Critics of ESG investing will say that it falls short of both of these goals with statements such as ESG investing may even lose you money, and there is no way of knowing if ESG companies are actually good things and that they may even be worse for the planet. I’m here to tell you that this is not exactly the case, you just need to know what to look for and better understand what ESG investing actually is.
What ESG Investing Actually Is.
While the common idea of ESG Investing as a tool to create a better world is close to what it really is, it misses the true intention. ESG investing is the idea that by examining the non-financial risks to a company and better managing those risks, a company is better able to ensure its long-term success and profitability.
Risks include Environmental, Social, and Governance risks.
Examples of environmental risks could include the risk of climate change damaging farming abilities, water shortages interrupting steel manufacturing processes, loss of diversity preventing fishing abilities and many others.
Social risks could include things like employees leaving a company to seek higher wages elsewhere, employees striking against work safety conditions, and so on.
Governance risks may include having a diverse board that is satisfactory to all stakeholders, avoiding bribes and corruption, and others.
All of these risks could damage the companies ability to profit in one way or another, may it be by directly impacting its ability to sell a product or service or through damage to its reputation. Companies that better manage these risks are often more profitable and attractive to investors because they are less risky than traditional companies.
By managing these risks, companies do good for profit, people and the planet. However, the benefit to people and the planet is more of a byproduct of ensuring profitability and protecting the company from these risks, rather than the company doing good because it’s the right thing.
This isn’t necessarily a bad thing, simply that the goal of ESG investing isn’t exactly what people think it is.
Companies are still doing good things for people and the planet, but it’s more out of self interest. Companies only manage their own risks and impacts, and not those outside their own operations or ones they have only small impacts on.
Companies exist to make a profit, so in my mind, if that’s what it takes for them to better consider their impacts, then I don’t think it’s such a bad thing. But this isn’t the real issue critics have ESG investing.
Where The Controversy Truly Lies With ESG Investing
The major problems people have with ESG Investing can be broken down into 2 main issues. The first is that critics claim that ESG investing does not actually lead to better investments and may even lead to bad investments. The second is that it’s difficult to know if a company or investment fund is truly following ESG practices or simply greenwashing.
Profiting With ESG
I’m not in any way an investment expert, and this article is not intended to be investment advice. I have a background in sustainability and simply want to give my take on an issue that I think has gotten some wrong attention.
The claim that you cannot make money with ESG investing is simply not true. In fact, in one of the most comprehensive studies [1] on ESG investing, researchers looked at over 2,200 individual studies of ESG and a companies financial performance. In about 90% of those studies, they found a nonnegative relation, and that the large majority reported positive findings.
Interestingly, one group of researchers attempted to show that ESG funds don’t lead to profit [2].
In this study, the researchers looked at a group of funds labeled as ESG funds on Morningstar, which is a site with a range of financial information and tools to help you make investment decisions.
What they found was ESG firms appear to financial underperform compared to other funds. I know what you’re thinking. Didn’t I just say you can make money with ESG?
This is where this study gets interesting.
In this study, the researchers looked only at a list of self-reported ESG firms. These companies simply claimed to follow ESG practices, even though there is no proof they follow through.
The interesting part about this is that Morningstar has its very own tool, known as Sustainalytics, that is used to screen companies for their ESG practices for this very reason.
For some reason the researchers decided to not use this well-vetted list of companies screened by Morningstar and instead focused on companies that self-labeled as ESG funds. It’s as if the researchers attempted to show ESG investing is a tactic used by companies to greenwash and mislead you in order to get your investment dollars, all while the researchers themselves are using misleading data.
This leads us to the other major criticism of ESG investing.
Truly ESG or Greenwashing?
Many companies try to claim they are ESG oriented, even though they really aren’t in order to attract positive attention and investments. A much less talked about issue is that companies that do have legitimate ESG practices can be hurt by this because they cannot stand out among all the noise.
To combat this, ESG rating agencies collect data from various sources in order to come up with an ESG score for a company or fund.
They will look at all the possible related financial ESG risks to a company and use available data to determine how well the company addresses the impacts of those risks. The ratings by these agencies are often so valuable or harmful to a company, that a positive annual ESG rating from a prestigious rating agency often cause stock prices to rise.
While these tools have been created to give investors a better understanding of the ESG landscape, critics will also point out flaws among the rating agencies and their methodologies.
