Environment, social and governance as a method of investing has become ever more popular over recent years, but it remains fraught with problems too. Here’s our guide to ESG investing — can it really deliver positive impact?

ESG stands for Environment, Social and Governance, and an ESG rating measures a company’s performance against these criteria. In theory, this allows an investor to see a company’s impact on the world, alongside its profits.

Environmental criteria might look at corporate climate policies, energy use, waste, pollution, natural resource conservation, and treatment of animals. Meanwhile, social criteria examines a company’s treatment of its employees and the communities in which it operates. Governance, on the other hand, deals with a company’s leadership and internal controls, ensuring a business uses accurate and transparent accounting methods, pursues integrity and diversity in selecting its leadership, and is accountable to shareholders.

Whilst individual companies will have ESG scores, provided by key rating agencies such as Bloomberg, Sustainalytics, MSCI and Morningstar, there are also specific ESG investment tools. These include ESG mutual funds, ESG exchange traded funds (ETFs) and ESG index funds, which allow an investor to invest in a place that values ESG principles. More information on the differences between these funds can be found here.

ESG principles are of increasing importance to investors and society on the whole and, as a result, the market is growing rapidly — according to the US SIF Foundation assets chosen according to ESG principles amounted to $17.1 trillion in 2020, an increase of $12 trillion from 2018, whilst the assets under management of ESF-specific mutual funds and ETFs also grew at significant rates. In fact, Bloomberg predicts that total ESG assets under management could exceed $53 trillion by 2025.

How does ESG scoring really work?

An article from Bloomberg, published in 2021, offers a great insight into how ESG criteria are measured and some of the pitfalls of this system. It explains how ESG investing does not measure a company’s impact on the planet or society, but rather the financial risk posed to the investor. An example used in the article is that McDonald’s Corp., whose supply chain generated more Greenhouse gas emissions in 2019 than Portugal or Hungary, and has increased its emissions some 7% in 4 years, received a rating upgrade due to their environmental practices.

This was because McDonalds installed recycling bins in stores in the UK and France (which they had to do to avoid fines), which therefore reduced the financial risk to the investor associated with packaging material and waste.

As a result of this dynamic, ESG ratings are related to the market the company operates in, so an ‘industry leader’ might get an improved ESG score even if they have an awful impact on the planet. Thus, incremental changes are disproportionately rewarded, while a company’s cumulative impact isn’t clearly assessed.

There is confusion between ESG rating agencies too. Different agencies often give significantly different scores for the same company because each has a different weighting for the E, S, and G components of ESG. All this creates an incredibly murky picture for investors and highlights the challenges we still face in even defining what sustainable business looks like.

Bloomberg predicts that total ESG assets under management could exceed $53 trillion by 2025.”

In addition, many ESG rating improvements seem to be driven by Governance increases alone. For example, of the 155 ESG rating upgrades that MSCI awarded to S&P 500 companies from the start of 2020 through to June 2021, 42% of upgrades were driven by improvements in Governance, 32% by improvements in Social, and just 26% in the Environment.

Furthermore, in research published last month by Kim and Yoon, it was found that whilst firms widely advertised their signing of the UN PRI (Principles for Responsible Investment) which led to greater fund inflows, many of their actual ESG scores did not improve. This would imply a case of greenwashing, with ESG commitments being used as a marketing tool and not really translating into real impact and improvements in their operations.

So, whilst ESG ratings can be useful and their increasing popularity is extremely positive, it’s clear that there remain some key issues. Namely, that ESG scores need to be driven by the impact of a company on the planet and society, not its governance, and that there must be more consistency in the measurement of ESG, to avoid greenwashing and a lack of transparency for investors.

The EU taxonomy and how it addresses the problems of ESG

The EU taxonomy regulation is a framework to classify ‘green’ or ‘sustainable’ economic activities in the EU. They define sustainable activity through six environmental objectives:

  1. Climate change mitigation
  2. Climate change adaption
  3. Sustainable use and protection of water and marine resources
  4. Transition to a circular economy
  5. Pollution prevention and control
  6. Protection and restoration of biodiversity and ecosystems.

To classify as a sustainable economic activity a company must contribute to at least one of the environmental objectives and “do no significant harm” to any of the other six. The economic activity must also meet “minimum safeguards such as the UN Guiding Principles on Business and Human Rights to not have a negative social impact, whilst also complying with the technical screening criteria of the EU Technical Expert Group”.

This provides a clear framework for sustainability and defines when a company’s economic activity is environmentally friendly. Also, the EU taxonomy reorients ESG to be more impact focused, which should benefit the environment, whilst simultaneously reducing opportunities for greenwashing.

The other most critical regulation is the Sustainable Finance Disclosure Regulation (SFDR), which targets asset managers. The SFDR sets out mandatory ESG disclosure requirements for asset managers with regard to their investment strategy and is divided into three primary sections:

  • Article 6: funds without a sustainability scope.
  • Article 8: funds that promote environmental or social characteristics (light green).
  • Article 9: Funds that have sustainable investment as their objective (dark green), meaning they only invest in sustainable assets and target a sustainable outcome.

Broadly seen as being more strict than many asset managers expected, the SFDR regulations are a step forward in addressing the key issues ESG investing faces. For example, in November 2022 seven funds classified under Article 9 of the EU’s SFDR had to reclassify themselves under Article 8 — a bold step in showing that the regulation will not tolerate over exaggeration of a fund’s climate credentials.

Newer, stricter regulations are a reflection of the increased demand for genuinely impact-oriented sustainable investment, and for ESG to be used in this regard rather than as a measure of financial risk to investors (Refinitive Lipper report in the FT).

Sure, there are A LOT of issues to iron out with ESG, but with better regulation and increased public demand it might just be possible in the future for us to know that when we invest our money it can genuinely do good for the planet and its inhabitants.