“Late at night, a police officer finds a drunk man crawling around on his hands and knees under a streetlight. The drunk man tells the officer he’s looking for his wallet. When the officer asks if he’s sure this is where he dropped the wallet, the man replies that he thinks he more likely dropped it across the street. Then why are you looking over here? the officer asks. Because the light’s better here, explains the drunk man.”1
The last few years have seen an explosion in sustainable or Environmental, Social and Governance (ESG) investing.
Morningstar estimates that as of 2021, the assets allocated to sustainable funds globally had grown to $2.74tn2, and the number of funds was just shy of 6,000. The US accounted for 13 per cent of these assets ($357bn) and 9 per cent of these funds.3
The Global Sustainable Investment Alliance puts the figure even higher. It suggests there were already $35tn of sustainably invested global assets under management (AUM) at the end of 2019. That would have represented nearly a third of total AUM.
What do we mean when we talk about ESG?
These numbers hide that there is no agreement as to what ESG means, either in the context of investing or corporate conduct.
Russia’s invasion of Ukraine brought this into stark relief. Depending on who was talking, ESG covered the full spectrum from ethical behaviour (doing the right thing, regardless of the financial consequences) to being a mechanism for financial risk management.
That is not to suggest that there are no definitions of ESG investing4, just that these are inconsistent. And, even where the language is the same, there are differences in interpretation and approach that may result in different outcomes – even for similarly labelled investment products.
Yet this is about more than just better product definition. All ESG investment (or at least equity investment) requires an evaluation of the ESG performance of the underlying companies. Investors can do this in-house or outsource it to third parties.
In many instances, these third parties are large rating agencies and data providers that score a company’s performance against a range of environmental, social and governance factors that the agency believes are relevant.
The inputs to this assessment include company-reported information and other data sources, such as news reports about controversies. It may also include some interaction with the company, (however, this is limited, given the sheer number of companies that rating agencies cover). The company is then scored on how ‘good’ an ESG performer it is.
So far, so straightforward. The reality, however, is far from straightforward.
Can we agree on ESG as a measure of financial risk?
Those close to our world know that several studies have found little or no correlation between ESG scores given to the same companies by different major data providers. Rating agencies claim largely to be analysing company exposure to risks that ESG factors may pose to a company’s bottom line.
Even with this narrow focus, researchers have found high levels of divergence across the agencies’ company assessments.
These studies concluded that the discrepancies were the result of not just different conceptualisations of the issue being examined5 but differences in how rating agencies measured the issue they claimed to be measuring.
There are differences in:
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the specific attributes evaluated (scope)
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the weight assigned to the different aspects that are measured
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the indicators used to measure or assess performance on a specific attribute
The low correlation exists at both the overall score level and the component levels (E, S and G).
The graph below shows comparisons of Sustainalytics and MSCI’s ESG scores for some of Baillie Gifford’s holdings.
What if ESG and sustainability are not the same thing?
The challenge goes beyond ratings divergence. It goes to the heart of what ESG is and what it is not. Rating agencies are clear that their ratings are about financial risk management.
For many clients, however, the promise of ESG products lies not just in better financial risk management but in investing sustainably. In other words, investing in a manner that aligns with their values or in a way that contributes to improved environmental or social outcomes.
The UK’s Financial Conduct Authority6 found that 80 per cent of respondents to its Financial Lives Survey “consider environmental issues important and believe that businesses have a wider responsibility than simply to make a profit”. These clients may be surprised at some of the companies making their way into an ESG fund and the fact the fund looks a lot like the benchmark index.
How do we resolve this?
For some, the solution lies in fixing the data. This involves pushing for greater data availability and data quality through standardisation of corporate ESG reporting and making it mandatory. Here, the thinking goes, ESG reporting will eventually take on the same status as financial reporting, leading to more consistent and comparable reporting and consequently better ESG outcomes.
Regulators seem to agree that this is a sensible direction of travel. In the last two months, the International Sustainability Standards Board, the US Securities and Exchange Commission and the European Financial Regulatory Advisory Group have all released climate and/or broader sustainability disclosure standards for consultation. They intend these to become mandated reporting in due course.
