Why ESG is shades of green, not black and white

Rob Morgan explains why investing according to environmental, social and governance principals is highly complex and will inevitably come with trade-offs and nuanced judgements.

This content is more than 6 months old now, please visit the news area of this site for more recent content

  1. Rob Morgan

Responsible and sustainable investing has grown significantly over the past decade with the amount invested in environmental, social and governance (ESG)-labelled funds now approaching $2trn worldwide. This is likely to continue as investors increasingly demand to do environmental and social good as well as secure decent returns. Continued growth is also going to be vital in solving many of the world’s most pressing issues from climate change to inequality.

It is also entirely rational to invest with ESG issues in mind. A thorough ESG analysis can highlight key risks and be useful to all investors, even those who don’t have non-financial goals. Businesses that don’t address key environmental and social concerns or pay attention to governance issues could be unsustainable in the long run and in the short term are more likely to suffer negative publicity or even a customer backlash.

Complexity

While ESG principles can be straightforward at a high level, things can quickly get complex the further you dive into them. Lots of issues are subjective and many things are hard to measure precisely. For instance, the carbon intensity of a company may be straight forward on one level (its own carbon dioxide emissions) but what about the emissions that are associated with its supply chain and the consequences involved in the use of the product it produces? A single data point taken across different companies, especially those in different jurisdictions, may not always give a meaningful or common-sense result. There are often different ways to measure the same thing, and they don’t always agree.

It’s also unfair to compare a company in one industry with another. For example, a concrete producer is going to have a higher environmental impact that a financial services intermediary, but there is little alternative to using concrete to build things, and as it has such a big impact improvements in the way concrete is produced could have a significant effect. On-site environmental improvements at a financial services firm won’t move the needle in the same way. Different things matter to different industries, which tends to be referred to as ‘materiality’ – in other words what really matters towards sustainable goals.

ESG ‘ratings’

One starting point for asset managers is the ‘ratings’ allocated to companies by agencies such as MSCI, the provider our research team at Charles Stanley use. These tools consider companies according to their industry and assign a variety of ESG scores, weighted by the materiality of their impact, and aggregate them to produce an overall average score.

There is no single, accepted methodology for calculating an ESG rating and many of the things they are trying to measure are subjective or intangible. This is particularly the case for some of the ‘S’ of ESG. While carbon emissions and diversity may be reasonably straightforward to measure, it is more difficult to assign a value to employee wellbeing or health and safety. Company reporting on some topics is also still in its infancy and not standardised.

MSCI’s ratings won’t therefore necessarily agree with others (indeed correlation between the scores from different agencies is often quite low) but they do highlight many key issues and provide a point of reference. Proprietary research may uncover other aspects, both positive and negative, surrounding a company’s activities that are either not captured at all by the ESG rating or ‘buried’ in average headline figures that span everything from climate change and biodiversity to health and safety and board diversity. Those appraising and managing assets must decide for themselves what is important and why.

Contradictions

Looking at investments through an ESG lens also results in lots of trade-offs, contradictions and even inconvenient truths. For instance, purely from a carbon emissions perspective, plastic bags are better than paper ones, but few would argue that increasing plastic use is a good thing. Electric cars use lots of metals, notably lithium which is often in mined in poor environmental and social circumstances, so what may be good for overall emissions could result in poor outcomes elsewhere. Looking at one metric – be it an ‘E’ and ‘S’ or a ‘G’ one, or indeed an overall score that averages the three, doesn’t tell the whole story.

This is why ESG is not black and white, but a multi-dimensional puzzle where the responsible investor must make nuanced judgements about a variety of issues using as much information as possible. The vast and growing amounts of ESG data available is welcome, but represents a starting point for the informed and pragmatic investor to use.

New to responsible investing? Take a look our hub.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

More from author

  1. Rob Morgan

    Three investments under 30s could consider for the long term

    Date: 16th Sep 2021 12:24pm

    A long time horizon generally means a higher risk approach is beneficial. However, yo...

  2. Rob Morgan

    Learning from stock market investing mistakes

    Date: 14th Sep 2021 10:41am

    Football managers frequently say they learn more about their team from defeats than f...

  3. Rob Morgan

    Home REIT – investing to help the homeless

    Date: 6th Sep 2021 08:30am

    Homelessness remains a significant issue in the UK. This investment aims to help addr...

Most read articles

  1. Why ESG is shades of green, not black and white

    Home REIT – investing to help the homeless

    Date: 6th Sep 2021 08:30am

    Homelessness remains a significant issue in the UK. This investment aims to help addr...

  2. Why ESG is shades of green, not black and white

    What are Shariah-compliant investments?

    Date: 25th Aug 2021 14:27pm

    Certain funds cater for the specific investment requirements of followers of Islam.

  3. Why ESG is shades of green, not black and white

    Why ESG is shades of green, not black and white

    Date: 26th Jul 2021 11:12am

    Rob Morgan explains why investing according to environmental, social and governance p...

Investment involves risk. You may get back less than invested.