ESG analysis is important, but not the holy grail

ESG implementation is here to stay, but the investment industry’s approach must go wider
than mere metrics, argues Kaushik Sridhar.  

As environmental, social and governance (ESG) research and ratings continue to gain momentum among mainstream asset owners and managers,  it’s important to recognise that comparing different companies’ ESG credentials is akin to comparing apples and pears.

Evidence of momentum can be seen in the actions of big investment research and index providers – such as Morningstar and S&P – who have taken stakes in ESG companies, or acquired them outright. 

What does this mean? 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. But demands are changing: more investors – both individuals and at an institutional level – require financial and ethical returns from their investments.

In response 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 isn’t enough. Many investors have used ESG long before it became an investment industry-buzzword: these people know that ESG analysis complements fundamental analysis, rather than replaces it.

ESG analysis should not be easy

ESG analysis is a discipline, predicated on the idea that investment decisions are about more than numbers; is about understanding how non-financial factors hinder, or help, company performance.

Isolating ESG metrics and relying on their ratings and rankings is risky: it limits ESG as another quantitative and exclusionary tool. This over-simplifies ESG analysis dramatically, and fails in terms of how ESG analysis can be used effectively to identify companies that can deliver on sustainable earnings growth, and positive social and environmental impact.

Relying solely on ESG ratings and rankings to scope prospective investments creates potential risk to the overall progress that the investment industry has made toward a more sustainable economy, and world.  Publishing information on a company in only the best light possible, neglects other information.

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.

“What gets measured gets managed” – that old mantra rings true for most businesses. But measurement often fails to provide insight into messy underlying processes – and that’s where important and actionable information can be found. 

Building the case for ESG integration

ESG implementation is here to stay for three reasons:

• 48 per cent of institutional investors believe ESG integration is associated with better investment practices, and two-thirds say it is associated with a longer-term investment mindset.
• Only 18 per cent say that their interest in ESG integration is driven by regulatory requirements, so it is largely not compulsory.
• Only 10 per cent of institutional investors say that peer pressure is a driver behind ESG integration, which suggests that it is not simply a fad.

So, what’s holding investors back from ESG integration? Unsurprisingly it comes down to data.

The most frequent barrier, reported by 60 per cent of institutional investors, is the lack of standards for measuring performance of ESG strategies. The second most common barrier is a lack of ESG performance data reported by companies, cited by 53 per cent. About two-thirds (67 per cent) of institutional investors say that greater transparency in ESG reporting from companies would be the most useful thing towards improving ESG integration.

Five actions

To help keep the dialogue going we developed a framework for ESG integration that is based on five actions. 

• Taking ownership – obtain decisive support from the C-suite and board on implementing ESG strategies.
• Conducting education and training – ESG integration cannot be effective when a dividing line exists between the sector analysts and a (usually small) group of ESG analysts who handle proxy voting and attempt to influence the decisions of the sector specialists.
• Requesting the necessary data – this primarily occurs through engagement with portfolio companies. Corporations often complain that investors fail to give them credit for sustainability efforts, and do not ask about their ESG performance; instead focusing on short-term financial performance. In turn, investors complain that companies don’t report useful ESG data and never talk about it on investor calls.
• Incorporating a materiality filter – effective ESG integration doesn’t require all the data at all times, but rather the necessary, materially important data.
• Aligning time horizons – this means adjusting performance metrics and incentive structure to reflect the long-term nature of ESG investing.

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.