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What is holding back ESG integration?

By Jenal Mehta

08:00, 13 December 2021

There is evidence of superior returns from ESG investments in the long term and during economic downturns – Photo: Shutterstock

ESG investing is a method of socially responsible investing, where environmental, social, and governance factors are considered along with traditional fundamentals while making investment decisions. 

There has been a change in attitude in recent years towards ESG investment. This increased interest comes not only due to heightened awareness in climate change but also because a company’s ESG practices helps create a more informed investment decision, giving light to risks and opportunities which traditional methods may miss.

There is evidence of superior returns from ESG investments in the long term and during economic downturns. Many ESG funds did in fact outperform during the recent pandemic. 

Despite this, it is clear from research that poor quality data behind ESG disclosures is holding back further integration. Many investors have shown concerns about ESG reporting, stating this is the biggest reason for them not investing in more sustainable investments.

Financial regulators have realised the need for tighter mandatory disclosures and are moving towards meeting these demands. This will hopefully give the sustainable investor the opportunity to invest more efficiently.

ESG becomes mainstream

Interest in ESG has been growing in recent years.  Per Morningstar, European sustainable funds attracted €120bn ($135bn) in the first quarter of 2021, an 18% increase from previous year, with climate change funds being the top sellers.

There also appears to be increasing confidence in ESG-focused stocks. They proved resilient against the downturns during the pandemic as per S&P market intelligence.

The impact of the pandemic has accelerated investor interest towards more sustainable investments. In a survey conducted by Berenberg, 112 individuals, 38% of whom were private investors, were asked on their sentiments about socially responsible investing.

They found that 85% said they consider Sustainable Development Goals (SDG) when investing, of which 50% said these issues directly affect their investment decisions.

This sentiment shift is also seen in professional investor sentiment. In a report by PwC,  325 Investors were surveyed globally, comprising of mainly active asset managers and analysts , they found the following replies:

Notably, the survey showed 75% of investors believe companies should address ESG issues even if it comes at the expense of short-term profitability, however these investors will only accept about 1 percentage point reduction in long term returns. Investors appear to be caught between their fiduciary duty towards their clients and adhering to their responsibility to social issues.

 The question becomes what is holding investors back from achieving both?

Calls for more useful disclosures…

As more individuals take interest in ESG investment, the more funds have started including these types of stocks in their portfolios. This in turn has brought ESG reporting into spotlight. In an environment where investment fundamental is tracked, the current ESG reporting standards are simply not comprehensive enough to be incorporated in robust investment practices.

PwC found that about two thirds of investors think the current quality of disclosures are not good enough. They also found that 76% of asset managers said that better regulation is a key driver of their ESG investment focus, and helps eliminate greenwashing concerns.

The current disclosures made by companies are in absence of any government-mandated standard. This results in a lack of consistency making a company’s ESG actions incomparable to its peers. Furthermore, these disclosures are not subject to third-party verification, majority of investors who surveyed with PwC found this to be a significant challenge.

Inconsistent regulation means ESG ratings are also difficult to be relied upon. As it stands, the current rating agencies all have different methods of calculating their ESG scores, resulting in a company having differing scores with different agencies. This creates a poor relationship between the ratings and returns. This is an issue pointed out by Schroders.

OECD have commented on these current shortcomings:

“This lack of comparability of ESG metrics, ratings, and investing approaches makes it difficult for investors to draw the line between managing material ESG risks within their investment mandates, and pursuing ESG outcomes that might require a trade-off in financial performance”

… are being heard

During Cop26 help in Glasgow in November 2021, the International Financial Reporting Standards (IFRS) formally announced that they will be establishing the International Sustainability Standards Board (ISSB). They will also consolidate existing Climate Disclosure Stands Board (CDSB) and also the Value reporting standard (VRF) by June 2022. The IFRS said this decision has come directly due to proven demand:

“Investors and other providers of capital want global sustainability disclosure standards that meet their information needs. Voluntary reporting frameworks and guidance have prompted innovation and action, although fragmentation has also increased cost and complexity for investors, companies and regulators”

Per Ernst and Young, the number of global mandatory ESG reporting provisions has increased by 40% between 2016 and 2020, with Europe having the largest number of mandatory and voluntary compliance measures.

MSCI reported that at least 34 different regulatory bodies have implements new ESG measures in 2021 alone, with all of them having transparency and materiality among their main objectives.

Does ESG add value to investments?

While we wait for regulation improvements, the current relationship between ESG and financial performance is a point of contention. 

A study published by MSCI showed that the top one third of the highest ESG rated companies outperformed the lower rated companies. These companies had higher growth in earnings, dividends, and active returns. MSCI noted this outperformance was not due to a higher premium that investors had to pay for more fashionable ESG rated stocks. 

A study published by NYU Stern reported on 1,000 plus studies on ESG between 2015 and 2020, and they found these key facts:

The OECD has also agreed on the potential long-term benefits of ESG:

“ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation”

In 2021, Larry Fink, Chairman and Chief Executive Officer at BlackRock, wrote in his annual Letter to CEOs : 

"It’s not just that broad-market ESG indexes are outperforming counterparts. It’s that within industries – from automobiles to banks to oil and gas companies – we are seeing another divergence: companies with better ESG profiles are performing better than their peers, enjoying a 'sustainability premium'”

BlackRock’s research found that in the first quarter of 2020, 94% of companies saw that their sustainable indexes outperformed their parent benchmarks.

In the other corner, studies have found the ESG positives are overblown. A study by The Scientific Beta said there is no positive alpha signal (the net forward-looking estimate of an asset's future potential relative to other securities in a coverage universe) from ESG factors, notably they used only one ESG rating agency and conducted their research for a short period of time. They conclude the following:

“Our findings question a widespread practice of using ESG as an alpha signal. They do not question the value-added of such strategies on other dimensions. Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk. Investors would benefit from further research on these important questions."

It would appear the market is not fooled by companies just making public disclosures, their actions and improved operations in line with their disclosures is what drives better financial performance, and this impact takes a long time to come to fruition and is beneficial for long term passive investors.   

By contrast, in a competitive market where active investors with short time horizons are constantly looking for information advantage,  inconsistent and unverified ESG disclosures do not keep up with the fast paced environment.

The future is green

As individuals become more aware of their social responsibility, especially regarding climate change, there will certainly be an increased focus on ESG commitments of the companies they invest in. This change has accelerated during the recent pandemic.

The positive results seen long term with ESG investing leaves hope for the sustainable investor, but there needs to be a regulatory push before we see better short-term performance.

The sustainable investor is for the moment stuck at a hurdle of finding meaningful ESG fundamentals to help them make informed decisions. Looking at the recent movements by regulators, a more efficient ESG investment market maybe just around the corner.

 

Read more: The rise of NFT companies floating on the stock market

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