Three Future ESG Challenges Investors Must Know

In our previous blogs, we covered the best and worst things happening in ESG investing today, as well as the approach we feel is best equipped to handle the latter.

But even though we believe that ESG investing is here to stay, we don’t claim that it is going to be completely smooth sailing from here on out. The concerns raised by recent historical developments are easily addressed, but there are genuine mounting challenges that ESG investors are called to address. Looking ahead, we believe there are three main areas where ESG investing is currently facing its greatest challenges: governance, crypto, and fragmentation. These are areas that expose weaknesses in the current approaches to ESG investing, but also represent the greatest opportunities for both meaningful impact and for potentially high investment rewards.

Governance

An important area where ESG investors should dedicate more attention is governance. Even though it has traditionally been the most neglected pillar among ESG investors, it is fundamentally as important as the other two, and vital for the validity of the entire approach. For one thing, the reliability of ESG data is necessarily dependent on the quality of the governance of the companies that provide them. For another, governance is the one pillar that appears to be persistently correlated with relative outperformance in most studies of ESG as investment factors, across time, markets, and regimes. This is despite it being the pillar for which reliable data are the hardest to come by. For instance, the MSCI cap-weighted governance score saw a big drop in 2015 due to a dramatic change to the underlying model, not a genuine change in the markets. Irregularities in governance scores suggest that the true underlying alpha signal may even be stronger than past studies indicate.

The recent historical developments help further amplify the role of governance by shedding light on two often neglected considerations. First, in addition to the other reasons for which companies with low governance scores tend to persistently underperform, they are more likely to be subject to economic sanctions and regulatory or even criminal penalties. Second, companies with higher governance scores are more likely to identify and take steps to reduce their exposure to geopolitical risk.

ESG investors have already been putting pressure on companies and regulators to improve the governance of companies, and the corresponding data; this pressure is beginning to pay off, both at the individual-company and the regulatory level. However, there’s still a lot of work to be done, especially at the data-provenance level.

Crypto

Cryptocurrencies and their associated ecosystem (e.g., DeFi, NFT, etc.) present a broad-spectrum assault on all pillars:

• Environmental, due to the high and rapidly increasing energy consumption and industrial-level usage of computational resources, including components that rely on valuable raw materials that are difficult to recycle.
• Social, due to their targeting vulnerable social groups, and the high technological and financial cost of diverting resources to potentially negative-sum endeavors.
• Governance, due to the ecosystem’s lower transparency and minimal regulation, the incestuous financial structures they appear to engender today, and the ethical challenges they raise.

ESG investors have yet to mount a coordinated response to this challenge. This is partly because technological advancement has generally had a positive impact on ESG causes, and crypto generally, and undeservedly, covers itself with the mantle of technological innovation. This has resulted in investors with limited understanding of crypto considering it as a potentially positive influence. Another reason for the lack of a coordinated response is that crypto is not taken seriously at the institutional level: this may be a mistake, because it has been generating a high short-term cost and is actively interfering with ESG initiatives, e.g., by obstructing the widespread utilization of sustainable energy.

Fragmentation

Perhaps the most material long-term issue that ESG investors face is the proliferation of choices at every aspect of ESG investing, including data sources, ratings, investment approaches, regulatory frameworks, etc. This large variety was to be expected in the early stages of ESG investing; it is even desirable to the extent that exploring different approaches makes it easier to identify the ones that are more effective in practice sooner rather than later. However, as this proliferation of ESG flavors continues, it is increasingly becoming counterproductive.

To take one example, the apparent embarrassment of riches for ESG data presents a recurring test for investment managers: if they forgo one of them, they might miss valuable information that complements aspects that can help them meaningfully improve their models. If they do not forgo them, they will incur an economic and analytical cost to obtain and digest it, while they will also often find that the data are redundant or useless (due to the data’s coverage, reliability, or materiality). This is a far cry from most other types of financial data, which are both standardized in format, mandated by regulators, and easily available.

The establishment of ESG standards at every level of investing is only beginning, and it will require uncommon levels of coordination and good faith, but it’s also the area that will have the greatest impact in helping to move ESG investing to the mainstream.