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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

 

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