ESG Metrics and Insights for 2022

Environmental, Social and Governance (ESG) metrics are becoming an increasingly popular and important way for investors to measure the sustainability and attractiveness of potential investments in large publicly traded companies.   If you are interested in learning more about the details of ESG investing and the related concepts of Sustainable and Impact Investing, we are pleased to provide the following insights for 2022.

What Is An ESG Metric?

ESG metrics are used to assess and understand an organization’s focus on responsibility from a social, environmental and governance perspective.  

Environmental criteria measure to what degree a firm is doing its part to address environmental issues.

 This could range from the size of a firm’s carbon footprint to the effectiveness of its recycling or pollution mitigation efforts. 

Social criteria involve how a company treats people.

This means how a firm manages relationships across the board, from employees and customers to suppliers and the community at large.  Factors considered in social criteria include health and safety, fair trade, employment practices, diversity, community involvement, and the nature or value of the goods or services provided. 

Governance criteria consider a company’s leadership.

Evaluating factors like board diversity and independence, executive pay, shareholder rights, business ethics and disclosure practices are all a part of measuring a company’s governance risk.

How is ESG Data Gathered?

There are three layers in the supply chain of generating ESG rating information:  the standard setters, the data providers and the ratings agencies. 

Standard Setters

There are probably hundreds of non-profit and quasi-governmental standard setting organizations around the world. They provide direction about how and what ESG information should be measured. Leading organizations include the Global Reporting Initiative (1997), the Carbon Disclosure Project (2000), the Climate Disclosure Standards Board (2007), the International Integrated Reporting Council (2010), and the Sustainability Accounting Standards Board (2010). These last two recently merged into the Value Reporting Foundation which is working to help develop an international sustainability standards board.

Data Providers
There are many challenges with gathering and using ESG data. Like financial disclosures, the raw ESG data is self-reported by the companies that are being rated. Many important types of information are not consistently reported or even produced by all the companies within an industry. In addition, the importance of a specific measure, such as the amount of pollution generated or energy consumed might be highly meaningful in a manufacturing setting but not nearly so much so for an accounting business. These once voluntary disclosures are increasingly being mandated by governmental decree, especially in Europe. While this is not yet in place in the U.S., it is being discussed by the SEC. We look forward to the day when ESG data is more widely available and consistently measured.
Rating Agencies

The final layer is comprised of the over 600 ESG rating agencies that gather and evaluate the company information to form databases and scoring systems. MSCI and Sustainalytics are the most prominent firms in the field and are popular due to their broad coverage. Other leaders include Bloomberg, CDP, FTSE Russell, ISS, and Thompson Reuters. Critics have noted that the ratings tend to favor larger companies, in highly regulated industries (such as utilities and telecom) and in regions with more disclosure requirements (such as Europe). The ratings firms use different methodologies and data sources in their scoring systems which can lead to very different rankings. The low correlation between the ratings is often cited as a major issue facing the industry, but not everyone agrees. While some argue for more harmonization and consistency within the field, others appreciate the value of differing perspectives.

What are the Benefits of ESG / Sustainable Investing?

There is a lively debate about the benefits of using ESG data and whether it can be expected to add or detract from financial performance.  Here we provide some background on both the quantitative and qualitative factors to take into consideration with respect to the investment performance of ESG (and Sustainable) Investing.

Quantitative Considerations

A recent meta study found 86 papers published between 2016 and 2020 that measured the relationship between ESG metrics and investment performance. Among these studies, “59% showed similar or better performance relative to conventional investment approaches while only 14% found negative results” (the rest had mixed findings). The outcomes were increasingly positive for those studies focused on climate change related variables and for those that considered risk (in addition to return). The authors also pointed to hypothetical research (back-testing) that suggested very strong financial benefits from focusing on ESG “improvers” (those firms making the biggest gains in ESG metrics) as opposed to ESG leaders.

Another data source that we look to is the Domini 400 Social Index, originally created in 1990 and rebranded as the MSCI KLD 400 index in 1999. It is one of the oldest and best-known benchmarks for Sustainable Investing (defined here as using both ESG metrics and exclusionary screens). This index is primarily comprised of large US stocks and is hypothetical in nature because it has no trading costs or management fees. It excludes sin stocks, weapons, GMO’s, and nuclear power, but not fossil fuels. Through August of 2021, it had outpaced its benchmark by about 0.4% per year for the last 10 years, and 0.7% per year for the last five years, but has underperformed by about 0.5% annually since 1999.

Qualitative Considerations
As past performance cannot be relied upon as being indicative of future results, we also suggest weighing qualitative considerations. On one hand, narrowing the universe of investment options (by excluding certain companies) would normally be expected to increase concentration risk and reduce portfolio returns. On the other hand, we would expect companies with high ESG ratings to be more attractive to customers, employees, investors and regulatory/legal authorities, and to thus have a lower cost of capital and be more profitable and highly valued. For many, it is simply common sense to avoid investments in companies that make harmful products, treat people poorly, damage the environment, have numerous lawsuits pending against them and/or are likely to be negatively affected by climate change. Investors clearly have a lot to think about in weighing the pros and cons of Sustainable and ESG Investing.
Beyond ESG Investing: Making A Return And An Impact

We believe the greatest impact can be realized by putting new money to work directly into the causes that you care about. We call this Impact Investing. It goes beyond what is available in the public stock market and typically involves funding specific projects with measurable impact. Common examples include affordable housing, renewable energy, organic farms and land conservation. It could also involve backing new ventures in education, healthcare, or beneficial infrastructure needed by a community. It might further address gender or racial inequality by investing in woman- or minority-led small businesses, particularly in under-served areas. These are all examples of impact investments. Usually these investments target market-rate returns, although some investors may place a greater emphasis on impact than on return.

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