Industry Investment Policy Technology

Editorial – The True Value of ESG Scores

While small groups of investors have been investing sustainably for decades, primarily through exclusionary approaches, the case for a quantitative measure of sustainability is quite clear for those who want to make money while protecting the planet. Rather than simply excluding businesses operating in areas deemed ‘unethical’ – a term which has encompassed everything from nuclear arms to pornography in socially responsible investment (SRI), a scoring mechanism allows investors to compare and identify the best firms and funds undertaking or facilitating sustainable practices.

However, a sustainability scoring mechanism has potential far beyond simply helping eco-warriors optimise their investments, they allow the value of sustainability to what might be a relatively small group (28% of investors favoured negative climate investment as of 2016[1]) to be propagated across the global economy.

As sustainability scores become better established and more commonplace, an increasing number of investors and sustainability focused funds will integrate them in investment decisions. Now we consider the implications of this upon markets more broadly. If for example, a business has made significant changes, such that it’s environmental scoring increases, those conscientious investors with a prudent eye to scores will be more inclined to invest in the firm – in other words demand increases. From here, fundamental economics leads us to the conclusion that this change in score will therefore result in an increase the price of any bonds or stock in the business.

As such, environmental scores become essential to all investors, fund managers and analysts, hence it is essential for all, but particularly those interested in a world of sustainable economic growth, to have a firm understanding of a selection on sustainability scores.

Taking into account a mixture of Environmental, Social, and Governance (ESG) factors based on data from various sources (notable leaders include Sustain Analytics, Vige Eiris and ISS), scoring methods use a variety of weightings to analyse the historical and current activities of companies against those in their own sector to give them a relative ranking.

These rankings can act as a quantitative guideline to potential investors when predicting the future economic performance of a firm and evaluating if it meets their standards of social responsibility. These scores are having an increasing impact on global markets, with a change in ESG score now having material implications for market capitalisation (see below figure). By taking this more nuanced approach (as distinct from the ethical binaries of SRI, defining potential investments as only ‘acceptable’ or ‘unacceptable’) markets can more easily internalise the ESG impacts of investments on the globe, allowing a more sustainable approach to investment to be undertaken. 

Sources: NN Investment Partners and the European Centre for Corporate Engagement

While it is likely apparent to the reader that ESG ratings are both useful for informing sustainability minded investors and influencing global markets to favour alignment with investors, they are not without their issues.

Firstly, as ESG scoring firms are not completely transparent with their scoring methodologies, firms with some none ESG aligned activities may not be identified explicitly as such by their score, leading investors to ‘reward’ firms with no ethical entitlement to the benefits of a higher ESG score. This is particularly the case for hedge funds, ETFs and banking institutions more broadly, where no direct non-ESG activities may be taking place, but funding and subsidiary organisations may be supporting unethical activity.

Secondly, many scoring mechanisms work on an industry basis. This can lead to firms being scored in a top category simply by being the most ethical in their field, even if that field is itself inherently unethical. However, some scoring mechanisms, such as Bloomberg’s ESG data service act objectively, therefore it is most important for the investor to have an understanding of the basis on which different ESG scoring mechanisms work, in order to achieve maximum impact with their capital.

Despite some shortcomings, which can be expected to be addressed as demand for clear ESG information continues its upward trend and regulations on ESG labelling become more stringent, most notably in the EU’s Mifid II [2], ESG ratings are a must for any investor looking to make ethical money, and even those who follow only the God of profit.

  1. Schroders November 2016
  2. European Securities and Markets Authority
  3. Emily Steinbarth, Scott Bennett, Russell Investments May 2018
  4. Betty Moy Huber, Michael Comstock, Davis Polk & Wardwell LLP July 2017