fox explained. “Can you really get down to the heart and the core and ask penetrating questions and truly understand what's happening in a company precisely to avoid those greenwashing type of situations?” (Greenwashing is a term used to describe when a company advertises misleading information to appear more environmentally conscious than they are.)

As the demand for ESG assets and sustainable products continues to grow, greenwashing not only gives consumers and investors a false impression of companies' practices, it can allow companies to collect a premium on greenwashed products.

When it comes to ESG ratings, “there is a higher degree of self-policing... where companies are worried about being called out if they make a statement that proves not to be correct, and as a result, they want to make sure that their own house is in order before providing information to the ranking agencies.”

And another form of oversight may soon come to pass as the SEC collects information on ESG ratings and contemplates mandatory disclosure requirements.

ESG investing: 'Checking a box' or 'genuine commitment'?

So what types of questions should investors ask to ascertain whether a company is making good on its ESG promises?

Fox suggested that investors interrogate companies’ motivations for addressing ESG issues: “Is it merely checking a box and doing it for compliance purposes? Is it only for public relations purposes or is there a genuine commitment to try to live the story on whatever it is with regard to ESG?”

“We see more and more of that happening,” he said of companies that are “truly ESG attentive.” And, those companies that are “pressing for any ESG agenda outside of their own business” are leading the way when it comes to ESG.

But it’s easy to be led astray. Fox alluded to Wirecard, a financial services company that filed for insolvency after admitting to missing 1.9 billion Euros, as an example of a company that “made all the right ESG noises” but ultimately was accused of fraud. Before collapsing in 2020, shares of Wirecard were held in ESG-themed funds, despite low governance scores underneath the top line ratings.

“On paper, everything looked all right,” Fox said. “But if you dug deeper into their governance and other aspects, it was not too difficult to determine, and as we did for a client in advance of this, there was likely to be fraudulent activity, which there turned out to be to the tune of billions of dollars.”

Another thing to watch for is hidden subsidiaries that may implicate companies in ESG risks. One example of this involved a palm oil business in Southeast Asia that Fox said his company had looked into.

“The company itself did all the right things, but in one of their subsidiary companies, the dirty activities were hidden there,” Fox said, “and it wasn't clear the subsidiary was a part of the business at first blush. And it was only through careful looking that one could see this.”

These aspects aren't always captured in ESG ratings, he stated. The challenge for investors is to understand what's happening on the ground, to learn about the intricacies of particular markets, and to ferret out the details of company dealings.

And for consumers, “it’s probably more difficult when they depend on media and others to be as scrupulous,” Fox added. Though it's not easy, he said, “the overall needle is moving."

Grace is an assistant editor for Yahoo Finance and a UX writer for Yahoo products.

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