The Informed Investor
This is the third article in a series on ESG Investing.
In this third article in our series on ESG Investing, we want to provide something very practical: insight into what to avoid in this new investment arena.
ESG Investing, also referred to as 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, there are many corporations and fund managers who are highly committed to this more ethical form of investing. But as in most 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.
- Beware of “greenwashing”
The push toward ESG (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, as well. With all of these pressures, any public company will be looking for ways to easily increase their attractiveness on these ESG fronts. This is often referred to as “greenwashing.”
Greenwashing can be quite different 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.
- Reporting standards do not really exist yet
In terms of concept maturity, ESG is still pretty much in the “wild west” phase. There are several firms now that 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.
Because the field is so new, however, there is no regulation, 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 is not even high-quality data available in many cases. As a result, there may be substantial inconsistencies in the raw data that can result in inconsistent or inaccurate ratings.
- 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.
- Certain sectors may generate strange results
The industry attempts to rate companies with a “sector-neutral” approach. But in reality, some sectors have far more sustainability challenges than others (for example, oil and tobacco). But because of this “sector-neutral” approach, you may find some oil companies receiving higher-than-average ESG ratings. Until there is a system for ranking these industries more appropriately, keep a lookout for these counterintuitive results.
- 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.
[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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