The widespread awareness and adoption of sustainable investing has shown us that, due to better technology and heightened transparency, investors are more aware of how their money is being put to work, with more information at their fingertips than ever before.
The growth in sustainable investing is undeniable, and was largely unencumbered until recently. For years now, leading asset managers have considered ESG issues in the investment process as a tool to make better investment decisions that reflect a broader set of risks and opportunities. More data and research to provide a clearer lens on companies. Increasingly more asset managers have decided to use ESG information. Many have decided to market that they do, and either overstate their use of ESG information in fund labels and collateral, or communicate their approach in generalities that are vague and that the average retail investor may not understand. This has led to a certain level of skepticism from investors, which is understandable. Regulatory bodies globally, as a result, are working towards implementing a framework and taxonomy for how to label and classify funds based on the approach to sustainable investing. These developments are an important part of an evolving financial ecosystem.
In the process of this shake out in terminology, proponents of sustainable investing have gotten caught up in their highbrow definitional debates, while critics have tokenized “ESG” and weaponized it as a political agenda. Typically, these critics have tended to have a fundamental misunderstanding of what sustainable investing encompasses.
The acronym ESG is relatively new to the average investor, not widely understood yet, and has been oversimplified and misconstrued.
Usually the minute someone says “it’s more nuanced than that” you see people’s eyes glaze over. They want the sound bite. The sexy tag line. And then the easy button. That’s how we got here.
So let’s set the record straight on a few things.
From the CFA Institute: In many ways, sustainable investing can be seen as part of the evolution of investing. There is a growing recognition among industry participants that some ESG factors are economic factors, especially in the long term, and it is, therefore, important to incorporate material ESG factors. There are three critical elements of sustainable investing:
• Sustainable investing is additive to asset management theory and does not mean a rejection of foundational concepts.
• Sustainable investing develops deeper insights about how value will be created going forward using ESG considerations.
• Sustainable investing considers diverse stakeholders, consistent with how companies are developing.
We should be guided by our accredited financial institutions to inform our investment decisions, not politicians.
ESG integration focuses on material risks that have an effect on company valuations. This is not about personal values, it’s about demonstrating value for investors.
Analysts and portfolio managers, from across the political spectrum, are paying attention to material risks in their investment process. Investing through the lens of ESG integration is for anyone—left, right, center—who recognizes that ESG issues are material risks and opportunities that affect our investments. Strong management of employees can result in lower turnover and higher productivity. Better relationships with the communities where companies operate can reduce the likelihood of lawsuits and operational disruptions. Water and waste efficiencies can reduce operational costs. It’s widely understood that companies impact the climate (through, for example, emissions and resource depletion) and the climate impacts companies (through, for example, operational disruptions and asset stranding). These are fundamental investment considerations where ESG information can offer insights.
The media focuses on company ESG ratings. But these ratings are not meant to be all things to all people. They are a starting point for further analysis. For passive investors, because the indexes that your portfolios may be built on are informed directly by ESG ratings, you need to understand what goes into them: what is being measured, how it’s being measured, and whether you agree with that approach. Some ESG ratings measure risk to a company’s enterprise value. Others focus more on how companies execute on ESG opportunities. Some focus on alignment to the Sustainable Development Goals (SDGs). Some measure net positive impact, weighing both negative and positive contributions to society.
For active investors, we need to be treating ESG ratings like equity analyst reports, not credit ratings. Active managers who have experience integrating ESG information do not simply use ESG ratings as is. They take in a multitude of ESG data i.e. all the underlying components of various ESG research providers (depending on the sector and company this could be metrics like employee turnover, supply chain programs, GHG emissions reduction programs, water intensity, etc.) and they map those data points to their own ESG materiality frameworks by industry.
The key here is to choose the manager that best aligns with how you view ESG risks and opportunities. Make sure that they have a consistent, intentional and repeatable process for incorporating this information, and that investment decisions are actually being made based on the process.
If stewardship (engagement and proxy voting) is important to you, make sure you know how the manager engages with companies on ESG risks and how they vote on ESG issues on your behalf.
Another approach to sustainable investing is values alignment. This can be done in conjunction with ESG integration or completely separate. A values-based approach is reflecting your own perspectives and beliefs and viewpoints in your portfolio. Every single person has different values. Put 50 people in a room and ask them what their values are and you’ll get 50 different responses. There are an increasing number of portfolio tools out there that will show you your exposure to areas like tobacco, guns, and fossil fuels. There are also tools to show you which investment products have explicit screens implemented to avoid exposures to certain areas.
We need to better differentiate between building portfolios around our personal values (values alignment) and creating value with our investments (ESG integration).
Tesla was recently dropped from the S&P ESG Index, and Elon Musk responded by tweeting that “ESG is a scam.” He even went on to tweet “I am increasingly convinced that corporate ESG is the Devil Incarnate.” The reason Tesla was dropped from the S&P ESG Index? The company’s weak handling of a federal investigation into multiple deaths linked to its self-driving cars, in addition to claims of racial discrimination and poor working conditions at its Fremont, California factory. Tesla has a notoriously poor record on labor issues (and corporate governance for that matter). Yes, the company makes electric vehicles and has contributed to a major positive low carbon shift in the auto industry. Yes, global carbon emissions will decline a result of the products Tesla manufactures. However, what gets lost here is the understanding that S&P’s ESG ratings look at more than just the environmental impact of a company’s product itself. There is also the “S” and the “G” to consider. And that’s where Tesla comes up short. ESG ratings don’t necessarily just look narrowly at the ESG risks and opportunities of the product or service the company provides, they may also be evaluating the ESG risks and opportunities within company operations and how they run their business.
While we’re on the topic, it’s important to point out that ESG is not about sorting companies into “good” or “bad” buckets and “cancelling” companies who are “bad.” As we continue to hear, there is a low correlation between ESG ratings companies. That’s a good thing—because investors who don’t agree with how S&P measures ESG have plenty of other ESG indexes to choose from that utilize different ESG ratings frameworks and data.
Complexity is a good thing. Nuance is the reality of any innovation. Too often, tag lines trump nuance, and we wind up with a lack of understanding of what’s really going on.
Listening to your clients and exploring investment risks and opportunities from an ESG perspective doesn’t make you a “woke capitalist.” It makes you a fiduciary who is acknowledging the reality of the world we’re living in.
Kiley Miller is director of ESG Investment Solutions at Envestnet.