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CEO of Tesla Motors Elon Musk speaks during a media tour of the Tesla Gigafactory in Sparks, Nevada, on July 26, 2016.James Glover/Reuters

When S&P Dow Jones Indices removed Tesla Inc. from an influential index of companies based on environmental, social and governance principles, some investors may have scratched their heads in bewilderment this week.

The source of their confusion: If a company devoted to making electric vehicles and curbing fossil-fuel emissions can’t gain admission into the S&P 500 ESG Index – but an oil producer like Exxon Mobil Corp. can – what’s the point of embracing sustainability?

Elon Musk, Tesla’s chief executive officer, turned the confusion into fury: “ESG is a scam,” he tweeted on Wednesday.

Cathie Wood, the famous tech stock investor who runs the ARK Innovation ETF, added her support: “Ridiculous,” she tweeted. “Not worthy of any other response.”

Welcome to the ESG backlash.

But here’s a thought: Perhaps ESG investing principles are doing exactly what they should be doing.

They exert pressure on companies to improve their operations, and a strong environmental profile shouldn’t give a company a pass on weaker social or governance issues. If S&P is concerned about Tesla’s response to working conditions and racial discrimination, then it doesn’t matter how green it is.

“Sustainable investing is not black and white,” Jon Hale, director of sustainability research at Morningstar, said in an interview.

He added: “The broader goal of ESG is to encourage companies to behave and operate in ways where they can embed this notion of sustainability into their long-term strategy. That will create value for all their stakeholders.”

ESG investing had been enjoying a relatively smooth ride in recent years.

Analysts quantified ESG through more refined methodologies and scores. Firms such as S&P, MSCI and Refinitiv created indexes that grouped together high-scoring companies. And asset managers launched new mutual funds and exchange-traded funds, some of which tracked these ESG indexes.

Money poured into ESG assets, as sustainability proved especially attractive to younger investors who want to align their savings with their views on diversity and climate change.

According to ISS Market Intelligence, US$150-billion flowed into global financial products that track ESG indexes last year, while assets under management increased by 80 per cent from 2020.

But a few bumps have emerged.

Some observers are questioning the ability of ESG strategies to make a dent in the world’s problems, and the impressive gains of traditional energy stocks and defence stocks this year add to skepticism over ESG performance in the stock market.

Political opposition is emerging as well. Mike Pence, the former U.S. vice-president, said this month that sustainability elevates “left-wing” goals, and that U.S. states such as Texas need to “rein in” pension funds that follow sustainability principles.

And now, with Tesla turfed out of a prominent ESG index, even the definition of what constitutes sustainability – never entirely clear or consistent – appears to have grown downright murky and even contradictory.

Is ESG in trouble?

Perhaps the approach to investing is going through some growing pains. But Mr. Musk’s criticisms, in particular, appear to miss the mark.

ESG is not a scam; rather, one methodology used to assess ESG suggests that Tesla needs to do better on its social and governance scores.

Tesla lost its place in the S&P 500 ESG Index, according to S&P, amid concerns about racial discrimination and poor working conditions at the company’s factory in Fremont, Calif. S&P also criticized the company’s handling of an investigation into accidents linked to vehicles running on autopilot.

At the same time, rival car makers have improved their ESG scores, pushing Tesla into the bottom quartile among its peers – and, therefore, out of the index during a quarterly rebalancing.

That’s hardly a disaster for ESG or Tesla.

For one thing, Tesla is still a component of other ESG indexes and ETFs. For example, it has the fifth-largest weighting within the iShares ESG Aware MSCI USA ETF, an exchange-traded fund with nearly US$22-billion in assets under management.

The stock is also a darling among retail investors, who invest directly rather than through an index.

And lastly, the removal of Tesla from the S&P 500 ESG Index could put pressure on the company to improve on its social and governance scores, which is exactly what ESG scores should do.

Mr. Musk’s apparent anger toward Tesla’s removal, as expressed in his tweet this week, implies that the pressure is real – and that ESG is working.

“Sustainable investors are trying to support the energy transition, as well as encourage public companies to become more sustainable and address broader systemic issues,” Mr. Hale said.

“It’s not easy to do,” he added. “But it doesn’t mean that it’s not worth doing.”

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