Evaluating an ESG Investment
Herding Cats Might Be Easier
By Carlos Pinto Lobo
September 7, 2021
Contents
1: What does “ESG” mean?
Figure 1: ESG Risk Factors
1.1: Why are ESG Factors Important
Figure 2: ESG Projected Global AUM
2: Is there a difference between ESG, Socially Responsible Investing (SRI) and Impact Investing?
2.1: ESG
2.1.1: What are some key ESG factors?
Figure 3: ESG Factors
2.2: Socially Responsible Investing (SRI)
2.3: Impact investing
2.4: Does an ESG Rating Identify a “Green Company”
2.5: What is Greenwashing
3: Evaluating ESG in a portfolio
3.1: Ratings Companies: Are they all the same?
Figure 4: Ratings Company
Figure 5: Ratings Company ESG Score for a BioTech Company
Figure 6: Ratings Company ESG Scores for a Pharmaceutical Company
Conclusion
1: What does “ESG” mean?
The term ESG means environmental, social and governance factors and was first mentioned in a 2004 UN report titled “Who Cares Wins, 2004 – 08”. At that time, the initiative was created by the UN Secretary General and UN Global Compact, in collaboration with the Swiss government and 23 financial institutions representing $6 trillion in assets. Got all that?
The concept was to support the growth of sustainable capital flow and enable capital markets to integrate ESG factors into the investment decision making process. It’s basically a way to have your cake and eat it, too. Profits and a way of saving the world from destruction – could it get any better?
Figure 1 below, shows some of the risk factors that companies must be aware of and the actionable plans they must have in place, to help reduce these risks and the impacts to their business. A company that addresses these risks is sustainable and attainable! Keep in mind that each company is not equal, and evaluating their ability to mitigate these risks can be daunting.
Figure 1: ESG Risk Factors
1.1: Why are ESG Factors Important
According to a recent Harvard Business Review article, a third of all professionally managed assets worldwide – or $30 trillion – are now subject to ESG criteria. What is even more remarkable about this number is that it represents an increase of over 30% since 2016; however, that growth rate is increasing. Between April and June of 2020, investors poured $70 billion into ESG equity funds. In a February 23, 2021 article, Bloomberg estimated that ESG assets may account for $53 trillion by 2025, or a third of the global AUM. The referenced article can be found here.
Figure 2: ESG Projected Global AUM
As can be seen from the above, the value of an investment is no longer just about returns. An increasing number of investors want to see their money go towards stocks of funds that are profitable and reflective of their social values.
This article will focus on ESG factors and how to evaluate those factors’ investments, but it would benefit the reader to understand the differences between the various types of values-based investing categories.
2: Is there a difference between ESG, Socially Responsible Investing (SRI) and Impact Investing?
The terms ESG, SRI and impact investing are used interchangeably to the point where they seem to mean the same thing. Despite this tendency, there are crucial differences:
2.1: ESG
The integration of ESG factors is used to enhance traditional financial analysis by focusing on potential risks and opportunities beyond technical valuations. While there is the additional focus of social awareness/responsibility/consciousness with respect to the investment, the overall financial performance of the asset is still the main factor.
2.1.1: What are some key ESG factors?
The chart below highlights some of the key ESG factors.
Figure 3: ESG Factors
| Environmental | Social | Governance |
| Energy consumption | Human rights | Quality of management |
| Pollution | Child and forced labour | Board independence |
| Climate change | Community engagement | Mitigating conflicts of interest |
| Waste production | Health and safety | Executive & board compensation |
| Natural resource preservation | Stakeholder relations | Transparency and disclosure |
| Animal welfare | Employee relations & diversity | Shareholder rights |
| Greenhouse gas emissions | Working conditions | Tax strategies |
| Carbon offsets | Indigenous nations | Structural complexity |
| Biodiversity | Supply chain standards | Business ethics |
2.2: Socially Responsible Investing (SRI)
For clients involved in socially responsible investing, this is a step beyond being aware of ESG factors. The goal is to generate profits without violating their personal ethical standards or consciousness. SRI investors actively remove or add investments based on their ethical guidelines. Examples of these guidelines may include:
- Weapons and defence tools production
- Tobacco, alcohol, or other addictive substances production
- Gambling
- Porn
- Religious criteria
- Terrorism affiliations
- Human rights violations
- Labour violations
- Environmental damage
2.3: Impact investing
Impact investors want to make a direct social or environmental impact while making a profit. This is achieved through values-based priorities, where the main objective is to determine how the investor’s capital is used. These assets report on financial performance but also initiate and quantify social impact.
