Critics of responsible investing miss a major point: Only investors can build the best ESG portfolio for themselves. We break down misconceptions and mistakes.
Environmental, social, and governance (ESG) is a hot topic these days, and with its success comes intense scrutiny. Critics have made very strong claims about ESG as a whole, claiming it prioritizes an ideologically monolithic agenda over investment performance. We anticipate more calls to “rein in” ESG as regulators take a closer look at greenwashing claims.
Amid all the hype, what should a reasonable person think? In our view, the controversy is based on confusion between ESG as an open-ended, investment-decision-making framework versus ESG as a single numerical judgment. Let us explain.
What is ESG?
The United Nations Environment Programme first coined the term ESG in 2005, aiming to capture the factors that can impact a company’s sustainability profile. The investment community quickly adopted the term as a succinct way of describing a broad information set about companies. Many observers don’t perceive ESG as explicitly financial in nature, although it can directly affect a company’s financial position. For example, the 2010 Deepwater Horizon oil spill is not only one of the world’s most notorious environmental disasters, claiming lives and polluting the Gulf of Mexico, but it also cost energy giant BP over $60 billion in criminal and civil penalties, natural resource damages, and cleanup costs. This price tag doesn’t consider the reputational impact the company suffered as it continues to make amends through community outreach.
However, there are as many ways to use ESG information in an investment decision as there are investors. A reasonable investor might look at a clean technology company and prioritize its working conditions, its product safety record, or its history of sexual discrimination over the technology itself. Another reasonable investor might look at the same company and judge its social lapses as less important than its environmental innovation. At the end of the day, companies are complex and multidimensional. That’s what makes investing challenging and interesting.
Help your clients tailor portfolios to their principles
Although we believe ESG is an approach and not an outcome, too many investors have come to view ESG as a simple binary label. This is understandable, given the way the media often paints companies as ESG or not ESG in totality, or the way some asset managers describe their process. Primary contributors to this misunderstanding are ESG research providers who sell proprietary ESG company scores that attempt to boil down a company’s “ESG-ness” into a single number. Each ESG research provider has developed their own methodology that seeks to define, prioritize, and assess the most relevant ESG metrics to a company’s performance. This means their scores only express their own individual views of which metrics are material to the company’s business. Furthermore, when many ESG research providers make their headline scores publicly available, they don’t give the public the underlying research and metrics that can help contextualize those scores.
While we welcome more transparency around these assessments, we’re also wary of encouraging the trend of reducing ESG to single and somewhat opaque scores, which are roughly analogous to buy/sell/hold ratings from sell-side stock analysts. Although managers could use that rating simply to decide which stocks to buy or sell, more often they’re using the deeper research insights that underpin that rating to inform their investment decisions. In other words, even if they don’t decide to buy a stock on the basis of the analyst’s recommendation, they might find value in the analyst’s estimate for sales growth and margin trends. Similarly, while some investors might automatically want to buy a stock with a particular ESG score from a particular ESG provider, more often it’s the information that underpins that score that provides value to the investor. This more critical information is available to investors who subscribe for access to the ESG research but not to the broader public, who can only access the overall scores through various portals.
Indexes complicate the matter further. All indexes tend to be rules-based, and they include only companies with criteria that meet a certain threshold, and ESG indexes are no different. Much like ESG research providers, ESG indexes have their own methodologies that reflect their choices of metrics to prioritize. A company may not be included in an ESG index, but that doesn’t necessarily mean it isn’t a “good” ESG company—it just didn’t meet that index provider’s criteria. Another ESG index with different thresholds and criteria could easily include that company.
Let’s take Tesla as an example. CEO Elon Musk was distraught when the S&P 500® ESG Index dropped Tesla, calling ESG metrics as a whole the “devil incarnate.” While most people agree that Tesla’s innovation in battery technology and auto efficiency is a strong win for the environment, its ESG profile is tarnished by controversies surrounding racial discrimination, sexual harassment, overworked workers, and safety concerns publicized after autopilot vehicle crashes. It’s also rather important to highlight that while the S&P 500® ESG Index no longer holds Tesla, the MSCI US Extended ESG Focus Index still does. As you can see, two leading ESG indexes with robust methodologies can have different views and outcomes.
The bottom line
Beware of oversimplifying ESG. There are no shortcuts in responsible investing. Investors who want to integrate ESG metrics into their portfolios should be very deliberate in their approach, making sure to define what matters to them most. Building a socially responsible portfolio that can bolster their beliefs and their bottom line isn’t as complicated as it first sounds. Following these four easy steps can be a great start.
