3 ESG Investing Challenges You Need to Know

Topics: ,

Published on August 8, 2019

| 5 min read

Kevin Armstrong, CFA, Managing Director, Consultant Relations

Share:

The investing world is seldom cut and dry.

Nowhere has this become more apparent than investing in environmental, social and governance issues, also known as ESG.

Definitions for handling ESG issues “responsibly” are somewhat ambiguous and subjective. How does one decipher – or even compare – corporate ESG reports? This has always been a challenge for Socially Responsible Investing – also known as Sustainable, Responsible and Impact investing.

But times are changing.

Just 100 years ago, financial reporting standards didn’t really exist either. Even the best investment analysts likely found it difficult to assess a company’s financials and compare it to others. That’s obviously changed, and we’re seeing similar movement with ESG reporting.

Organizations like the Sustainability Accounting Standards Board, Task Force on Climate-related Financial Disclosures and industry groups like the Edison Electric Institute, who engage directly with the institutional investment community, are beginning to codify ESG disclosure standards for investors.

These efforts, combined with multi-national agreements, have helped pave the way to more complete and comparable ESG assessments. For example, in 2007 only 66% of companies in the MSCI World Index had a score for carbon emissions versus 99% of the companies by 2018 (Figure 1).

share of companies reporting carbon emissions

 

Some Challenges Remain

While ESG reporting standards have emerged, they’re certainly not today’s financial standards. Despite more reporting consistency, assessments of those reports vary from manager to manager because of differences in appraisal, use of third-party data and assessment methodologies.

First, ESG appraisals inherently involve judgments. All ESG managers incorporate ESG criteria in their analyses. But which do they include? And how do they prioritize them? The specific ESG criteria and their relative importance will differ from manager to manager, resulting in different assessments and different portfolio holdings at different weights.

Second, a complete ESG evaluation of a company requires data sources beyond company reporting, including governments, NGOs and private research firms. ESG information from companies might be gradually homogenizing, but ESG information from third parties will generate different estimates even when measuring the same ESG element. Prioritizing and incorporating this information may also create differences in assessments – even biases (Figure 2).

 

potential bias in ESG research

 

Size Bias – Larger companies may receive better ESG reviews because they can dedicate greater resources to prepare and publish ESG disclosures, and control reputational risk. This can skew cores, rewarding large firms with higher ratings while penalizing those smaller companies with limited resources. Geography Bias – Higher ESG assessments for companies domiciles in regions with higher reporting requirements are another potential bias. For instance, a manager may positively bias an ESG analysis for a European-domiciled company, given the region’s stringent company disclosure requirements – a primary ESG data source. Industry Bias – Normalizing ESG reviews by industry is important given common systematic risks, but weighting those risks uniformly higher relative to company-specific risks can be a source of bias. Companies in the same industry may not operate similarly or respond to ESG issues equally. Normalizing analyses can oversimplify.

Finally, ESG managers, in an effort to uncover unique insights, have developed proprietary – sometimes-opaque – assessment methodologies. While all approaches may offer strengths, they also have contrasting characteristics of ESG impact, making differences in ESG appraisals inevitable.

Tackling the Challenges

Sustainable investing has matured from a ‘save the world’ philosophy to mainstream investing in a relatively short period of time. This rapid growth has unearthed new challenges for institutional investors. To help you navigate these new challenges, we offer a framework to assess your investment priorities as well as your ESG preferences in our most recent paper, “What to Look for on the Road to ESG.”

What to Look for on the Road to ESG ESG investing guide for decision-making. Download Paper

 

The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions. The information, analyses and/or opinions expressed are for general information only, and are not intended to provide any specific financial, economic, tax, legal, investment advice, or recommendations for any investor. It should not relied on as the sole basis for investment decisions. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained in this webcast. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed. Past performance is no guarantee of future results. Investing involves risk, including fluctuation in value, the possible loss of principal, and total loss of investment.