For example, with these assets, an investor will be able to see how many solar projects were completed, how many schools were built, the percentage drop in recidivism due to the increase of educational resources in prisons, the number of immigrants who are given job opportunities, as well as the integration of indigenous markets into the mainstream.
Impact investing falls between charitable giving and SRI, with one distinctive advantage being that an impact investor can support causes like poverty reduction or community development in a way that public financial markets do not address.
2.4: Does an ESG Rating Identify a “Green Company”
Short answer: “No.”
An ESG rating identifies how well a company – with respect to its industry peers – has identified and addressed various environmental, social and governance risks (See Figure 2), that the company faces, but having addressed those risks does not mean that a company qualifies as green. In fact, some companies use their ratings to market themselves as being a “Green Company” when in fact, at a closer look, they may not be. This tactic is called “Greenwashing.”
2.5: What is Greenwashing
Greenwashing, which is a play on the term whitewashing, is a deceptive marketing practice that various companies use to promote their practices as eco-friendly. Since the public is increasingly moving their money towards companies that align with their social values, some companies use this to their advantage. They capitalize on this trend and will go so far as to claim that they have policies and procedures in place to be environmentally or socially committed, when in fact they have not implemented any significant changes at all.
Common examples of greenwashing can be seen when some companies include words such as vegan, sustainable, eco, alternative materials or green in their marketing campaigns.
The tactic of using an ESG rating is also used by public companies with the hope that investors will invest in their companies. The issue remains: How does an average investor know (i) Which rating is favourable and, (ii) How does the company measure up to similar companies in a specific industry?
3: Evaluating ESG in a portfolio
Investors believe that focusing on companies that have good ESG practices alongside good financial performances will lead to sustainable risk management and long-term profit generation. The issue for most investors is how to evaluate which asset(s) best aligns with their values. For most investors, this can be a daunting task and they leave it to active managers by purchasing either mutual funds or ETFs which include ESG factors.
In 2020, inflows into Canadian-based environmental, social and governance (ESG) funds topped $3.2 billion. Currently, assets under management (AUM) in Canadian-listed ESG-focused funds account for less than 1% of AUM in all Canadian funds – $22 billion compared to about $2 trillion, according to ISS – but that number could see a dramatic increase over the next several years.
If however, an investor wants to emphasize certain values that are important to them, such as focusing on companies that have high human rights scores (Increased “S” score) or on companies with lower carbon footprints (Lower “E” scores) it becomes difficult to choose.
Also, making a choice based on what is popular, can lead to false scores. For example, when assuming electric vehicle companies should have high ESG scores or that such investments may be considered low risk, but are they, really? Or looking for specific data captures without looking at the results, for example, assuming companies that have increased diversity on their management teams lead to better results. The data captured may only include the amount of diversity and not the actual financial performance of the company as a result of the diversity.
Most investors do not have the time, expertise, or the resources to evaluate each ESG asset effectively, so that they may manage their portfolio in a timely manner. As a result, most investors turn to independent research firms/ESG ratings agencies to help them make their decision.
3.1: Ratings Companies: Are they all the same?
ESG rating agencies are becoming a major force in markets. Most institutional managers rely on ESG data to make their investment decisions, and they rely on the ESG ratings companies to provide that data.
Companies that measure and rate ESG factors include but are not limited to those listed in Figure 4 below.
Figure 4: Ratings Company
| Rating Company | Is ESG Embedded in Financial Information | Description |
| MSCI ESG Ratings | No | One of the world’s largest ESG research provider, publishes ratings and research on over 14,000 equity and fixed income issuers |
| S&P Global ESG Score | No | The ESG scores of 7,300+ companies are calculated based on company answers to S&P’s own Corporate Sustainability Assessment (CSA) and/or publicly available data. Each participating firm is assessed using almost 1,000 data points. |
| Sustainalytics ESG Risk Ratings | No | A Morningstar subsidiary, offers data on 40,000 companies worldwide and ratings on 20,000 companies and 172 countries. |
| Morningstar Inc. | Yes, information includes:Quotes; Stock analysis; News; Financials. Valuations, etc. | Morningstar is a respected and reliable source of independent investment analysis for all levels of fund and stock investors |
| Refinitiv ESG Scores | No | Owned by the London Stock Exchange, it measures a company’s relative ESG performance, commitment, and effectiveness across 10 main themes, based on publicly available and auditable data. |
A known truth about these ratings companies is that their metrics conflict with one another, as shown in Figure 4 below. In some cases, as illustrated in the ratings of Sustainalytics and Morningstar, the parent and the subsidiary’s ratings do not agree.
