In the last couple of years, ESG investing has been beaten down by the US-born backlash as well as the constant stream of criticism for lack of standardized, objective, and impartial information about the sustainability of companies and investments. The insatiable search for an objective truth makes many miss the point.
The Tyranny of Labels
It seems to me that we are increasingly having to deal with strawman arguments when it comes to ESG. To a certain extent, this is a badge of merit and progress—but it also perhaps mirrors a societal development contrasting with this progress.
There is no universally accepted definition of ESG, nor is there one for what constitutes a sustainable company, product, or service. This might seem like walking through an open door for many, but it deserves pointing out – and as such ESG finds itself in good company with many other concepts in finance. Do you know what else doesn’t have universally accepted definitions within finance? The list is long. What constitutes a value, growth, quality investment, company or strategy. Even indexes or benchmarks have no universal definition—so why are we obsessed with finding an objective truth when the letters E, S and G are attached?
The Tyranny of an Objective Truth
We would perhaps be well served by separating the need to standardize the data, from standardizing the entire concept. Key data points need to be consistent over time, and transparent in definition, collection and how they have been aggregated. This is a good thing and can be beneficial so that end clients are better able to understand the data and how it has been used. However, as with any other financial product, just because it has a tag of value, growth or quality – it does not mean that this data has been applied in the same way or that they have used the same methodology.
We tend to agree on some sort of general principles that describe these areas—and I don’t believe the variance itself is a problem, it is rather how binary we communicate our convictions that create problems. If you claim something is the truth, or you utilize juxtapositions between right and wrong, black and white, and sustainable or unsustainable to understand complex issues, then we have bigger problems than E, S, and G. Not everything has or needs a simple answer.
For every complex problem, there is an answer that is clear, simple, and wrong. - H.L. Mencken.
Here are some common principles I believe we can agree on:
- ESG should consider a long-term view.
- ESG is a search for environmental, social and/or governance information that is material to either the bottom line of a company or its valuation.
- ESG needs to consider “when” something is material, just as much as “what” is material
- ESG materiality is a moving target, it shifts along with markets, technology and politics
Beyond this, the skill of the practitioner, the ability to know when to use information, when to disregard the information and when to realize that the information doesn’t exist is key to the practice. In the same way that financial analysts don't agree on the analysis of a company, neither do all ESG analysts agree on the same companies. If the latter is a problem, then surely the former is as well?
The Tyranny of Ratings
ESG has to some extent become conflated with ESG ratings. Rating agencies have been hugely important in driving the development of ESG reporting and represent a huge leap forward from where we were when I started in 2006.
While aggregated ratings might have a use—the concept of gathering hundreds of data points across such a vast range of topics to come up with a useful number that represents the answer to not one complex problem such as "what is sustainable" but a multitude of these complex problems including if a company is a good investment or not boggles my simple mind.
And the incentive structure too leaves little room for good judgment. Ratings, and the companies that provide them “must” offer something that the others do not. If the information becomes perfectly correlated across different agencies, the business proposition disappears. Unless we all agree to use the same vendor, your rating will never be the same as my rating, and the agencies will strive to create differences to keep attracting customers.
For example on the topic of controveries, consider this scenario: one data provider assesses a company and determines that it violates international norms and conventions, while another provider hasn't even acknowledged the issue as controversial. In such cases, the responsibility falls on investment professionals who evaluate the company, much like we do every day when assessing potential investments. Our responsibility is to interpret all available information and make informed decisions based on it given our mandate and investment strategy, in a similar way as with any other inputs and data points.
As a repository for information, transparent ESG ratings can absolutely hold value. However, from my position, this is clearly a case of the parts (i.e., data points) being more valuable than the whole (i.e., the singular rating).
ESG is not the answer to everything
But it is the answer to some important things. While the practice of ESG can address both risks and opportunities, there are some principles that form the foundation:
Environmental, social and governance issues are not necessarily perfectly understood or priced for markets and companies.
Companies and their boards have not always had the correct competence to understand and/or act on information outside of their fields.
In a world where we are overloaded by information, we are still looking for edges—and ways of better understanding markets, companies, and their stakeholders. Not considering non-traditional issues would be a neglect of fiduciary duty. Business and markets evolve.
Along the way, increased focus on ESG may also have resulted in:
- A reduction in carbon footprints where investors and stakeholders have pushed for substantial reductions.
- More sustainable and transparent supply chains
- More community engagement
- More focus on labor practices, diversity and inclusion, and fair wages
- Better public disclosure from corporate entities
None of these issues exist in a state of vacuum where there is only one cause and effect, and few of these issues are solved, but like many other issues progress is often measured in the delta of past versus the present.
In the future, we should aim for academic rigor in the practice of ESG without making it a search for the one and only truth (that is an entirely different discipline), and we should be transparent about how we do so. That is the only way ESG can continue to evolve and stay relevant.