The Informed Investor

This is the third article in a series on ESG Investing. Read the additional articles:

ESG a Real Thing or Passing Trend in Investing?

ESG Investing: Can You Do Good and Do Well at the Same Time?

Financial Planning: Getting Started with ESG Investing

In this third article in our series on ESG Investing, we want to provide practical information to add to your strategy.  We will give you insight into what to avoid in this new ESG investments arena.

ESG Investing, also called socially responsible investing, has taken the investment world by storm. The pandemic has put this trend into overdrive, with new companies and investment funds jumping on the bandwagon.

Of course, many corporations and fund managers are highly committed to this more ethical form of investing. But as in almost any situation, big money can bring out those who either do not know as much as they should or have other motivations.

Either way, it is imperative that you understand what to avoid when your money is at stake.

1. Beware of “greenwashing”

The push toward ESG investments (which stands for Environmental, Social, and Governance) is not just happening in the financial sector. There are significant cultural and political pressures to move other aspects of our lives in this direction. With all these pressures, any public company will easily look for ways to increase its attractiveness on these ESG investment fronts. This is often referred to as “greenwashing.”

Greenwashing can differ from actual efforts to make a business more sustainable using these factors. So do not just believe a claim or a line on a website; realize that these may be attempts to capitalize on this trend.

2. Reporting standards do not really exist yet

ESG is still in the “wild west” phase regarding concept maturity. Several firms now act as ESG rating agencies. Similar to bond rating agencies (such as Standard & Poor’s, Moody’s, and Fitch), these companies set out to define metrics and rank firms based on ESG factors.

However, because the field is so new, there are no regulations and very few established standards. So, investors are somewhat at the mercy of information providers.

Additionally, because companies are not required to report on ESG factors, there’s not even high-quality data available in many cases. As a result, there may be substantial inconsistencies in the raw data, resulting in inconsistent or inaccurate ratings.

3. Larger firms can look better than they actually are

When it comes to ESG ratings, size matters. Research suggests that a “size bias” may result in larger firms having higher ESG scores than smaller ones, on average.[i] However, that does not mean that large companies do better things for society or the environment than smaller firms. Instead, it is more likely the result of these big firms having more resources to devote to developing specific ESG policies and programs.

4. Certain sectors may generate strange results

The industry attempts to rate companies with a “sector-neutral” approach. However, some sectors have far more sustainability challenges than others (for example, oil and tobacco). Because of this “sector-neutral” approach, some oil companies may receive higher-than-average ESG ratings. Until there is a system for ranking these industries more appropriately, keep an eye out for these counterintuitive results.

5. Ratings you see today may be out of date

Because of the current lack of reporting requirements and standards, a “rating” may go out of date quickly. Change in management or other factors may impact company policies or activities, but due to infrequent reviews, may not be picked up for a few years. Hopefully, as new ESG rating technologies and standards are introduced, review points can be more frequent, and this will not be as much of an issue. But for now, those ratings should be looked at based on a specific point in time, not based on frequent updates.

What is in an ESG Rating?

ESG is an exciting development in the investment world, but we need to remember that it is still in its early stage.

ESG ratings should not be looked at as facts. Here is why: a research team at the Massachusetts Institute of Technology (MIT) found that the “correlation” between ESG ratings from different agencies was low when compared to the differences found between bond rating agencies. This team concluded that the information investors receive from ESG rating agencies could be called “noisy.” Another referred to it as “aggregate confusion.”

Changes on the Horizon

While the U.S. has not enacted any regulation, the European Union, fortunately, has taken concrete steps in that direction.[ii] A plan is now in place that will require portfolio managers in Europe to explain how they applied minimum safeguards to determine whether companies are indeed following a sustainable path.

Final Words of Advice

The U.S. is, unfortunately, not keeping up with Europe on any proposed regulatory changes yet. So until then, it is critical to keep in mind that ratings are only opinions, not facts. Until this industry has some regulation and standards on its side, ratings need to be seen primarily as the beginning of research, not the end.

LEARN MORE ABOUT ESG INVESTMENTS WITH ICC

If you’d like to learn more about our ESG investment planning services and have $1,000,000 or more in investable assets, contact ICC founder Randy Garcia at 702-871-8510 or [email protected].

[i] Doyle, Timothy. Ratings That Don’t Rate: The Subjective World of ESG Ratings Agencies. 7 Aug. 2018, corpgov.law.harvard.edu/2018/08/07/ratings-that-dont-rate-the-subjective-world-of-esg-ratings-agencies/.

[ii] Randazzo, Roberto, and Fabio Gallo Perozzi. “EU Sustainable Finance & ESG Factors: Recent Legal Implications for Investors and Entrepreneurs.” Lexology, Law Business Research, 2 Sept. 2020, www.lexology.com/library/detail.aspx?g=befb9df7-2e88-4f03-bd62-c541b88590a3.

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