Each of these companies have their own criteria for measuring ESG factors based on auditable data points, but as explained earlier, their results vary, for example:
- MSCI ESG ratings focus on a letter scale from AAA (“Leaders” on ESG) to CCC (“Laggards” on ESG).
- Sustainalytics ratings fall into 5 categories from “negligible” to “severe”
- Refinitiv ESG ratings are out of 100 both for both an overall score and per subcategory score.
Figures 5 and 6 below show the results of searches using the companies listed above. For these examples, two companies were chosen because of their high-profile roles and media exposure during the COVID-19 pandemic. Figure 5 shows the various ESG scores for a Biotechnology and Research Medical company, whereas Figure 6 shows the various scores for a Pharmaceutical Company. Both companies are public companies and are listed on various exchanges and both have had substantial stock growth in the past year.
Figure 5: Ratings Company ESG Score for a BioTech Company
| Rating Company | # of Sector Companies | Score/Risk Rating | Comments |
| MCSIAs of 07/2021 | 40 | BB – Laggard | ESG Laggard: Corporate GovernanceESG Average: Corporate behaviour; Toxic Emissions & Waste; Product Safety & Quality; Human Capital Development and Access to Health CareESG Leader: Not a leader on any key issue for its industry |
| S&P | Not found | ||
| Sustainalytics | 899 | Medium | No comments |
| Morningstar | Not available | High | Material ESG Issues: Product Governance; Access to Basic Services; Human Capital |
| Refinitiv | 24/466 | 57/100 | No comments |
Figure 6: Ratings Company ESG Scores for a Pharmaceutical Company
| Rating Company | # of Sector Companies | Score/Risk Rating | Comments |
| MSCIAs of 06/2021 | 95 | B – Laggard | ESG Laggard: Corporate Behaviour; Product Safety & QualityESG Average: Corporate Governance; Human Capital Development; Toxic Emissions & WasteESG Leader: Access to Health Care |
| S&P Global | Not Found | ||
| SustainalyticsAs of 05/12/2021 | 87/901 | Medium | No comments |
| MorningstarAs of 09/01/2021 | Not available | Medium | Material ESG Issues: Product Governance; Bribery & Corruption; Access to Basic Services |
| Refinitiv | 46/311 | 67/100 | No comments |
Conclusion
With all this information it is easy to get weighed down and investors may find themselves unable to decide. Is it better to drive greater comparability and standardization or is it better to keep the ratings differentiated?
This is an individual choice and depends on whether the investor wants standardized ratings or if they want data. At the current time, given the diversity in the ratings it is in the investor’s interest to:
- Identify which ESG priorities align with their values,
- Understand how and why an ESG ratings provider(s) meets the priorities the investor has set for themself,
- Monitor the ESG scores and review the ESG assets in their portfolio,
- Make sure that the ESG service provider is not just providing data, but that their input is also making corporations use them as a call to action and dedicating material resources to mitigate material issues which leads to better results and ratings.
It is inconvenient for investors to have so many different opinions because it is hard to consolidate and have one version of truth, but at the same time the diversity of thought is beneficial. By having ratings companies viewing the data through different lenses all in the attempt to do some good, it makes us smarter and more equipped to make better conclusions.
References
1Who Cares Wins, 2004-08 Issue Brief, International Finance Corporation
2Courtesy of HSE International as of April 12, 2021
3Harvard Business Review: ESG Impact Is Hard to Measure — But It’s Not Impossible by Jennifer Howard-Grenville – January 22, 2021
4Bloomberg Intelligence: ESG May Account for $53 Trillion by 2025, a Third of Global AUM
5Investopedia: https://www.investopedia.com/financial-advisor/esg-sri-impact-investing-explaining-difference-clients/
6Investopedia
7DBS Bank
8Market Business News
9Beutel, Goodman and Company
10Candice Batista; “What is Greenwashing? Are the Companies You are Buying From, Tricking You” April 28, 2021
11BNN Bloomberg; “Why Interest in ESG Investing is Set to Explode”. https://www.bnnbloomberg.ca/why-interest-in-esg-investing-is-set-to-explode-1.1567634
12Rate the Raters 2020: Investor Survey and Interview Results. March 2020. Christina Wong and Erika Petoy