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As pensions, companies and mutual-fund managers come under pressure to act in line with their investors’ conscience, so-called socially responsible investing strategies have blossomed.
Indeed, investments in funds focused on SRI have grown to $17.67 billion through November, from $2.83 billion in 2015, according to Morningstar. Moreover, the U.S. Forum for Sustainable and Responsible Investments estimates that around $12 trillion of assets in the U.S. are managed under some sustainable investing strategy in 2018, reflecting growing demand for investments that purport to align with clients’ social values.
On top of that, the number of large, publicly traded companies across the globe that have said that they are adopting environmental, social and corporate-governance criteria and the number of fund managers who say they are using ESG screens to identify investments also has been growing rapidly.
According to a survey by KPMG, 75% of the largest 100 companies across 49 countries say they are employing ESG business models or incorporating aspects of sustainability approaches, as of 2017, compared with 12% in 1993.
Yet the debate over how to define ESG or to implement strategies that employ such considerations has drawn confusion, even division, among those interested in furthering those investing aims. This has led to heightened scrutiny among regulators who have complained of a lack of consistency in ESG data and ratings.
“I think the first issue is that we don’t even know what ESG means,” said Securities and Exchange Commission Commissioner Hester Peirce on Tuesday, in an interview with CNBC. “So, I think defining that would be an important first step before trying to develop metrics,” she said.
See: ESG funds face SEC questions over criteria
With that in mind, here’s a general primer of what its proponents claim sustainable investing achieves as well as some of the challenges.
So, what is ESG?
ESG attempts to encompass how a company is performing against a rubric of nonfinancial risks that can’t be measured as a line item in a corporation’s accounting statement, but could still harm it economically if incidents around these risks arise.
Sustainable investors, or anyone who employs ESG criteria, put such risks in three buckets: The environmental component tracks a range of issues including a company’s carbon footprint or how a business has adapted to climate change; Social issues can include product-safety problems and labor abuses in supply chains; Corporate governance assesses the quality of a company’s management and whether the board maintains sufficient oversight.
Yet beyond that, there is a lack of uniformity around basic terms in the industry as different fund managers follow their own approaches to sustainable investing, said Bonnie Wongtrakool, global head of ESG Investments at Western Asset Management, a Pasadena, Calif.-based global investment manager with more than $400 billion in assets.
What are the different approaches?
The broadest pool of sustainable investors fall in the ESG integration school—preferring to look at ESG factors as just another risk to screen stocks and bonds when they are selecting assets. In practice, this might be more about scoring how well companies address nonfinancial risks, and working with executives to improve company performance on such aspects, according to Wongtrakool.
There are other less inclusive approaches, too.
Impact investors look to deliver a specific social and economic benefit and not just financial gains as part of their investment, while socially responsible investors, or SRI, look to exclude and divest from companies outright.
“Clients are unsure of what they want to achieve when they refer to ESG,” said Dan Chi Wong, global ESG specialist at Nikko Asset Management. “Clients may also have varying degrees of understanding of what ESG integration means, conflating it with other ESG strategies such as exclusions.”
This confusion may have also resulted in accusations of mis-selling as investors are surprised by what is held within their ESG-oriented portfolios. In particular, the general public has sometimes been surprised by the inclusion of oil-and-gas companies in ESG-friendly indexes and mutual funds.
“You have investors saying ‘I thought ESG was just not buying fossil fuels,’” said Wongtrakool, but companies that generate revenues from oil-and-gas production could be held by ESG-integrating money managers, who might look to buy stakes in energy companies that perform better on ESG criteria compared against other competitors.
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A recent Wall Street Journal report indicated that the SEC has sent examination letters to investment firms looking into how they determine ESG criteria. Peirce, a Republican commissioner for the SEC appointed by President Donald Trump, has been vocal about ESG investments and has criticized the lack of consistency in ESG ratings across the investment management industry.
Read: ‘Socially responsible’ investors may have unwittingly backed police-state surveillance in China
What issues do sustainable investors face?
A lack of standardized and frequent data on ESG metrics have been a major issue for a category of investing seeking uniformity and consistency, according to analysts at State Street.
Different scoring methods have led to varying grades, at times, for the same company. For that reason, some asset managers have compiled their own scores that use data from third-party providers.
“Different ESG data providers may provide varying but overlapping data, and the opaqueness in how the different data are used in the analysis makes it difficult to integrate the information,” said Wong.
Investors have also complained that not enough companies disclose ESG-related information such as their level of carbon emissions or the number of women that sit on their board. That can sometimes lead to lower ESG scores for smaller companies simply because they may not have the staff and resources to report such information, according to Hamish Galpin at Hermès Investment Management.
That is why institutional investors such as the California Public Employees’ Retirement System have called on the SEC to pressure companies to provide more ESG-related information, and to release accompanying standards for their disclosure. Currently, the SEC doesn’t make such disclosure mandatory, and its officials such as William Hinman, director of the regulator’s division of corporation finance, have outlined a reluctance to force businesses to report such information.
To make up for the lack of regulatory assistance, market participants have turned to organizations like the Sustainability Accounting Standards Board, or SASB, an organization formed in 2011 that provides voluntary guidelines for companies to report sustainability issues that are considered financially material to investors.
In 2018, SASB published a list of 77 standards that they say could materially affect the financial condition or operating performance of a company.
And impact-investing participants point to the Global Reporting Initiative, or GRI, which was started in 1997 and recommends standards for sustainability reporting.
However, there currently is no universally accepted standard for reporting.
Does ESG enhance returns?
Sustainable-investing proponents insist that what is good for society can translate to good investment returns. It is a position advocated by major asset managers who say monitoring ESG factors can offer a valuable window into matters that aren’t reflected in a company’s financial statements.
“ESG data…can indeed be a proxy for reputation and quality of management,” said Wong.
A recent study by the BlackRock Investment Institute found that ESG-focused MSCI equity indexes matched or beat the annual returns of traditional benchmarks over a period between 2012 and 2018. The outperformance was particularly noticeable in emerging markets where corporate disclosure on ESG risks can lag behind that of the U.S. and Europe.
But critics say claims of outperformance are reliant on how investors break down periods of comparison, with different lengths of time yielding different outcomes as to the benefits of ESG.
The promise of marrying profit and values has allowed the industry to rapidly expand beyond its small-time origins when 18th-century Methodists and Quakers would avoid investing in companies involved in the sale of liquor and tobacco, or so-called sin industries, according to Jennifer Coombs, associate professor at the College for Financial Planning.
Modern-day impact investing, perhaps, is often pegged to a 2004 report titled “Who Cares Wins: Connecting Financial Markets to Changing World” from the United Nations secretary-general and the UN Global Compact along with the Swiss government.
Part of that argument is that inattention to nonfinancial risks can lead to a sharp blowback against complacent investors. Recent scandals such as Boeing’s 737 Max airplanes has highlighted the importance of paying attention to such issues, said Thomas Graff, head of fixed-income at Brown Advisory.
“These are the kinds of risks that ESG analysis can sometimes unearth, but classic quantitative business analysis can miss,” he said.