Yet it is not clear that the core problem is the data. Recent research into ESG ratings correlation found that more company disclosure exacerbates ratings divergence rather than improves it.
Even more fundamentally, the study concluded that while more disclosure of input metrics (eg the existence, or otherwise, of a policy) might improve correlations, disclosure of more output metrics (water withdrawals, worker fatality rates) made it worse. This was particularly pronounced in environmental and social metrics.
That led the authors to conclude that “a lot of work still needs to be done to develop rules and norms to determine what characterises good ESG performance”. We, and others, have written about our disagreement with rating agency assessments. Our argument is that they:
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do not capture the factors that we believe matter
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focus too much on where a company is now and not where it could or should be going
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give emphasis to quantification and scoring, which ignores complexity
Do these inconsistencies matter?
Some market commentators have argued that none of this matters. They say that, assuming ESG-related investing is about avoiding risky companies and enhancing long-term performance, then any disagreements about specific firms' ratings and ESG outcomes are exactly what the markets exist to speculate on.
But we think the inconsistencies do matter, for several reasons:
- ESG is being hard-coded in a way that ignores the complexity of the issues it claims to address
Investment managers are being asked to disclose portfolio performance against a range of ESG metrics, not all of which may be used for purposes of investment analysis. And companies are increasingly under pressure to both disclose ever-more ESG data points and to ‘score well’ on ESG ratings assessments. This is not the easiest of tasks, as the above-mentioned research demonstrates. - Large sums of ESG-aligned investment rely on company ESG ratings provided by rating agencies and index providers
Regulators around the world are consequently starting to focus on this market. - ESG factors go to the heart of a business and its operations
This affects how a company treats the environment, how it manages relations with its employees and how it thinks about human rights in its supply chain. To the extent that we are signalling to companies that these things matter, we should be clearer about what good looks like. Otherwise, we risk encouraging companies to focus on irrelevant factors that may turn out to be a costly and ultimately unhelpful distraction.
Where to from here?
Our starting point as long-term investors is to think about the companies we invest in holistically. We look not just at their long-term potential but the impacts, positive and negative, they have on the broader system.
We can only consider long-term value creation to be successful if we continue to see broad-based improvement in human quality of life. Even as bottom-up investors, we recognise the need to think systemically.
That leads us to the questions we think are worth exploring.
First, is there value in slowing our headlong rush to demanding more metrics and disclosure? Should we be focusing more on figuring out how we measure what really matters? Like our man looking for his wallet, can we spend more time trying to illuminate the areas that are most relevant and less looking in the areas where the information is easily available? If yes, how do we do this?
Second, is our current approach to ESG too static – box-ticking, even? Does it focus too much on where we are now and not enough on where we have the potential to go? We believe that just as there are no perfect human beings, there are no perfect companies. And that even perceptions of ‘good’ will vary, depending on the prevailing norms and standards and how they evolve. If we are investing for the future then, by definition, we are on a journey, and we should treat it in this manner. How do we best encapsulate this in our frameworks?
Third, where are the opportunities for investors to contribute meaningfully to this journey? Investors will always have different perspectives on the specific factors that are likely to generate long-term returns. But how do we ensure we contribute to the overall health of the system?
We continue to believe that the answers lie at least in part in deep company analysis, drawing on a range of sources and commitment to long-term investing. For the rest, we acknowledge the need to keep having conversations.
1 The exact source of this anecdote/metaphor is unknown. We use it in this context to refer to the tendency to look for answers where there is available data, rather than where the answers may lie. What David Freedman refers to as the ‘streetlight effect’ – see Freedman, D.H. (2010) Why Scientific Studies Are So Often Wrong: The Streetlight Effect, Discover Magazine
2 Morningstar (2022) Global Sustainable Fund Flows: Q4 2021 in Review
3 As above
4 Morningstar defines sustainable investing – which it acknowledges can be used interchangeably with ESG investing though it differentiates it somewhat – as investing “to deliver competitive financial results, while also driving positive environmental, social, and corporate governance outcomes”
5 At this time, it was still framed as corporate social responsibility
6 The FCA is the regulator for UK-regulated financial firms and markets
Risk factors and important information
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in May 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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