The Future of ESG Investing
There is near-consensus on the strong correlation between companies with high ESG scores and financial performance. Portfolios composed of companies with disclosure practices and sustainability reporting that earn them high ESG scores have systematically outperformed portfolios that aren’t. The resilience of ESG investing in the context of the ongoing pandemic’s impact on public equity markets provides only the latest evidence of this trend.
What we are less certain about, however, is the direction of causality for this positive correlation — do well-run companies get good ESG ratings, or do companies with solid environmental, social, and governance practices outperform the competition?
The body of empirical evidence indicates that the answer, very likely, is ‘both’. One recent study looking at firms in Asia over more than a decade illuminates some of the interdependencies in this relationship, finding that the mere fact of robust ESG disclosure mechanisms, paired with effective governance, strengthens corporate sustainability and economic performance.
A more granular picture, however, is only beginning to emerge, as the ESG industry is still in its infancy. Despite ‘meteoric’ growth in flows into the sector as a whole, critics remain skeptical of ESG data quality.
Indeed, given the heterogeneity of industry reporting practices and differences in ratings methodologies, companies’ disclosures often don’t earn them the same scores across raters. Furthermore, the tendency to oversimplify reporting into a single metric across E, S, and G is often poorly suited to different investors’ needs.
Add to this a mostly hands-off regulatory stance from national governments, and the result is a largely unharmonized taxonomy for rigorously assessing ESG data and its impacts — though this is evolving rapidly worldwide thanks to efforts by ‘governing principles’ bodies like the Principles for Responsible Investing (PRI), UN Global Compact, Sustainable Development Goals (SDGs), and others.At this time, however, what is clear is that integrating ESG reporting into core business practices is inexorably becoming standard across corporations; for investors, strategies that don’t make use of ESG data have simply become decision-making with less information than the competition.
The next wave of ESG investing, however, will go much further than relying on oversimplified ratings currently dominating the landscape; in this future, investors will access with much greater granularity the source data - e.g. company reporting - that currently constitute rating agencies’ differing and often oversimplified aggregate scores.
This will allow for greater visibility and nuance in interpreting how a company’s practices actually translate into impact for both its shareholders and broader stakeholder communities. And, perhaps most importantly, this next wave in the visibility and transparency of ESG data will unlock a new frontier in comparability across companies and portfolios.