Why sustainability indices fall short

By Michael Kramer

When an index bears the Dow Jones name, it’s taken seriously around the world, and the Dow Jones Sustainability Indices (DJSI) are no exception.  The global DJSI, which focuses on the largest corporations in the world, started in 1999; regional indices have followed in recent years. While there are older and more widely used sustainability-focused indexes, the DJSI’s institutional credibility continues to garner the lion’s share of media attention. Who gets in, who moves up, and who’s in the top tier are all fodder for news stories, basking companies in a “green” spotlight.  Thanks to its high profile, the public may believe the DJSI is the sustainable and responsible investment (SRI) industry standard. But it’s not, and here’s why.

“Best-in-Class” Doesn’t Mean Much

The DJSI doesn’t exclude any sectors from consideration, in contrast to SRI industry norms. This is problematic because grading on a curve doesn’t take a stand on which sectors are – and aren’t – leading us towards a sustainable society. If companies are only benchmarking their progress against one another, how do they, or we as investors and consumers, know when they’ve achieved a truly credible sustainability standard? Should we really be celebrating companies with marginally less carbon emissions than their peers?

Update: Michael reprises this theme in his October column for GreenBiz.com, which highlights a newly-announced UN-backed sustainability index:

The U.N. Global Compact recently launched the Global Compact 100, its first index comprised of multi-sector companies ranked for their adherence to its 10 principles, which include human rights, labor standards and environmental stewardship. . . . The GC 100 includes companies long appreciated by sustainable shareholders, such as Ericsson, Hewlett Packard, Johnson Controls, Novo Nordisk and Electrolux. But there are some surprises, such as companies in sectors that include oil — even tar sands — natural gas, mining, petrochemicals, automotive and airline sectors, as well as companies with significant military contracts, such as General Electric. 

If these are the best representatives of where the U.N. wants the global economy to go, let’s just say, for the record, that this is unacceptable. Any list being promoted, representative sample or not, as an example of what the world needs more of in terms of corporate practices simply should set a much higher bar. 

A sustainable society is best achieved by reaching consensus on how to make a healthier society and planet. For forty years, 

the consensus among SRI managers on ESG screening has meant exclusion of tobacco, alcohol, gambling, firearms, nuclear power, and military contractors in indexes and investment products. Exclusion of these sectors is widely considered to be the foundation of the SRI industry, so ignoring this best and standard practice is a significant flaw of the DJSI’s construction. Today, discussion is turning toward expanding this “avoidance screening” practice to include some carbon-centric sectors.

Sustainability’s Narrow Definition

If you’re travelling in the wrong direction, slowing down doesn’t really solve the problem. Sure, reducing carbon emissions and waste while conserving energy and water make a difference, but society should not be celebrating industries that are, in fact, the primary cause of ecological and health problems. The truth is that the global human response to climate change and degrading ecological systems is grossly inadequate. Industries that are in the business of polluting or whose processes and products create toxicity that cannot biodegrade should be required to change their practices, not be put into an index and championed as if they are saving the planet. 

The DJSI may include corporate information across numerous categories, including some social and governance issues, but it doesn’t intentionally include those industries that are leading society in a more sustainable direction, such as organic, recycled, or biodegradable products. While most such companies aren’t large, they are leading the transformative charge. But the DJSI instead evaluates the largest companies in all sectors across broad environmental, social and governance criteria, while omitting the following issues common in ESG analysis:

  • Board of directors minority representation or options expensing
  • Management fraud and SEC violations
  • EPA violations
  • Climate change risk
  • Environmentally-friendly products and services
  • Political contributions disclosure
  • Cultural diversity in management
  • International Labor Organization standards regarding child labor and workplace conditions
  • National Labor Relations Board cases and findings
  • Equal Employment Opportunity violations
  • Hazardous or unsafe products
  • Deceptive marketing or consumer fraud
  • Offensive images in labeling or marketing
  • Animal cruelty in research, development, and production
  • Operations in oppressive political regimes
  • Relocation to countries that allows practices that are against domestic law

As these are among the issues widely accepted by longstanding SRI managers and research firms, their lack of consideration limits the credibility of the DJSI.

Transparency and disclosure is a low bar

The DJSI relies primarily on corporate self-disclosure. Welcome as it is that more companies are choosing to share information with ESG research firms and investment managers, awarding points for transparency and disclosure means little if what’s being revealed are practices harmful to employees, customers, investors, communities, and the environment.

For example, a company may reveal its supply chain procurement standards, risk management protocols, or environmental impact and sustainability measures, but reports that illustrate harmful policies and practices should not be valued over companies that avoid these challenges or implement credible solutions to these problems. Mandatory disclosure using clear performance standards is the only true way for the public to develop an accurate understanding of ESG issues across an industry and for investors to make truly informed investment decisions.

Similarly, disclosure of CEO and median employee compensation is not the same as assessing whether or not executive compensation is excessive in both absolute terms or relative to cuts in company-wide labor costs during hard times.  Finally, a company can have a code of conduct regarding employee behaviors, but if the code’s standards are not assessed by the rating agency, the public doesn’t know if the code is adequate.

Unless one looks closely at the underlying methodology of ESG investment indexes, it’s difficult to know what is being evaluated. Nevertheless, even though corporate leadership within a given sector does have an impact, companies placed on a list claiming to reflect principles of sustainability should truly push human civilization in this direction. Being better than others is not good enough.

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Michael Kramer

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