Investors Should Demand Transparency From ESG Research Firms

End-of-year data show that in 2021, investment surged in stocks rated positively by financial research firms on Environmental, Social and Governance (ESG) criteria, which include an ever-growing list of issues ranging from corporate ethics and climate change to data privacy and human rights. However, ESG ratings are only as reliable as the sources of their data, which are not always clear, due to ESG firms’ opacity. If firms use information from the United Nations or biased non-governmental organizations to inform ESG ratings, the research they provide to investors may downplay abuses by autocracies such as China while magnifying false accusations levied against democracies such as Israel. If so, ESG firms would not only be undermining investors’ ESG objectives, but may also be violating U.S. state laws that prohibit boycotts of Israel, for which these firms could face federal penalties in the future.

The Power and Non-Transparency of ESG-Rated Funds

According to data from the Chicago-based finance firm Morningstar, ESG-rated funds received a record inflow of $508 billion in the first three quarters of last year. The New York-based finance company MSCI’s World ESG Leaders Index, which features companies with the best ESG ratings in their sector, has solidly outperformed the MSCI World Index, a benchmark representing a broad cross-section of global markets. According to a 2021 HSBC study, nearly 60 percent of investment firms have policies on responsible investing.

Investors relying on ESG research from firms such as Morningstar and MSCI operate under the assumption that the ESG data they receive are based on reliable, objective, and apolitical sources. That assumption could be mistaken — with possible reputational, legal, and financial consequences.

ESG research firms vary in the extent to which they provide information about their sources and methods. MSCI, for example, publishes an explanation of its methodology, but the list of its sources, which include more than 100 specialized databases and more than 3,000 news sources, is not available for analysis. Morningstar provides even less transparency into its ESG risk calculations. However, independent organizations have acquired research materials produced for clients by a Morningstar subsidiary. These materials have prompted intense scrutiny of the company’s ESG research practices — scrutiny that other companies deserve as well in the name of transparency.

Morningstar rates companies for “unmanaged ESG risk” on a scale from “negligible” to “severe,” basing its assessments on “a firm’s involvement in negative incidents.” Morningstar does not disclose if or how it assesses whether such incidents are factual or potentially distorted by corrupt or politically biased actors. This lack of clarity in an industry built on demanding corporate transparency should alarm investors.

Morningstar did announce last year that its “analysts leverage the United Nations’ Guiding Principles on Business and Human Rights as our assessment framework,” but the company provided no details on what that means in practice. UN data, particularly on human rights, come with well-documented flaws and biases that would call into question the integrity of Morningstar’s ESG research.

UN Data on China

Based on Morningstar’s references to the United Nations, and absent greater transparency in its methodology, the 47-member UN Human Rights Council (UNHRC) may be the source driving the human rights component of the company’s ESG ratings. Despite its name, the council is a club for the world’s most abusive regimes, including China, Cuba, Pakistan, Russia, and Venezuela. In its most recent annual report assessing political rights and civil liberties in countries around the world, Freedom House ranked more than two-thirds of the UNHRC’s current members as “not free” or “partly free.”

The Chinese Communist Party (CCP) has exerted a particularly malign influence on the council. Chinese economic and political influence spurred the UNHRC to refrain from condemning the CCP’s crackdown on pro-democracy protestors in Hong Kong, which began in June 2019. In fact, 13 of the council’s members expressed support for China’s repressive moves.

According to UN whistleblower Emma Reilly, who worked for the UNHRC for nine years, the council has repeatedly provided China with the names of Chinese dissidents who submitted human rights complaints. In 2018, China’s country report for its UNHRC review questioned the universality of human rights, effectively challenging the United Nations’ own Universal Declaration of Human Rights. Nevertheless, more than half of the council’s recommendations for China advised Beijing to “continue” improving its human rights record. Moreover, China’s threats of economic retaliation against foreign governments have served as an effective deterrent against criticism of its abhorrent abuses against Uighurs, Tibetans, and other populations under CCP dominion.

Thus, if research firms are relying on UN data — such as blacklists of companies or reports published by the UN high commissioner for human rights — to inform ESG human rights ratings, they may be relying on incomplete, biased, or manipulated information. Some of China’s biggest companies, such as Alibaba and Tencent, are included in MSCI’s China ESG Leaders Index and the MSCI Emerging Markets Index, the latter of which captures large- and mid-cap stocks in 25 countries. Yet WeChat, owned by Tencent, censors and surveils its users on behalf of the Chinese state. Alongside the Chinese state-owned enterprise Hikvision, Alibaba has helped construct China’s surveillance state, including by producing facial recognition software that specifically targets Uighurs. In a June 2021 interview, Alibaba co-founder and Executive Vice Chairman Joe Tsai openly endorsed China’s crackdown in Hong Kong, including its so-called national security law, which criminalized dissent and stripped Hong Kongers of basic political and press freedoms. Tsai said, “Overall, since they instituted the national security law, everything is now stabilized.”

Also included in the MSCI China ESG Leaders Index: state-owned China Construction Bank, which contributes to China’s “debt diplomacy” and has exploited developing nations under the umbrella of the Belt and Road Initiative. The debt incurred through loans granted by the bank has helped China gain leverage over poorer countries.

