ESG is incomplete: An investor's perspective

ESG is incomplete: An investor's perspective

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True environmental, social and governance analysis must consider financial performance.

Environmental, social and governance (ESG) research and ratings continue to gain momentum among mainstream asset owners and managers. The big investment research and index providers, such as Morningstar and S&P, have taken stakes in ESG companies or acquired them outright. The recent mergers and acquisitions all point to the fact that ESG is important to the investment process, and when used properly can identify both risk and opportunity. 

While the sweeping uptake of ESG research and ratings within the investment industry is a welcome evolution, many recent adopters use a check-the-box approach. More investors, both individual and institutional, demand that their investments achieve both financial and ethical returns. To cater to this increasing demand, managers are touting the fact that ESG and other sustainability criteria are, at the very least, considered in the investment process.

But solely relying on ESG data and ratings is incomplete. Investors that have used ESG long before it became a buzzword in the investment industry know that ESG analysis is a complement to — not a substitute for — fundamental analysis. ESG analysis should not be easy. It is a discipline rooted in the fact that making an investment decision is about more than analyzing numbers; it is about understanding how non-financial factors hinder or help company performance.

Isolating ESG metrics and relying on their ratings and rankings is risky and limits ESG as another quantitative and exclusionary tool. Not only is this approach a dramatic oversimplification of ESG analysis, but it also fails in terms of how ESG analysis can be used effectively to identify companies that deliver on both sustainable earnings growth and positive social and environmental impact.

The practice of solely relying on ESG ratings and rankings to screen out prospective investments stands to negatively impact the overall progress companies and the investment industry have made toward a more sustainable economy and world.

True ESG integration and analysis can identify those companies and other investments poised to achieve meaningful financial performance. Indeed, if ESG considerations do not correlate with improved financial performance, widespread adoption of ESG as a sound investment discipline will fail.

Exclusionary screening is not an investment discipline; it is a simple way for investors to respond to social and environmental concerns and it is the primary reason that socially responsible investing (SRI) failed to gain mainstream traction in its early years.

Even for those claiming to only invest in "best in class ESG" performers, the approach falls short when it comes to uncovering non-financial and other sustainability-related information needed to determine risk and opportunity in investment evaluation for three primary reasons.  

1. Regulation and standardization of ESG disclosure is lacking

It is important to understand that ESG analytics are not the only set of factors that need to be identified in the process of researching companies. Many additional factors and questions need to be examined and determined to grasp the full mosaic of what could materially affect a company going forward. The lack of regulation and standardization with ESG disclosure, corporate sustainability measures and human rights issues leads to an incomplete assessment. Investors need to look deeper and ask more questions to understand the full picture.

2. Materiality is missing

As corporate social responsibility (CSR) has become commonplace, companies are getting savvier about what to report. Publishing information that sheds a company in the best light possible in relation to ESG criteria neglects other information — both positive and negative — and fails to address issues that may be more material to a company and its business.

3. Data looks backward, not forward

ESG data, ratings and rankings are creating unjustified confidence primarily based on what a company has done in the past. As investors, however, we want to know how a company views ESG factors now and how consideration of these factors will affect the company and its financial performance in the future.

Within the environment of lacking regulations and standardization which contributes to imperfect data, investors should inquire if those that manage their investments are taking the additional steps to execute a holistic sustainable, responsible and impactful investment approach.

The following questions can provide a deeper understanding of how particular investments are suited for future success.

  • Is there ongoing dialogue with company management to learn more about their approach to ESG risks?
  • Is there a sense of whether a company has a short-term or long-term mentality and is considering its environmental footprint as well as social impact throughout its business operations?
  • Has there been consideration of feedback and analytics from industry peers and external stakeholder organizations?
  • Is there a methodology or process for obtaining outside perspectives relative to employee satisfaction, employee pay, and how a company treats and values employees, customers and other stakeholders throughout the supply chain? 

While ESG reporting and standardization has come a long way, the data is only useful in the context of a thoughtful investment discipline. Even when we reach ideal standardization of reporting across all industries and sectors that is more uniform and all-encompassing, investors need to understand that ESG information is merely the starting point for forming the kind of critical questions that can lead to valuable insights.

There will always be an element of personal analysis and research needed to determine what information is available and whether to invest.