Four Challenges in the ESG Market: What’s Next?

By Christopher K. Merker, PhD, CFA Posted In: Drivers of Value, Economics, Future States, Performance Measurement & Evaluation, Portfolio Management

When I began teaching sustainable finance at Marquette University about a decade ago, environmental, social, and governance (ESG) investing and socially responsible investing (SRI) were backwaters. Of course, that has changed dramatically, particularly over the last four years, and here we are today.

But the increasing adoption and application of these types of investing criteria conceal some underlying challenges.

Despite the rapid growth of ESG funds across several measures, I still see four main obstacles to ESG investing’s continuing emergence. Below I outline these challenges, rate them according to their severity, and chart the progress towards potential solutions.

1. Defining Standards and Terminology

Severity: High

Problem: A survey conducted last year by State Street Global Advisors found that over half of those institutional investors already implementing some form of ESG strategy in their portfolios were struggling with clarity around standards and terminology. That shows considerable confusion on the subject. MSCI scores ConocoPhillips an A, the third highest rating available. That’s, comparatively speaking, a relatively strong ESG rating. So good, that two of the largest asset managers in the world both hold CononoPhillips in their ESG funds. To include or not to include? Are we avoiding the oil sector altogether or not? Maybe the strong “non-GAAP”-related performance and transparency demonstrated by energy companies should be embraced? Or maybe not. This issue creates a real conundrum for investors, and there are, of course, many less extreme, if no less challenging, examples to untangle in this context.

Another criticism targets the ESG ratings firms themselves. Their ratings are inconsistent due to significant differences in data collection, analysis, and reporting. Indeed, ratings are rarely the same, or even similar, for a given company. And there are a lot of them. The empirical argument on ESG yielding better risk-adjusted performance is untenable if we can’t point to consistent standards. If our interpretation of the data leads us to use one rating and not another and that trade makes our portfolio worse off, what then? We have a fiduciary obligation to our clients in almost all cases to outperform, and ESG’s most important claim is that doing good will drive better returns. That argument is weakened by inconsistent ratings. As James Mackintosh recently observed, Warren Buffett’s Berkshire Hathaway was ranked dead last in the S&P 500 by one ratings firm and in the middle of the pack by another. That’s simply too much dispersion.

We should strive for greater consistency, as we see with bond ratings, and for ratings differences among the ratings agencies to become more the exception than the norm. But that consistency needs to be driven by something other than human judgment. Rather, it needs to be tied to both financial and impact results.

Discussion: Standards and reporting are catching up through the good work of such organizations as the Sustainable Accounting Standards Board (SASB). The SASB’s complete set of codified standards are due out in Q3 2018. The launch of products such as the Morningstar Sustainability Rating in late 2016 and ISS-Ethix were likewise positive developments for fund analysis.

How ESG expresses values needs to be better understood, and the gray area made less gray in relation to SRI principles. Are we investing for better performance, impact, or both? What differentiates one ESG manager from another? Better performance, impact, or both? Standardization of reporting to investors will help.

2. ESG Adoption

Severity: Medium

Problem: Awareness and understanding of ESG and its role need to improve. We also need to clarify how ESG differs from SRI and even impact investing. Institutional investors are having conversations on these issues, and adoption rates are brisk of late, but few others are jumping in, especially among retail investors.

Discussion: This is not as pressing an issue and is less demand- and more supply-driven. ESG methods should help mitigate risk and drive higher returns on the asset management side of the business. As asset managers increase their understanding of ESG as a core investment process, the notion of an ESG product as distinct from other active or indexed products starts to wither away. ESG will just become the way investing is done and will theoretically be applied to all manner of investing.

At some point, no one will ask whether a security is ESG or not. They may inquire what values are expressed or what constraints are in place, as we see today with SRI. Asset managers are clearly not waiting for buyers. Rather, perhaps too many are claiming to be ESG managers without any standards of practice attached to that.

3. The Quality of ESG Information

Severity: Medium

Problem: We need more and better issuer disclosures as well as more insightful data. Too much of the available ESG information is of poor quality.

Discussion: There are lots of people and organizations working on this problem — the Global Reporting Initiative (GRI), Governance and Accountability Institute (GAI), and SASB, among them — and it should eventually sort itself out.

However, information overload is a Big Data problem that requires better quantitative methods. We’ve been working on this at Marquette. For example, governance factors can run more than 150 variables. How can all that data be distilled down to something useful? Applying statistics in a unique way, we reduce the 17 most important variables to a single index. Not only is that index consistently predictive within a 12-month time frame, but it has very strong R-squared explanatory power across multiple financial variables and impact measures. An investment manager, client, or investment board looking at a report may only be interested in a single index measure. That measure needs to be well-researched and robust to be effective.

It’s time for ESG to become more of a science and less of an art. This should help address the consistency problem as well.

4. ESG in Other Investment Markets

Severity: High

Problem: As the Wall Street Journal reported recently, private markets have eclipsed the public markets for the last six years in a row when it comes to new issuances.

We’ve all heard about the incredible shrinking equity market, wherein the number of publicly traded companies is about half what it was two decades ago. The question is how does all this ESG work find its way into an area of investing that is overtaking the more traditional forms.

ESG has a natural home in the public markets, which already have ongoing disclosure requirements. Unfortunately, these requirements are why many companies no longer want to remain public.

But what about other areas, say, municipal bonds? One of the constraints on the growth of ESG municipal exchange-traded funds (ETFs) is the lack of data available to the exchanges. Frankly, governments need to be held to the same standards as public companies, especially in light of the rapid growth in green bonds, recent tax legislation around Opportunity Zones, and the emergence of social impact bonds (SIBs), not to mention the controversies around such major defaults as in Detroit and Puerto Rico, financial and social distress in Dallas, Illinois, and Connecticut, and water quality in Flint, Michigan.

Discussion: The solution needs to be driven by issuers, investors, intermediaries, and standard-setting organizations, just as with the public side of ESG. This will, no doubt, be a long process.

This article is based on remarks presented during a panel discussion at the Barron’s Impact Investing Summit in San Francisco on 21 June 2018.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.