UN Data on Israel

Secretary of State Antony Blinken and U.S. Ambassador to the United Nations Linda Thomas-Greenfield have both criticized the UNHRC for its bias against Israel. The council maintains an agenda item that requires scrutiny of Israel’s human rights record at every meeting — holding the Jewish state (a democracy rated “free” by Freedom House) to a different standard than every other country in the world. The council has passed nearly as many resolutions condemning Israel as the rest of the world combined. The UNHRC also maintains a special rapporteur with an open-ended mandate solely to investigate Israel.

In March 2016, the UNHRC called on the UN Office of the High Commissioner for Human Rights to compile a database of companies operating in “Occupied Palestinian Territory, including East Jerusalem, and in the occupied Syrian Golan.” The high commissioner released the database in February 2020, and it now serves as a resource for anti-Israel boycott activists. Yet the database fails to provide evidence that listed companies have done anything illegal. Nevertheless, the UNHRC’s Israel-focused special rapporteur has advocated divestment from companies on the blacklist.

Anti-Israel bias also pervades the rest of the UN system. The United Nations maintains numerous bodies devoted exclusively to presenting the Palestinian narrative and delegitimizing Israel. These include the Division for Palestinian Rights and the related Committee on the Exercise of the Inalienable Rights of the Palestinian People (CEIRPP). Conferences held under the auspices of the CEIRPP openly advocate for the boycott of Israel.

The United Nations also maintains a Special Committee to Investigate Israeli Practices, whose mandate is slanted against Israel. The committee’s reports include unsubstantiated allegations, such as claims that Israel requisitions Palestinian homes by planting ancient artifacts in them to claim Jewish heritage, or that Israeli excavations undermine the structural foundations of the Al-Aqsa Mosque.

UN casualty figures in the Israeli-Palestinian conflict also demonstrate the untrustworthiness of UN data. The UN Office for the Coordination of Humanitarian Affairs’ branch in the “Occupied Palestinian Territories” publishes casualty figures that rely on the Gaza Ministry of Health, which is run by the Iran-backed terrorist group Hamas.

State and Federal Legal Implications of Boycotting Israel

ESG research firms and investors that rely on biased or politicized information to formulate quantitative ratings that drive disinvestment from Israel do so at considerable risk. A 2015 Illinois law preventing state investment in companies boycotting Israel — the model for legislation in more than 30 other states — defines boycotting Israel as “engaging in actions that are politically motivated and are intended to penalize, inflict economic harm on, or otherwise limit commercial relations with the State of Israel or companies based in the State of Israel or in territories controlled by the State of Israel.”

If they use biased sources to discourage investment in companies targeted by the global Boycott, Divestment, Sanctions (BDS) campaign against Israel, firms may be engaged in a boycott of the Jewish state as defined by the Illinois statute. Furthermore, if an ESG research firm proactively contacts other companies to inform them that they will receive a negative ESG rating from the firm unless they terminate Israel-connected business (as Morningstar’s Engagement Services allegedly does), such activities might also constitute a violation of the law as an act of penalization or infliction of economic harm. Illinois reportedly opened an investigation into Morningstar last year based on these concerns.

In addition to being at risk of legal action in Illinois and more than 30 other states with similar anti-boycott legislation, Morningstar may one day need to reconcile its ESG ranking system with federal law. Congress has considered legislation in recent years to amend part of a 1979 federal anti-boycott law — originally enacted to threaten penalties against U.S. companies that complied with the Arab League boycott of Israel — to apply to boycotts sponsored by international governmental organizations. The legislation’s intent is to apply existing fines and export restrictions to any U.S. company that complies with a UN-sponsored boycott of Israel. Should this legislation become law, Morningstar’s potential reliance upon the UN blacklist of Israeli firms as a basis for its ratings could become an even greater liability.

These state and federal legal risks, of course, could also extend to customers who use Morningstar data to guide investment and divestment decisions. The risk would be most acute if states determine that customers directed Morningstar’s Engagement Services to pressure Israel-connected firms or knowingly used Morningstar data to inflict economic harm on Israel.

A Wake-Up Call for the ESG Community

Corporate transparency is supposed to be a core value of the ESG movement, yet investors are making decisions today based on non-transparent research from firms such as Morningstar. The ongoing Illinois investigation into Morningstar’s practices may provide an opportunity for the ESG community to re-evaluate the sources and methods used to rate companies across key indicators, including human rights. Investors will ultimately be on the hook for the reputational, legal, and financial harm caused by using flawed or biased ESG ratings. Chief investment officers should implement appropriate safeguards accordingly.

Richard Goldberg is a senior adviser at the Foundation for Defense of Democracies (FDD), where David May is a senior research analyst. They both contribute to FDD’s Center on Economic and Financial Power (CEFP), International Relations Program, China Program, and Israel Program. Follow the authors on Twitter @rich_goldberg and @DavidSamuelMay. Follow FDD on Twitter @FDD and @FDD_CEFP. FDD is a Washington, DC-based, nonpartisan research institute focusing on national security and foreign policy.