Five pervasive myths surrounding ESG
Five pervasive myths surrounding ESG
ESG (Environmental, Social, Governance) has become a common term throughout the investment world, frequently used by corporations and governments and within board meetings. Considering the concept of ESG barely existed a decade ago, this is a remarkable development.
In 2020, 96% of the world's 250 largest firms reported on sustainability. Of those companies, 56% acknowledged the financial consequences of climate change in their reporting, and the majority set carbon emission reduction objectives. In the same year, the European Union (EU) began reviewing its nonfinancial disclosure requirements in order to strengthen the foundations for long-term investment and leading global reporting frameworks committed to the goal of developing comprehensive, unified ESG reporting standards.
As nonfinancial criteria becomes increasingly important for a comprehensive assessment of company risk and performance, it’s important to identify and dispel the pervasive ESG myths that continue to mar forward progress.
Myth # 1
ESG programs negatively impact investment performance & long-term shareholder value
It is still widely believed that company initiatives to address ESG issues have a detrimental impact on financial returns. In an article for the Journal of Applied Corporate Finance called "ESG Integration in Investment Management: Myths and Realities", authors found companies that are committed to ESG are gaining competitive advantages in the product, labor, and capital markets, while portfolios that have integrated "material" ESG criteria have consistently delivered investors with average returns that are higher than traditional portfolios while posing less risk.
Many studies have also demonstrated a correlation between strong ESG initiatives & financial performance. According to the CFA Institute, 35% of investment professionals use ESG to increase their financial performance. Between December 2015 and November 2019, an MSCI analysis found that companies with above-average ESG performance had better than projected growth and a lower cost of capital.
A recent report by Calvert Instruments showcased how corporate social and environmental activities can and have led to value creation, such as:
- Companies that can demonstrate financial benefits through environmental measures such as waste reduction or improved energy efficiency have a higher corporate value.
- Risk management may help a corporation protect its reputation while requiring lower returns on capital, impressing and attracting investors.
- Sustainable business strategies have been shown to attract a more competent and engaged workforce as well as loyal customers.
In a nutshell, companies that dedicate significant resources to material ESG issues have greater profit margins and risk-adjusted stock returns than their peers.
ESG is well integrated into mainstream investment management
In reality, the global sustainability market represented around $35.3 trillion, roughly 35% of the global $103.1 trillion managed by UNPRI signatories in 2020, according to the Global Sustainable Investment Alliance.
While UNPRI is a positive step forward, not all signatories comply fully with the principles, are at different stages of development of their ESG integration process, or don’t apply ESG integration practices to their total assets under management (AUM).
Many sustainable investing strategies only employ "negative screening", which involves excluding industries that are thought to have destructive social implications, such as tobacco, alcohol, and weapons. This practice represents a minimal level of ESG integration, yet accounts for $15.9 trillion of AUM. The majority, $25.2 trillion of AUM, employ an ESG integration approach and another $10.5 trillion focus on corporate engagement & shareholder action strategies.
While the Paris Agreement, UN Sustainable Development Goals (SDGs), and Task Force on Climate-related Financial Disclosures (TCFD) are examples of global developments that have greatly impacted the sustainable investing industry and the financial services industry, there is still ample room for growth.
It’s expected that industry drivers such as greenhouse gas emission regulations and growing demands to meet and standardize financial sector data flows will continue to push companies toward more mainstream ESG integration.
ESG investment strategies eliminate entire sectors
When it comes to ESG, many people confuse the concept of screening (the exclusion of specific stocks) with ESG integration. This myth is perpetuated by the interchangeable use of socially responsible investing (SRI), sustainable investing, and ESG investing, three investment approaches that are very different from each other.
In general, SRI investors encourage corporate practices that are morally grounded and promote environmental stewardship, consumer protection, human rights, and racial or gender diversity. SRI investors employ negative screening strategies and morality often trumps the bottom line.
As a blanket investment term, sustainability has become a catch-all for a company’s efforts to “do better” or “do good.” The sustainable investment approach is best defined by the three pillars of sustainability: economic growth, environmental protection, and social progress, also referred to as “people, planet, and profits.” In a nutshell, sustainable investing directs capital to companies fighting climate risk and environmental destruction, while promoting corporate responsibility.
