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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.

| 5 min read

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 at our dedicated page on how to start your investment journey.


Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Why ESG is shades of green, not black and white

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