The development of common standards for ESG investing is still a work in progress, making it vital for investors to look “beyond the ratings" when building and executing an ESG strategy.
The UN Principles for Responsible Investment (PRI) have become the basis for the ESG frameworks and philosophies that many major asset managers and investors use to guide their ethical investing strategies. These six principles are “a voluntary and aspirational set of investment principles that offer a menu of possible actions for incorporating ESG issues into investment practice”.
Signatories to the PRI commit to following six broad principles. Three of these directly relate to how the signatories implement ESG issues in the assets they manage or own:
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
While the other three are intended to promote the wider adoption of ESG investing:
- Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
- Principle 6: We will each report on our activities and progress towards implementing the Principles.
Exactly how each principle should be implemented is down to the signatories, but the PRI provides guidance on possible actions, which range from the development of ESG-related tools and metrics to inform analysis and decisions to the adoption of formal policies on how the shareholder will vote on ESG-related resolutions.
The benefits and limits of ESG disclosures
While ESG investing sounds simple in theory, analysing whether a company makes a positive or negative contribution on many of the key ESG factors is not always straightforward. The kind of financial reports that companies have always provided will often give little insight into the ESG implications of their operations.
A growing number of companies are now providing additional ESG disclosures, but these disclosures are typically voluntary. While financial reports are governed by well-established international accounting standards and regulations, there are no consistent global standards for ESG reporting. This makes it difficult to compare the information that companies provide.
The problem of greenwashing
Some firms still choose to disclose very little ESG information. In the worst cases, unscrupulous management teams may exploit the lack of standards to distort or fabricate their ESG performance – a practice known as “greenwashing”.
However, the International Financial Reporting Standards (IFRS) Foundation has started discussions to integrate climate-related disclosures into financial reporting. In addition, there is a welcome trend towards expanding the scope of sustainability disclosures and going beyond climate-related issues to provide a more holistic picture of environmental impacts. For example, the Taskforce on Nature-related Financial Disclosures (TNFD), which is planned for 2023, builds on the work of the Task Force on Climate-related Disclosures (TFCD) and is intended to ensure that companies give a fuller picture of their environmental risks.
Meanwhile, the European Union’s Sustainable Finance Disclosure Regulation (SFDR), which came into effect in 2021, is intended to ensure that financial institutions provide investors with more insight into the sustainability standards of many of their products and services. Companies must explain how they integrate sustainability risks into their investment decision-making process, while products that promote ESG characteristics or have a sustainability objective must provide details of how their goals will be measured and met.
ESG criteria: why it's vital to look beyond the ratings
Various private companies have developed their own ESG criteria and ESG ratings to fill this information gap. For example, index providers such as MSCI, S&P Dow Jones and FTSE Russell have developed a range of ESG data, ratings and reports that are used for analysing the ESG performance of individual companies, assessing the ESG impact of portfolios and constructing ESG indexes and other benchmarks.
The growing availability of ESG data is helping to drive the expansion of ESG investing and helping to integrate ESG into the investment process. However, ESG ratings for the same company can differ significantly between two providers. This suggests that the future development of global ESG reporting and analysis standards will be vital to ensure that ESG investing achieves its full potential for integrating ESG issues into global capital markets.
While the existence of such ESG ratings and scores is critical for financial institutions to offer ESG investment solutions, the use of them presents a number of challenges:
- Lack of common standards means that the choice of ratings provider may influence investment decisions
- A weak ESG score is not necessarily a reason to exclude an investment if the company is making better progress at improving its standards or actions than other businesses in its sector
- A high ESG score at the present time does not necessarily equate to a business that is sustainable over the long term
These challenges show that investors need to look beyond the ratings and analyse more closely how companies are performing against selected ESG themes.
The most popular ESG strategies
There are a vast number of ways in which investors can implement ESG strategies and work towards ESG goals. These include screening investments based on ESG factors such as the ones listed above; the use of investment vehicles designed to achieve specific ESG objectives, such as “green bonds”; making direct investments in companies that aim to have a positive impact on particular ESG issues; and engaging with companies with the express intention of pushing management to improve ESG performance.
Three of the most popular strategies are:
- “ESG integration” – which involves systematically incorporating ESG factors into financial analysis as part of the process of assessing a company’s strengths, weaknesses and risks – has grown rapidly in recent years and is now the largest strategy globally. It accounted for around $25.2 trillion of assets by 2020, according to the Global Investment Sustainability Alliance.
- “Negative screening” or “exclusionary screening” – under which investors avoid companies that do not meet their environmental, social or governance criteria – is the longest-running approach to ESG investing and remains the second-largest area today. Almost $15.9 trillion in assets was managed on this basis in 2018.
- “Corporate engagement” and “shareholder action” – which covers a broad range of scenarios in which investors try to bring about positive change at investee companies – was the third largest category, with around $10.5 trillion in assets.
ESG and the climate crisis
The transition from an energy system based on fossil fuels to one based on renewable energy in order to reduce carbon emissions is one of the world’s most pressing challenges but also potentially an enormous opportunity. ESG-focused investors could choose to eliminate sectors such as coal mining or oil and gas production from their portfolios. This would be an example of negative or exclusionary screening.
Alternatively, they could choose to take into account the ESG impact of the oil and gas industry, and the way that each individual oil company behaves, as part of their analysis of whether it presents a sufficiently attractive investment. This would represent ESG integration. Pushing the company to take all possible steps to reduce its environmental impact (as well as any social or governance concerns) would be an example of shareholder engagement.
Other approaches to ESG investing include “positive screening” or “best-in-class screening”, where investors look for companies that have the best ESG performance relative to sector and industry peers, and “norms-based screening”, where companies are screened against internationally accepted minimum standards in areas such as environmental protection, labour welfare, human rights and corporate governance.
What is the difference between ESG and sustainable investing?
Investors sometimes use the terms “ESG investing” and “sustainable investing” as if there is no difference between them. In a small number of cases, this is true, but ESG investing covers a much wider and more complex range of scenarios.
Sustainable investing usually refers to investments in companies that use natural resources and interacts with people and other organisations in a way that causes as little harm as possible. It will often be applied to investments in industries such as clean energy or sustainable agriculture, although it could apply to any business practice that is viewed as sustainable over the long term.
Any sustainable investment criteria will fall under one of the three ESG pillars, because these are intended to measure the full non-financial performance of a company. However, sustainable investors typically see avoiding causing damage as their top priority and are likely to be willing to accept lower investment returns as a fair price for a clean conscience.
However, research has shown that a broader approach to ESG investing can allow us to do good without compromising on returns. An ESG investor may decide to invest in a company that operates in an industry that currently has significant ESG impact, but strives to do so in the most responsible way possible, or one that can be pressured to do better. As such, ESG can provide a powerful mechanism to motivate companies to improve their performance.
What is the difference between ESG and impact investing?
Like sustainability investing, impact investing is a smaller area that falls under the wider umbrella of ESG investing. As its name suggests, impact investing is an approach that actively aims to bring about positive change, rather than avoiding or mitigating harms.
This typically means specific investment focused on solving environmental or social problems. These might be a large-scale investment, such as funding a clean energy project that will replace fossil fuel power sources.
However, impact investing projects are often focused on communities, social groups and individuals that are not well served by the market. Examples include physical infrastructure (clean water, sanitation, better housing) or social infrastructure (education, financial services).
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