ESG 2.0 is in the making | Opinion Eco-BusinessRead More
Impact Investing Forum 2022
London. April 28-29, 2022.
Over the past few years, investor interest in ESG information has increased dramatically. According to some estimates, around a third of assets under management now consider ESG information as part of their investment strategy.
However, there have been doubts about ESG’s validity as an indicator of financial performance. These doubts have led to an apparent backlash against ESG investing. They can be summed up into two spheres. The first is that all ESG information that is financially relevant is already captured by traditional market fundamentals. This is an iteration of the efficient-market hypothesis in which prices are believed to reflect all information. This sphere of thought suggests that empirical studies linking ESG to financial performance are either poorly constructed or measure proxy information for a market fundamental, rather than a single impact of ESG.
The second is that ESG issues are by nature externalities to a business and that accepting responsibility for externalities is a cost and a drag on financial performance. This view is rooted in Milton Friedman’s ideals and argues that businesses should only consider ESG aspects if they are subject to penalties or incentives. The correlation between ESG performance and financial performance can only be established when there is market-distorting regulation. This creates a situation in which capital flows to sustainable investments are inherently less efficient. Markets will therefore seek out more efficient investments or avoid regulations.
Some may see ESG as an investment fad and expect its repudiation. However, we believe that the current debate over ESG’s validity does not mean the end of ESG investing. Instead, it marks a transition towards major improvement.
Externalities market-related to the economy do not disappear, they are integrated
Markets are not always efficient. Markets have always faced new factors, as demonstrated by the dot-com crash. ESG is a complex and extensive system of new factors that markets can use. Market players will interpret global ESG factors differently, which can lead to inconsistent pricing. These factors are also changing rapidly as we observe the impact of ESG factors upon society and economies.
There is a real risk that the backlash against ESG will slow down capital movement towards more sustainable investments in short-term.
Digitalisation and decarbonisation are driving profound transformation at the corporate level. Across entire industries, strategies that were based on industrial-era methods are being replaced by smarter, cleaner and more agile models. ESG plays a key role in this. The cost of human and environmental capital is on the rise, which drives greater efficiency in time and resource usage. Incentives to promote renewable energy are being created by governments in the trillions of dollars. ESG externalities are one of the most important non-market forces currently at work.
Although protecting the environment and social capital is an externality, it is also a fundamental asset that companies and economies depend on. The world is rapidly changing and corporations are trying to thrive and compete in a rapidly changing environment. However, the fundamental need to have access to human, social, and ecological systems to create financial wealth will remain. Recent technological and regulatory changes, the effects of climate change and evolving social norms that ESG factors capture make them more important for valuations.
Major transitions are not always smooth or linear.
ESG is messy. ESG is difficult to assess and collect data. ESG also challenges our ability to measure economic growth and value. Our efforts to understand ESG factors are closely linked with corporate transformation and the adoption of digital technologies for data-driven assessment. This transformation impacts all segments of society as well as all market players.
It’s not surprising that there will be bumps in the development, scaling and integration of ESG in investing. ESG’s growth will be like other major market transformations. There will be backlashes and bubbles. ESG will have some fundamental aspects that will help you achieve short-term financial success. Others will have a longer-term impact or will be felt more by investors and companies through complex, intangible consequences.
It is difficult to see the relationship between ESG performance and financial performance in the short-term. It is possible that only a small number of ESG factors will have an impact. While some companies will continue to generate strong returns over the medium and short term by burning the globe with their profits, we will see bubbles in performance in portfolios that are more sustainable stocks. However, analysts agree that ESG and long-term financial performance are well-established over longer periods.
Multiple successful investing strategies have been possible due to the time-dependency market transformations. Investors can exit quickly before long-term changes take place. ESG has a different set if consequences for society and markets. Failure to decarbonise or delay will cause irreversible and huge damage. The key to success is managing consistent performance over multiple timescales simultaneously.
ESG ratings are now part of the problem
How can we identify ESG factors that contribute to financial success in the short- and long-term? We have always relied on analysts to find the right relationships. There is ample evidence to suggest that ESG ratings are not perfect and sometimes unhelpful. One of the main problems is that ESG scores are often based on biased or greenwashed datasets and backward-looking information. This has been widely criticized.
Most attempts to impose quality standards on rating organizations have failed. There are 600 rating systems in existence today, and despite industry consolidation, the market remains fragmented.
Arabesque, a sustainability-based financial technology company, where one of our chairman is, will soon launch a digital solution that makes ESG data more accessible, comparable, and scaleable. Machine learning and artificial intelligence are enabling smarter data analysis. Investors will have greater flexibility and the ability to customise data at a lower cost through digitalisation.
Regulators will also drive comparability in ESG data. The European Union is currently defining minimum standards for ESG disclosure for asset managers and companies. The United States Securities and Exchange Commission recently opened consultations to discuss potential disclosure rules or guidance regarding climate change and ESG. More clarity will be achieved through consistent and broad disclosure, particularly of carbon emissions and financial risk of climate change. These trends will reduce the burden on companies. Businesses spend significant time and capital responding to the myriad requests of investors, raters, or other stakeholders. Companies will be able to track ESG information that is vital to their business strategy and improve their management of ESG opportunities and risks with the help of new technology and more consistent reporting requirements.
The current backlash against ESG won’t stop the inevitable integration. It is likely to have both constructive and destructive consequences. It can be disastrous to delay and there is a real risk that the backlash will slow down the flow of capital towards more sustainable investments in short term, right when it is most needed.
However, increased scrutiny of ESG data and the correlations between ESG and financial performance can only help to improve data quality. As data becomes more accessible and relationships between ESG factors become clearer, the importance of ESG analysis will increase. Technology and regulation are making it easier to gain these deeper understandings. This will result in new ways of adjusting valuations to reflect current and future global changes. ESG 2.0 is on the horizon.
Arabesque’s chairman is Georg Kell. Todd Cort is the faculty co-director for Yale’s Center for Business and Environment.
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