Why You Need to Understand ESG Investing Better

Controversy surrounds ESG investing, nevertheless you can make a difference with "impact" investing

Jan 8

ESG, or Environmental, Social, and Governance-focused investing, has gone from a little-noticed trend to a controversial topic very quickly. At its core, it is about incorporating ESG into the investment and risk management processes. However, it appears that virtually every investor, ESG reporting company, auditor, and ESG rating agency has a different approach, resulting in a lot of confusion, misunderstanding, and even anger. In this article, I explain the origins of ESG investing, what it means, and my own opinion—that impact investing is a better vehicle for investors with causes to invest in. I will end the introduction with the Latin phrase caveat emptor, or buyer beware! Similar to buying the first model year of a newfangled automobile, ESG and impact investing, especially in the U.S., is pretty new. So, be a cautious and informed consumer. From the corporate side, I identify a few things executives can do to align better with ESG rating systems without greenwashing.

Executive summary/action items

Investors should consider shifting from ESG to specific-focus impact investing (e.g. a climate-focused mutual fund).
To understand this better, besides this article, buy Terrence Keeley’s Sustainable: Moving beyond ESG to Impact Investing here (paid link)
The SEC plans to require public companies to appoint responsible parties for climate risk at the corporate and Board level and file climate risk and GHG reports for fiscal 2023. Be prepared.

If you work at a public company or are an executive or sustainability expert, ESG is even more important to understand. It is easy to assume that a company focused on sustainability should automatically get a great ESG rating! As we will explain later, the two are not interchangeable, as Elon Musk discovered when Tesla was not included in an ESG stock index leading him to label ESG “an outrageous scam”. See Elon Musk: ESG is an Outrageous Scam.

ESG investing sounds a lot like sustainability (one of the primary topics of this blog) and the two do overlap, but they are not exactly the same. While one might think that ESG has nothing to do with technology or AI, that is actually not the case. One example is that some of the primary third-party ESG ratings and data services use a fair amount of unstructured data and artificial intelligence to gather ESG data for companies they rate, and many of the smaller companies may be rated by AI with very little human intervention! This can obviously be frustrating for a small company that gets a poor ESG rating and potentially makes the ESG ratings quality for smaller companies suspect in some cases.

Origin of ESG Investing

The United Nations Principles for Responsible Investing (UNPRI) started back in 2005 when UN Chair Kofi Annan asked a group of the world’s largest investors to create the Principles for Responsible Investing. These were released in April 2006 at the New York Stock Exchange.

It is technically an investor initiative and a company (with roughly 200 employees globally) in partnership with the UNEP Finance Initiative and the UN Global Compact. As of this writing, there are 4,902 signatories with US $121.3 trillion of assets under management. Signing on requires a company to report very detailed information annually to UNPRI, collaborate with UNPRI and other signatories, and make progress on goals set by UNPRI based on how many years the company has been a signatory. Here is a link to the UNPRI annual report for 2022: UNPRI annual report for 2022

The principles themselves are pretty generic and subject to interpretation. They are:

As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognize that applying these principles may better align investors with broader objectives of society. Therefore, where consistent with our fiduciary responsibilities, we commit to the following:

1. We will incorporate ESG issues into investment analysis and decision-making processes.

2. We will be active owners and incorporate ESG issues into our ownership policies and practices.

3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.

4. We will promote acceptance and implementation of the Principles within the investment industry.

5. We will work together to enhance our effectiveness in implementing the Principles.

6. We will each report on our activities and progress towards implementing the Principles.

Allow me to translate into my own words:

1. ESG should be part of the investment analysis and portfolio management process at firms that are UNPRI signatories. There should be an escalation process to senior management for really “bad” ESG companies. Or perhaps, the investment process specifically excludes them. That depends on the investment manager.

2. Investors should vote proxies and for management and Board members that are in favor of ESG-related initiatives.

3. Investors should ask for ESG-related data and written policy materials from the companies in which they invest.

4. Investors and asset owners should convince others to sign UNPRI.

5. Investors should collaborate with other investors who have signed UNPRI on UNPRI-related matters, such as ESG investing.

6. Annual reports to UNPRI are required, some of which become public. Note that asset owners may require more ESG disclosure than is made publicly available by UNPRI.

Lack of Standard ESG Data and Definitions

Note that while ESG is mentioned here, it is not defined. That lack of a standard definition is certainly part of the confusion. The graphic below shows one (not exclusive or inclusive) version of ESG. Should an investor be aware of these issues, both from a performance and risk standpoint? Absolutely. However, with any investment, there are typically a couple of key items (probably not ESG-related) that will drive whether the investment makes money. For example, will the company go bankrupt, or will it grow earnings a lot? Many of the ESG factors are ancillary to central investment theses, which is why the key phrase “consistent with our fiduciary responsibilities” appears in the introduction of the principles.

In addition, since ESG is not defined in the six principles, companies, investors, and third parties may have different interpretations or versions. For example, the governor of Florida, Rick DeSantis, pulled money from BlackRock saying that ESG was being used as a bludgeon to enforce woke capitalism. See Rick DeSantis pulls money from Blackrock over ESG [USA Today].