In contrast, ESG integration focuses on three specific, foundational pillars that are crucial to both corporate management and investors. Environmental issues can include pollution, climate risk, exposure to extreme weather, carbon management, and the use of scarce resources. Social issues can include product safety, human rights, worker safety, customer data protection, and diversity and inclusion. Governance issues can include factors such as accounting standards compliance, succession planning, and anti-competitive behavior. ESG factors can be applied to all industries and promote sounder investments through ethical business practices and improved risk mitigation.
While SRI, sustainable investing, and ESG investing each offer a way to incorporate sustainable practices into corporate decision-making and investment strategy, ESG investing is proving to be the most effective method. Because ESG investing considers the key aspects of an organization's environmental, social, and governance risks and opportunities, investors are able to enhance traditional measurements of company operations that have a material impact on its performance.
ESG ratings perfectly measure ESG performance
Markets rely on trustworthy ratings. Third-party ESG ratings, contrary to common assumption, show only a poor link with corporate outcomes such as performance, risk, and failure, all of which are considered markers of ESG quality. Yet, fund managers, investors, and executives rely largely on ratings established by third-party companies like MSCI, Sustainalytics, Refinitiv, and others.
Independent institutions attempting to measure company characteristics in a thorough and reliable manner should, in theory, have similar methodologies and results. This is not the case with ESG ratings at the moment.
Unfortunately, studies have found a lack of agreement between rating providers, and the ratings assigned by these providers have an unproven correlation with performance. Researchers have found significant differences in both scope, the criteria used to evaluate ESG, and measurement, the metrics used to determine ESG. These differences create confusion among investors as well as companies regarding market expectations. It can also contribute to a lack of accountability as companies can always find one rating provider where they score well. Because of this, these studies conclude that ESG ratings have low validity.
What will help resolve this issue? A global agreement on how to define ESG, what constitutes good or bad ESG performance, and what measures are utilized to capture ESG performance and drive disclosure are the first major steps.
While a lot of work still needs to be done, reporting and investor organizations, such as SASB and Ceres, and data providers like Bloomberg and MSCI are adding stronger, value-relevant ESG data on companies.
For example, SASB and the International Integrated Reporting Council (IIRC) recently finalized a merger to form the Value Reporting Foundation and unite their ESG reporting frameworks. And organizations such as the International Financial Reporting Standards Foundation (IFRS) announced the formation of a new International Sustainability Standards Board along with the consolidation with the Climate Disclosure Standards Board (CDSB, an initiative of CDP) and the Value Reporting Foundation, as well as the publication of prototype disclosure requirements.
ESG is just a fad
ESG investing often gets stereotyped as a millennial fad, one suited for younger investors. A Harris Poll found about one-third of millennials often or exclusively use investments that take ESG factors into account, compared with 19% of Gen Z, 16% of Gen X, and 2% of baby boomers.
Why is this important? Because the largest intergenerational wealth transfer in history will pass down over $30 trillion in inheritance from baby boomers to millennials and Generation X across the next few decades. Millennial earning power will also increase by almost 75% across the next few years.
While millennials may have spurred the growth of sustainable investing, billions of dollars are now flowing into sustainable investing strategies from investors of all ages. As of June 30, there were 534 sustainable index mutual funds and exchange-traded funds globally, accounting for $250 billion, according to Morningstar.
With a focus on mitigating climate-related risks and aggressive global emissions goals, ESG, SRI, and sustainable investing are expected to maintain their strong momentum. Other issues such as diversity, equity, and inclusion (DE&I), data privacy laws, and worker safety are also driving greater corporate transparency surrounding social & governance issues.
So, it’s safe to say ESG investing is here to stay.
Fact: ESG & sustainable investing are the future
In the face of change, ESG funds have proven to be robust. There is enough evidence to suggest that sustainable funds can outperform non-sustainable funds and yield better long-term returns for investors. While ESG ratings alone are often insufficient to establish credibility, investors will benefit significantly from innovative approaches and streamlined reporting efforts that will provide enhanced insights into sustainable investing.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.