Environmental, social and governance (ESG) investing has been a hot topic in investment circles for many years. As more people seek to use their money for responsible investing, public awareness of the potential benefits – and shortcomings – of ESG factors is increasing. In this post, we’ll look at how ESG scores are calculated, why these three letters are important and how impact investing can help create a sustainable global economy.
Measuring the limits of ESG
The purpose of ESG investing continues to be called into question. As scrutiny of the metrics used to determine ESG suitability increases, many investors are noticing inconsistencies.
Investors are placing greater attention into which companies are being included (or excluded) in ESG funds. As a result, some have started questioning the logic of the metrics upon which ESG ratings are based. How can a single score accurately and usefully rank companies on such diverse factors as carbon emissions, worker inclusion and corporate governance?
It is true that inconsistencies abound. For example, electric car maker Tesla was removed from the ESG version of the S&P 500 in May 2022, even as oil giants like ExxonMobil stayed in. The reasons related more to social and governance factors, such as claims of racial discrimination and poor working conditions at the company’s California factory.
How are ESG ratings decided?
Investing in ESG funds is not the same as choosing sustainable companies with a low environmental impact. Indeed, the shorthand connection between ‘green’ and ‘ESG’ has caused confusion to many people.
Few investors – even some with significant holdings of ESG funds – understand exactly how ESG ratings are decided. This is partly because, with every ratings agency using their own metrics, there is no single definitive way of measuring ESG.
Moreover, most ratings are based on ‘single materiality’, which means they are a measure of the impact of the changing world on a company’s profits and losses. Or, to put it another way, an ESG rating measures how exposed a company is to non-financial risks rather than certifying that the company is having a positive environmental and social impact.
The finance industry needs to quantify because people get paid based on what is measured. When it comes to assessing the sustainability of a company, there are two conflicting truths:
- What gets measured gets done
- Not everything that matters can be measured
Given the vagueness of the ESG label, it is not surprising that different ratings agencies often have wildly different criteria. Many put the greatest emphasis on environmental factors – but even within the ‘E’, there are significant differences in what is measured.
Using measurements the right way
In this way, ESG ratings are an industry solution to an industry problem. Trying to reduce a company’s complexities into one objective figure is close to impossible. But having a measurable rating is important as it pushes companies to make positive change.
This is where the PWM Green Matrix comes in. Launched in 2021, the PWM Green Matrix uses independent sustainable methodology to help you build a bespoke portfolio that combines returns with protection for the planet. By filtering thousands of options, we can match your individual requirements with the most appropriate sustainable investment opportunities.
A sustainable global economy
Klaus Schwab, founder and Executive Chairman of the World Economic Forum, has argued that it is time to move to a new system of stakeholder capitalism. This would allow the full impact of corporate activities to be better considered, he claims; it could also help build a “more inclusive, sustainable, and resilient global economy post-COVID”.
Many people would agree that consumerism, which underpins capitalism, has contributed to the world’s environmental problems. Unfortunately, with key climate deadlines fast approaching (or already passed), there is little time to invest in something new. As such, consumer habits and capitalism must be a part of the solution.
So, what might this look like in practice? How can we rapidly decarbonise the economy without harming development and living standards? And how can ESG measures help?
Who can lead this transition?
There are three main groups who have the power to create a more sustainable global economy: governments, corporations and consumers.
Governments can act unilaterally, bilaterally or through supranational organisations (like the UN) to set policy and lead the world into a more sustainable future. A good example is the Clean Cooking Alliance, which works to lessen the environmental damage caused by dirty fuels while improving human health.
The next group is corporations, which have the power to invest to produce positive outcomes for people and planet. Alongside a surge in green technology start-ups, large corporations are increasingly focusing on research and development of more sustainable solutions. For example, car manufacturers are investing heavily in electric vehicles (EVs) and meat companies are ramping up efforts in the fields of plant-based products and lab-grown meat.
ESG metrics are most relevant to mainstream businesses, which have a larger scope for impact. For example, Unilever, a multinational corporation with a carbon footprint the size of a small country, has pledged to achieve net zero across its value chain by 2039. Providing more incentive for companies to focus on sustainable measures – for example, by linking board renumeration to ESG metrics – would help accelerate their transition.
How consumers impact ESG performance
The final group, consumers, might seem like the least powerful; however, they are arguably in the best position to bring about change.
This is because consumers influence both governments and corporations, the former with their votes at the ballot box and the latter with their spending habits. If enough consumers choose not to buy an unsustainable product, the company selling it goes out of business. This behaviour would force companies to respond to and influence its customers’ needs and wants.
Some governments and companies act to facilitate the required changes out of a greater self-interest. But often it is the collective actions of individuals that can drive through the changes required by both.
If ESG isn’t the answer, what is the question?
Measuring green credentials alongside investment performance is essential to creating a balanced and sustainable portfolio. Consumers, corporations and governments all have a role to play in the transition to a green economy.
The UK Government is tightening up the measurement of sustainability of retail investments, which is due to be implemented later this year. This is a welcome development in a rapidly evolving space.
We’re here to help
If you would like to discuss how we can help you to invest in a more sustainable future as well as your retirement, please contact your Partners Wealth Management adviser, or call us on 020 7444 4030 for an initial conversation.
Partner, Head of Sustainable Investing
020 7444 4037
The contents of the article have been prepared solely for information purposes. The article contains information on financial products and services and such information is designed for and addressed solely to individuals seeking generic industry information. Past performance is no guide to future returns. The above content does not represent a personal recommendation.