The Economist wrote a cover article back in February and then a special report in July, 2022 that ESG was broken, needs repairs and may not be the solution to sustainable investing. See ESG is Broken [The Economist].

As this is a blog focused on sustainability, I do think it is interesting to identify where that lies in the E,S, and G. And don’t stop reading now as I do have a solution for you if you are interested in investing for sustainability, but now think that ESG is just a hot mess. I also have some ESG reporting advice for business owners and executives.

Impact Investing vs ESG Investing

First, understand that ESG and impact investing are not the same and not completely defined. I think of ESG investing as more generic, and impact investing as focused on a specific cause, like clean energy or social impact. I think that impact investing is the solution to many of the issues around ESG. One of the issues with ESG investing is you may not really know what you are getting. Impact investing specifically identifies an investment theme you may want to invest in. For example, you could invest in a “climate focused” fund that buys stocks of companies that make electric cars, windmills, and other sustainable world energy solutions. Frankly, this area of investing is much further along in Europe and better regulated, but there are plenty of impact funds available in the US.

Here are some examples of impact investing styles:

Climate focused
Renewable energy
Companies with good work environments
Socially focused (e.g., excluding alcohol and tobacco stocks, including workplace diversity screens)
Sustainable agriculture/forestry
Microfinance/focus on world’s poorest people

ESG and impact investing are not necessarily that well understood by investment professionals, so the same is true for the general public. Many individuals might feel that investing through a smaller institution, say a credit union rather than a big financial institution might be enough to “go green”, but this is not necessarily the case. I personally think that impact investing, whether from a large or small institution, is more likely to accomplish sustainable investing goals than generic ESG investing or relying on a smaller institution.

ESG Investing is divided into three areas:

The E, environment, is square in the sustainability zone. A company’s net-zero greenhouse gas (GHG) plan, consumption of natural resources, what business they are in (pumping oil versus producing solar panels), pollution or other impacts on the planet, are all important. Nevertheless, it may be hard for an external ESG analyst to know everything going on at a company. It is important for companies to be both transparent and explicit about their sustainability policies so investors and ESG analysts can understand. Companies should have written policies and procedures about environmental factors and sustainability to get credit for them. For example, at what size of a hazardous spill or leak does it get reported and to whom? What does the escalation process look like? What percentage of their energy consumption is renewable?

The S, social, does not completely overlap with sustainability. It is certainly important to understand the supply chain of a company to make sure poor social policies are not simply being hidden from view. One cynical trend is companies spinning off subsidiaries or outsourcing manufacturing processes that emit GHG and not counting them as reported scope 1 GHG emissions for the parent company.

The G, governance, is certainly important to guide a company’s sustainability efforts! One example here is Board of Directors diversity. Ethics around company management, including sustainability, are critical. Unfortunately, many issues around sustainability are not well understood, and the potential for misstatement, greenwashing, or even outright fraud is real.

If you want to learn more, The Case Foundation put out a “short” guide to impact investing a few years ago: Case Foundation Guide to Impact Investing

ESG for Executives, Board Members and Owners

I have saved a bit at the end here for business owners and Board members, but I will make it brief. The SEC is planning to require climate risk reporting and filings around GHG starting with fiscal 2023: SEC Climate Risk Proposed Deadlines. I will be addressing this topic in depth in a future article.

There are a few pieces of advice I can give that are pretty straightforward:

1. First, most ESG ratings firms use only what is publicly available. If you have great, ESG-aligned policies, but they are not accessible somewhere (e.g. your corporate website), then that does not help your firm.

2. Second, because there may be more limited information for some companies, the information that is public becomes more important, for example Board diversity.

3. Third, regardless of how much ESG risk your firm takes, showing that you are actively measuring, managing, and controlling that risk is the way to improve your ESG score over the long term.

Of course, despite these tips for management, ESG remains extremely complex. As mentioned above, there are some critical issues with ESG accounting, data and choices about reporting frameworks and standards. See the links below:

ESG Accounting Standards [Harvard Business Review]

Barriers to Using ESG Data for Investment Decisions [Jonsdottir et alia]

ESG Reporting Frameworks

In conclusion, it looks like ESG investing may be shifting into the rear-view mirror, at least for some investors, if not reporting companies. If you want to make a difference in your investment portfolio, think about impact investing. As a corporate entity, despite that potential shift, the regulatory environment looks to get tougher, and it is important to address ESG reporting from quantitative and qualitative standpoints as well as staff appropriately to comply with the new proposed SEC climate risk rule.

News of the Week, Etc.

Sustainable Fund Challenges [Barrons]

US Agency Determines Millions in ESG Investing [Barrons]

CES 2023 highlights enterprise push toward sustainability [TechTarget]

Green jobs are booming, but too few employees have sustainability skills [Salon]

How to harness the ancient partnership between forests and fungi [TED Talks]

Activating Sustainability in the Boardroom [Harvard Law School]

Top Clean Energy ETFs [NASDAQ]

Sources

Keeley, Terrence. Sustainable: Moving beyond ESG to Impact Investing. Columbia University Press. 2023. Buy it here (paid link)

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