Investing in a manner that aligns with one’s environmental and social responsibility is becoming more and more mainstream these days. Money management companies become increasingly pressured by their clients and the broader woke generation to incorporate so-called “sustainable investments” into their portfolio.
Indeed, according to Morningstar, the relatively short period between 2015 to today saw investments in SRI funds grow from $2.83 billion to a staggering $17.67 billion. What’s more, it’s been estimated by the U.S. Forum for Sustainable and Responsible Investments that the assets in the U.S. that are being managed under some form of sustainable investing strategy lie in the vicinity of $12 trillion in 2018.
Large, publicly-traded companies have also been following suit. In fact, many fund managers will happily admit to considering only the potential investments that have performed well at an ESG litmus test.
If this all isn’t proof-positive of a growing trend toward values-oriented investments among fund management and money management companies, then I don’t know what is.
The problem is that, as with any new process that needs immediate implementation, the initial stages can often be mired in both confusion and division—and the implementation of strategies that have ESG as its focus is no exception. Indeed, the lack of any consensus on the definition of ESG, and the inconsistencies between the various metrics involved, has led regulators to complain that ESG data and ratings are too vague and amorphous to be useful.
In an interview with CNBC, Hester Peirce, the Securities and Exchange Commission Commissioner, said: “I think the first issue is that we don’t even know what ESG means. So, I think defining that would be an important first step before trying to develop metrics.”
To answer that important question, we’ve written below what socially responsible investing is and what its challenges are.
What is ESG?
Basically, ESG stands for Environmental, Social, and Governance. The Financial Times Lexicon helpfully defines ESG as “a generic term used in capital markets and used by investors to evaluate corporate behavior and to determine the future financial performance of companies.”
This means that companies who use ESG to screen for investments assess the risks these will have to those three criteria (environment, social, and governance). The environment component, for instance, might track an investment’s carbon footprint or its ability (or lack thereof) to mitigate the effects of climate change. The social component, meanwhile, might assess various product safety or labor violation issues, while the governance part tracks the quality of the management team, or evaluates whether it has ample oversight.
The Two Most Common Approaches
Most sustainable investors use ESG during asset selection as another metric by which to screen stocks and bonds. These investors basically rate companies in terms of how well they can mitigate nonfinancial risks. Another type of sustainable investor—the impact investor—doesn’t simply invest for financial gain, but also does so for a specific environmental or social gain, with the latter benefit sometimes being, to a huge degree, and even more desirable than the former.
Challenges to Sustainable Investors
For a category of investing that seeks the quality of being assessed objectively, there exists a gross lack of standardized metrics that companies can use. Indeed, the various scoring methods that are commonly employed end up yielding different results for the same company. This has led to asset managers cherry-picking the scoring method that gives them the best results.
“Different ESG data providers may provide varying but overlapping data, and the opaqueness in how the different data are used in the analysis makes it difficult to integrate the information,” says Dan Chi Wong, global ESG specialist at Nikko Asset Management.
The disorientation has resulted in a lot of accusations of misrepresentation. Indeed, quite a number of investors have had their jaws gaping with incredulity over the inclusion of oil-and-gas companies in their sustainability-oriented portfolios. “You have some investors saying ‘I thought ESG just meant excluding fossil fuels,’” says Bonnie Wongtrakool, global head of ESG Investments at Western Asset Management.
Despite the regulatory assistance of a few organizations like the Sustainability Accounting Standards Board, which has provided ESG guidelines for companies, and the Global Reporting Initiative, which has made efforts in standardizing sustainability reporting, a universally accepted way for companies to report on ESG issues still does not exist.
How Are the Returns?
Proponents of sustainable investing still insist, and with good reason, that socially responsible investments will ultimately render good returns. “ESG data…can indeed be a proxy for reputation and quality of management,” Wong said.
However, some critics still argue that the lack of any standardized way of reporting and the fact that companies use scoring methods that are convenient to themselves mean we have a long way to go before sustainable investing can get to the center of the Overton window.
Based on Materials from MarketWatch