Environmental Impact of <scp>ESG</scp> Investments: Addressing the Lack of Cross‐Industry Calibration in Current <scp>ESG</scp> Ratings

ABSTRACT Investment funds pursuing environmentally sustainable portfolios use Environmental, Social, Governance (ESG) ratings as a basis for selection. However, ESG ratings are not standardized, and environmental ratings are scored only relative to peers within the same industry. The study introduces the Environmental Delta Score (EDS) designed to improve the assessment of environmental performance within investment funds. The EDS recalibrates traditional ESG metrics by incorporating industry group (IG) weighting, thus adding a layer of cross‐industry consideration. This is done by assigning a larger weight to IGs that have a greater environmental impact and higher potential to improve on this impact than IGs with a lower potential for improvement. We test the EDS in terms of portfolio construction and performance analysis on 11 Exchange Traded Funds (ETFs). Our data reveal an investor bias toward assets in industries with lower potential to create positive or reduce negative environmental impact. We propose a different portfolio selection with emphasis on environmentally impactful sectors. This highlights the importance of cross‐industry considerations currently still underdeveloped in the ESG landscape. The EDS thus offers a framework that can provide asset managers and investors with a tool to optimize portfolios toward better environmental performance without compromising financial returns. The EDS also offers insights for policymakers seeking to improve ESG rating frameworks and guide sustainable capital allocation.