ESG is a widely discussed topic nowadays and has recently become increasingly politicized. The logic behind it is obvious and sound: investors will do better in the long run if the businesses they invest in are sustainable for the long run. However, putting that logic into practice has been challenging. In part, this is due to the vagueness of the term “ESG”, which The Wall Street Journal dubbed as 'the latest dirty word in corporate America.'
Investors began ESG initiatives in the 1960s, starting as “socially responsible investing,” to exclude stocks or entire sectors from their portfolios based on business activities such as tobacco production or involvement in the South African apartheid regime. The main motivations were ethical considerations and alignment with values.
Today, the field has expanded to consider financial materiality as well. Many investors now consider incorporating ESG factors into the investment process alongside traditional financial analysis. Some studies suggest that companies with high ESG scores tend to outperform the market, while others indicate no significant difference. I would suggest that it is too early to tell. The interplay between ESG ratings and stock performance may vary based on the time horizon, sector, and region.
Much of the data and information about companies used in sustainable investing has historically been self-reported, voluntary, backward-looking, non-standardized, and, therefore, inconsistent over time and from one company to the next.
“Green-washing” and “social-washing” have become ubiquitous, with companies announcing bold, ambitious, long-term goals while having little accountability to provide follow-up information. In some cases, the data provided is misleading or even fraudulent. The most notable example of this is Volkswagen cheating on their emission tests by fitting cars with special “defect” devices while simultaneously touting the low emissions of its vehicles.
The need for improved transparency has led to the emergence of a cottage industry of providers offering ESG ratings and data for investors to consider (See graphic).
Source: Corporate Citizenship + SLR
To make matters worse, there is little correlation between each of the ratings. The graph below illustrates the ESG rating divergence. The horizontal axis indicates the value of the Sustainalytics rating as a benchmark for each of the 924 firms. Rating values by the other five raters are plotted on the vertical axis in different colors.
Source: Aggregate Confusion – The Divergence of ESG Ratings (2022)
The purpose of ESG ratings is to assess a company’s ESG performance. However, with the multitudes of rankings available and the confusion they cause, how can investors know which companies to trust?
The SEC’s push to make ESG ratings more transparent and standardized has the potential to provide a solution to the controversy surrounding ESG. The SEC proposed climate disclosure rules for the first time in 2022, and final rules may become available this year. The rules will require narrative disclosures, independent attestation, and inclusion into financial statements. Although this only addresses only the “E” in ESG, it is a meaningful step forward.
Like any regulation, this new requirement will come with significant costs and effort for any impacted public company. On the plus side, regulations will level the playing field for all companies. It will discourage greenwashing, enable investors to make sound decisions, support socially and environmentally conscious companies, and generate better outcomes for society as a whole.