For investors who want to promote the values around Environmental, Social and Governance (ESG) factors in their investments, there is no perfect solution. And it remains an open question whether the growth in ESG-centric decision-making over the last decade has been the luxury of a generally rising market. For now, the best approach is to maintain an open dialogue with your advisor, so that your assets can be invested in ways that support the values you hold. By working with each client individually through a separately managed account, Mitchell Capital has been doing this for years.
ESG refers to the idea that how a company impacts the world should influence our investment decisions. Makes sense, but how do you apply that to your investments? ESG is based on the view that how companies, for example, respond to climate change, treat their workers, and conduct their governance can impact their financial performance. This is different than Socially Responsible Investing (SRI) which has been practiced for decades and which considers the environmental and social effects of investing and typically manifests itself in negative restrictions such as no alcohol, tobacco or weapons companies.
Generally credited to an idea loosely connected to the United Nations in the early 2000’s, ESG has since grown rapidly over the last decade. The U.S. Sustainable Investing Foundation estimates that 25% of professionally managed assets incorporate ESG in their decision-making. As investors began paying more attention to ESG factors, they turned to ESG ratings agencies for the details. ESG ratings agencies assemble the data and produce an ESG score. But the challenges are numerous.
First, there are no agreed-upon standards for ESG disclosures. Each company can make its own assessment of what and how to disclose. Second, there is no auditing process to verify what data is reported. As a result, ESG ratings agencies must apply assumptions, the degree of which is uncertain. Third, there is no common framework for ESG ratings. Each agency model is unique in terms of data input and weights applied, which results in a low degree of correlation across agencies for any one company score. Contrast this with credit ratings agencies whose ratings are far more correlated due to relatively exacting financial reporting standards. Put simply, ESG ratings are highly, highly subjective and the predictive nature of any ESG scores should be viewed with healthy skepticism.
Most investors would agree with the concepts behind ESG investing because companies that prioritize the underlying values embedded in ESG are more likely to thrive than those who do not. A business may make huge profits in the here and now, but if doing so results in them polluting their communities, mistreating their workers, and fostering a toxic culture, those profits will slip away quickly. We cannot put the cart before the horse. A company with strong ESG characteristics that reports weak cash flows, is run by an ineffective management team, or holds little prospect for growth will be a bad investment any day. It is important to keep the business and financial analysis first and foremost. Positive ESG factors are icing on the cake.