It now seems likely that ESG-driven asset allocation will develop a place in the ecology of global financial markets. Properly executed, it can add to the array of choices available to investors. It certainly fits the prevailing “stakeholder” Zeitgeist.
ESG (environment, society and governance) featured prominently in Berkshire Hathaway’s annual meeting last Saturday, as major institutional investors, themselves seeking to attract and retain more high-margin funds from ESG-motivated clients, pushed for a greater sustainability focus across the Warren Buffett-run conglomerate, including the composition of its own board. Management did not seem convinced.
Indeed, the fact is that ESG metrics continue to rest on sand, not granite. There’s still plenty of work to do in identifying and tracking ESG efficacy, including genuine consensus on separating “better” from “worse” outcomes, and what’s behind the curtain in cooking ESG ratings.
Today’s focus on ESG is a continuation of advocacy over the years to better align the conduct of corporations with improving social welfare, only this time with new labels, new institutions, global application and greater attempts at precision—all with a generous helping of hype.
Many ESG objectives remain complex and controversial. Those involving the natural environment [E] at least offer the advantages of natural science to help define and measure outcomes. But even widely shared goals like combating global warming leave a lot of room for controversy. They range from rates of climate progression, remediation costs and damage reversibility to the right price of carbon emissions.
On the bright side, there are good prospects for market-based approaches to work in favor of, not against, a viable solution.
Less credible are social impact [S] objectives like income and wealth inequality, systemic racism and gender-based discrimination – all of which reflect the imprecision of the social sciences. They sharply raise the difficulty of building consensus on what are “better” and “worse” outcome. People differ widely in their preferences, so forced changes in corporate behavior will inevitably leave some people better and others worse off.
Governance attributes [G] are only slightly less controversial. There is plenty written about corporate governance and its reflection in management performance, the responsibilities of boards, the fiduciary role of institutional investors like pension funds and mutual funds, and ultimately the individual investor. Many governance flaws have had to be corrected over the years in response to corporate scandals – through legislation and regulation or simply market intolerance of poor governance. This is an evergreen issue. Stay tuned for the next governance controversy.
If it’s hard to come up with agreed and measurable ESG outcomes, it’s even more challenging to identify the kinds of metrics that drive “better” or “worse” ESG results.
There are plenty of published indicators and disclosures available which may or may not predict ESG results. Digging below readily available information, though, requires intensive and expensive research on the conduct of thousands of business firms, investigated by an army of analysts of unknown competence.
Each indicator then has to be rated and weighted to come up with composite ESG scores – a herculean task reminiscent of grandma’s chicken soup before she discovered Maggi. What rating scale should be used, and how should weights be set? And to be fully credible the whole process needs to be replicable, so that others can check the integrity of the work and compare ratings across vendors. Lack of transparency underlies the dramatic differences we see today among competing marketers of ESG ratings.
While the credit-rating industry has run into plenty of controversy over the years, bond ratings issued publicly by Moody’s, S&P Global and Fitch show a high degree of consensus in assessing the ability of issuers to meet their debt obligations in full and on time, using much the same data and rating methodologies. No such consensus exists in ESG ratings sold to investors.
Certainly, selling ESG ratings to investors is a growing and highly competitive business. There’s money to be made. There’s also more than enough obscurity and inconsistency in “manufacturing” the summary scores. Rating customers, being human, much prefer simple reporting like numbers or letters, and don’t worry too much about the details. The ESG rating industry supplies its assessments in a user-friendly way, and the investments industry wields them to build portfolios and pitch them to ESG-sensitive clients.
Wide disagreement among ESG raters don’t seem to produce a lot of sleepless nights. Except for opportunistic misrepresentation (“greenwashing”), everyone’s happy. Even individual investors. If ESG-labeled funds outperform (often part of the sales pitch) that’s great. And if they underperform these investors consider it the price of doing good.
The impressive run-up in assets under management of ESG-driven funds suggests this dynamic works. It cuts the cost of capital for ESG-positive firms and encourages others to join the club. It helps throttle access to capital for ESG-negative firms. It boosts satisfaction on the part of investors and makes money for the middlemen. No wonder there’s no shortage of raters on the road to consolidation.
The hype will continue for a while, even as vendors and users try to bring order to the ratings business and national governments (and the European Union) try to define how to identify definitive ESG outcomes, metrics and reporting standards as a way of promoting a new definition of “efficient” capital allocation. Best to wait a couple of market cycles to see what sticks.
Ingo Walter is a professor emeritus of finance at New York University’s Stern School of Business.
More on ESG investing
ESG investing now accounts for one-third of total U.S. assets under management
Your ESG investment may be a ‘light-touch’ fund and not as green as you think
What new Amazon CEO Andy Jassy needs to do to become a leader in sustainability like Apple
Vanguard is beefing up its ESG staffing – are more sustainable-investing funds on the way?