Some 30 years ago, when the socially and environmentally responsible investing field was starting, the approach was focused on the company’s external impact or impact on the greater good or society. A frequently-used approach was screening out industries harmful to the environment or people (toxic chemicals), examining corporate governance practices, and examining how companies lobbied on these issues.
This approach allowed people to align their values with their investments. But as more individuals became interested in responsible investing, mainstream firms sought to capitalize on this demand and rolled out new products using ESG data. They claimed screening out environmentally harmful or socially objectionable industries was the outdated method and that using ESG data was the modern and improved approach.
What was missing from this characterization was the explanation that these two methodologies don’t yield the same results. The ubiquitous pictures of rolling hills, windfarms and serene water that often accompanies ads for products using ESG data seemed to imply that using this data had an impact on the planet that may not be there.
ESG data can measure how a company is managing the material, environmental, social, and governance risk factors facing a company. Using ESG data or integrating ESG data into your selection process provides additional screenings for your investments that may affect their performance and risk in various market cycles.
Take the example of a company that uses a high amount of water in its processes. One might assume that a strong or high environmental or ESG score means that the company is managing its reliance on water by implementing systems to protect watersheds or to reduce the company’s consumption of finite water resources. But not so fast. Some companies might reduce their water risk by applying water conservation methods.
Alternatively, the company might be managing its risks by taking steps that don’t align your environmental values. For example, the company could be buying up water rights from nearby communities. Securing these water rights does reduce the company’s risk of running out of water and so can merit a strong score on this material risk factor. But this method isn’t a practice that most people would think aligns with their environmental values or is making a positive impact on the world’s growing issue of water scarcity.
Looking under the hood
Investors need data to make decisions and using ESG data can help them evaluate material risks to the companies they are evaluating, which is why so many asset managers now take this information into account and will continue to do so regardless of how others try to politicize its use.
To help investors make informed decisions, asset managers need to be clear in their communications, compliance teams need to be on guard against marketing that could mislead investors, and marketing and sales teams need to avoid greenwashing their products.
Asset owners and investors need to look under the hood of their investments and see if it matches their expectations. There are various tools including screening, ESG data, or community investing that address different issues and deliver different results for the investors and the world and there is no one size fits all. With these steps, everyone will be better prepared to answer the question: What is ESG and what is it not?