I think all of this brings up an important point. So far, there is no issue with ESG investing itself, rather its the misinformation around and about ESG investing that causes problems.
So how do we find credible ESG ratings that can deliver on their promise of revealing how well companies manage their ESG risks?
Which ESG Rating Should I Trust?
As I said before, I have a background in sustainability and part of that is in creating a sustainability rating system that has touched hundreds, maybe thousands of companies across the world. The rating system is used by a different industry, but there are some key concepts I’ve learned over the years that are helpful with finding a solid ESG rating agency.
Here are some key things to keep in mind about rating systems and in finding a rating agency.
Tip 1: Materiality – Less is More
First, when trying to build a rating system, companies will often only focus on the impacts that matter most in building their ratings. In my experience, this is a good practice.
If you try to collect all possible related information on sustainability to build the most robust picture possible, you’ll need to collect so much information that companies simply won’t want to complete your rating system, as they are busy with other things.
Only including the important impacts is often referred to as materiality and each company will decide what is and is not considered material. Plus, the more information that you cram into a rating, the harder it is to find reliable data sources and the less important each individual criteria becomes.
Tip 2: Scientific Rating System
The next thing I would keep in mind is to find a rating system that selects its criteria based on data and reason, rather than something more arbitrary. For example, are climate change variables being included because they have a clear, data proven impact on financial performance? Or simply because the rating agency thought it should be included?
The goal of ESG investing after all is to reduce real threats to financial performance and so the ratings should actually be built to do just that.
Tip 3: Valid Data Sources
Related to this, the next thing I would look for is that the company uses legitimate data sources to power their ratings. Critics of ESG investing will point out that different ESG rating agencies often use different criteria in their ratings and evaluate each of those criteria differently.
One study [3] even found that there is only about 30-70% overall among the popular rating agencies. So how can a company be truly measuring ESG when different ratings from different agencies are also claiming to measure ESG properly, all while having different ESG ratings?
It’s not exactly a bad thing that different models have different results. It’s not uncommon for this to happen. Just look at the weather data. Each weather station may say something different about the path of a hurricane for example.
This brings up the important point that each model is showing something very specific and often slightly different.
For example, one study [3] found that 56% of the difference in ESG ratings is simply because different agencies use different data to compare the very same variables. It would be as if I were to measure the weather based on average temperature and you do it based on the number of sunny days.
They are both correct, just showing slightly different things. So as an investor using ESG data, you need to understand the ratings put forward by a company and what they do and don’t actually mean.
Tip 4: Clear Rating Values
One of the last tips I can give is to use data from a well-respected agency that gives you the data in a digestible way.
Rating agencies often try to get creative with their ratings and this can get confusing. For example, if a car agency told you the rating they are given to a car you are interested in buying is 4 stars, what does that mean to you?
To me it means almost nothing.
What does 4 stars even mean? How much better is it than 3 stars? Is there anything higher than 4 stars?
4 stars also tells me nothing about the individual performance of different parts of the car. Is it getting 4 stars because it’s really good on gas and affordable, but is also bad on safety?
This is why it’s best to look for a rating system that gives a clear score, for example from 0-100. It also helps to get scores in individual areas.
In the case of ESG investing, is there a separate score for environment, social, and governance? Can they break it down even further?
If so, that data can be particularly useful, especially if you want to invest in companies that better align with your own goals. You may care a lot about the environment and social risks, and less about governance, may it be because of your own sustainability values or because of your investment strategy. Either way, a more transparent rating system gives you this ability.
One of the companies that does this well in my opinion is one I mentioned earlier, Morningstar’s Sustainalytics. Again I’m not an investment expert and not trying to give investment advice, so I’ll leave that to the experts. In one study, it was noted:
“Sustainalytics is “known for its credible and independent environmental analysis as well as its vast research coverage” [4].
I think Morningstar checks a lot of the boxes for things I mentioned to look out for. Still, just like with traditional investing, there is no guarantee you will or won’t make money. You still need to know what you’re doing and what to look for and I hope this article helped with at least part of that.
If you want to learn more ways to save or make money through sustainability, check out this article on the solar tax credit next.
Sources
[1] – ESG disclosure and financial performance: Moderating role of ESG investors
[2] – Do ESG Funds Make Stakeholder-Friendly Investments?
[3] – Aggregate Confusion: The Divergence of ESG Ratings
[4] Newsweek Releases its Green Rankings Featuring America’s Top 500 Companies