The demand for socially responsible investments has exploded in the wake of the Covid-19 pandemic, evidenced by record capital inflows into funds built around environmental, social and governance (ESG) considerations.
The heightened interest in sustainable investment has, in turn, led to a record number of ESG funds launching in 2020. These funds are composed of companies with strong ESG credentials and have sustainability built into their business models.
Experts argue, though, there’s more to ESG investing than just staying away from fossil fuel or tobacco companies. Moreover, most companies nowadays claim to be committed to global ESG issues, including workforce diversity, gender and racial equality, clean energy and community support, among others.
As the pandemic underscores the interconnectedness of sustainability and financial costs, investors want to know if the companies they are holding in their portfolios genuinely care about ESG.
“Investors are becoming increasingly aware of ‘greenwashing’ as some investment companies seek to capitalise on the global boom in ESG investing,” says Nigel Green, chief executive and founder of deVere Group, a financial advisory firm.
To avoid buying into companies that are fudging their ESG credentials, investors should understand ways these businesses are evaluated for their commitment to sustainability.
Metrics to measure ESG
The need for assessing ESG credentials of businesses has spawned companies that specialise in issuing ESG scores, reports and ratings that serve as a benchmark for sustainability and guide investing decisions.
Firms that rate companies on ESG issues look at a range of metrics. These assessments identify issues financially material for a company and demonstrate how well companies are managing their ESG risks.
In a sense, it's a measure of the ESG risk that has not been managed by the company, says Trevor David, associate director at Morningstar-owned Sustainalytics, a global ESG research and ratings firm. "Ultimately, we reach an absolute overall rating based on five categories of unmanaged risk [spanning from] negligible to severe," Mr David says.
The agency, which rates nearly 12,000 businesses, looks at certain characteristics when determining a company’s ESG score. The process of identifying issues with significant business risk forms the foundation of the overall assessment.
“Corporate governance, for instance, is considered a material issue for all companies,” Mr David says, adding that a company’s corporate governance practices could detract from or add to their business strategies.
It’s also important to examine the degree to which an ESG risk can be managed by the company and what portion of it is unmanageable.
“For certain issues, like cybersecurity, we consider a portion of risk exposure to be unmanageable,” Mr David says. “Despite a company having strong data privacy and security programmes in place, there remains a degree of inherent risk of a data breach.”
A typical ESG risks assessment “involves [studying] relevant policy commitments, operational programmes and management systems against underlying elements of best practice”, Mr David adds.
Other indicators such as lost time injury rates and a company’s involvement in negative events – such as an oil spill or community protest of a pipeline – also serve as “important data points to inform our view of how companies are managing a given issue, and to what extent policies are translating into practice”, he adds.
Sometimes, the rating agency may ask companies to provide additional information that hasn’t previously been publicly disclosed, but is relevant to the assessment.
Knowing the score
At the end of the evaluation, a company is given an overall ESG risk score, which is the aggregate of its environment, corporate and governance risk scores. Based on a 0 to 100 scale, the higher the score, the more elevated a company’s ESG exposure and the greater the probability of a material financial shock.
A risk score between 0 and 10 is rated negligible, 10 to 20 is low, 20 to 30 medium, 30 to 40 is categorised high and anything above 40 is regarded as severe ESG risk exposure.
These ratings are critical, not least because some companies talk the talk but won’t walk the walk. While more companies than ever before are taking ESG seriously, some still don’t disclose relevant information or back statements with meaningful actions.
“Our approach to getting past this disconnect is to apply a robust and consistent research framework to evaluate a company’s exposure to and management of material ESG risks,” Mr David says.
In other words, a company isn’t awarded any points for Facebook posts about their recycling programme. It is the adherence to principles of best practice that guides the assessment of the strength of a company’s ESG programme.
Having robust structures in place to address issues such as carbon intensity, fleet emission, workforce injury rates or having whistleblower programmes around business ethics are “really helpful in understanding how company performance is changing year over year relative to peers”, Mr David says.
Historically, investors have associated ESG investing primarily with environmental performance, but the pandemic has highlighted other issues including employee health and safety, diversity and inclusion, and data security associated with increased remote working.
How should investors make sense of this?
Investors need to be clear about what they expect from their investment in a fund and what role it will play in their overall portfolio, says Anaelle Ubaldino, head of ETF research and investment advisory of the Amsterdam-based TrackInsight.
However, massive marketing budgets for ESG funds and slick social media campaigns can gloss things over and mislead unsuspecting investors.
“Investors need to do their homework and look closely at the methodology of the ETF, the fund’s holdings and exposures to countries and industrial sectors, as well as more ESG-focused metrics with sensitive sectors [such as weapons or nuclear] and international norms [such as human rights or environment],” she says.
ETFs are usually very transparent with information on underlying securities, but they rebalance their holdings periodically. The investor should look at whether the readjustment has altered the exposure, creating a conflict with their investment goals or ESG principles.
Look out for key attributes of a fund including its core values, in-fund reporting, its voting policies, whether the research is in-house or third-party, and whether they are signatories of the United Nations’ Principles of Responsible Investment (PRI), Mr Green cautions.
“All of this,” he adds, “should be transparent and well-documented. If it’s not, you may want to question why.”
ESG factors and pandemic
Apart from environment, workforce is another leading factor that has leapt to the forefront of conversations during the pandemic, Rajesh Nair, fund director at Ganita Group, says. The pandemic served to “separate those who were first to kick their workforce to the curb and those who [took steps] to protect their employees”, he says.
Companies that recognise the importance of adapting to changing socio-economic and environmental conditions are better able to identify strategic opportunities and meet competitive challenges.
“ESG compliance has been integrated into business reporting [and] every major business now is extremely likely to have a climate/sustainability policy and good governance strategies,” Mr Nair says, pointing out that “those companies that have focused on ESG have been rewarded with strong performance and are likely to continue to do so in the future”.
For that reason, the uptake in ESG investing is expected to continue to accelerate. “Sustainability considerations now sit at the heart of the investment decision-making process,” Mr Green says. “The health of our planet and how it affects human health and the way we all live and work has come dramatically to the fore.”
Funds investing in ESG
A growing number of fund issuers are tapping research firms that specialise in ESG risk assessment to create ESG funds that are tailored to specific sustainability themes and investors’ values. Money managers, however, have their own definition of what constitutes ESG, so the methodologies many vary dramatically.
“Many fund managers opt to construct portfolios using a ‘Best-in-Class’ approach – selecting the ESG leaders from the target country, sector or region based on either their own research or a third-party rating,” Ms Ubaldino of TrackInsight says.
“Others may use an exclusion approach – removing companies that carry high ESG risk or are involved in controversial industries like tobacco, weapons or gambling.”
Ms Ubaldino says data from her firm shows that the most widely used ESG methodology in ETFs (49 per cent of all ESG ETFs) is full integration.
“This goes beyond attempting to ensure that every company in the portfolio is ESG-focused, by under-weighting companies with low ESG scores and over-weighting companies with higher ESG scores,” she says.
However, as the meaning and scope of ESG evolves, and the range of products grows, it becomes harder for the average retail investor to compare, screen and choose investments that fit in with their idea of ESG and investment needs.
The financial industry is trying to fill the gaps in investor understanding through sustained efforts to educate consumers. For now, though, it may be advisable for investors who lack financial sophistication to rely on the expertise of investment managers and financial advisers.