Sustainable investment is becoming much more widely adopted. In the US, at the start of 2018, US$11.6 trillion of assets were managed using various environmental, social and governance (ESG) criteria. However, there are still important hurdles to overcome to more widespread adoption. Jason’s presentation focussed on three of these.
Hurdle 1: Mental models
The mental models of participants in the investment industry are generally built on quantitative factors such as risk and return, portfolio optimisation and fees. ESG criteria cover a wide range of factors: from air pollution to audit committee structures; from biodiversity to bribery; from child labour to climate change. These criteria are often seen as in conflict with the standard financial criteria. Indeed that conflict is often seen in everyday life: ecological cleaning products that maybe do not work as well as conventional ones; electric cars which don’t have the performance of their conventional fuel competitors.
This makes many of the conversations about adopting ESG overtly challenging and political. One approach is to say that some investment performance may have to be sacrificed to meet ESG requirements. However, a body of evidence suggests that performance need not be compromised. Perhaps the most comprehensive assessment of the link between ESG criteria and corporate financial performance (CFP) found that “the business case for ESG investing is empirically very well founded. Roughly 90% of studies find a nonnegative ESG–CFP relation.”
Furthermore, a recent study mapping sustainability characteristics on a firm-specific basis showed that firms with good ratings on material sustainability issues significantly outperformed firms with poor ratings.
Hurdle 2: Data
The second hurdle is the issue of whether the data can be trusted. The general approach taken is to collect ESG data, do a rating of companies based on this and then an analysis of performance in relation to it. Data availability is growing: the proportion of S&P 500 companies reporting such data was 85% 2017, up from 20% in 2011. Even so, there are 45,000 listed companies in the world and we have ESG data for only 7,000 of these.
Another major concern is that there is little correlation between different agency rankings: only 66% between two major ones, for example. For credit ratings, the correlation between the major agencies is typically 90-95%. The explanation of the weak correlation lies in: measurement error; the use of different indicators; and different processes for aggregation. In this environment, analysts can take a very simple view – such as “I like company X for these reasons” – and not make a proper assessment of each of the many ESG criteria.
Hurdle 3: Impact
Many people want to behave responsibly and also want to feel good about their investments. But if we want, for example, less gun crime, what can we do? One approach would be to provide capital to firms that actively seek to reduce this. But in a well-functioning capital market, most firms have access to capital. An alternative would be to buy into gun companies and put pressure on them to deal with gun crime themselves through, for example, tighter checks, providing information about how the guns they sell are used, and so on. Jason gave an example of that approach – “nuns with guns” – where a nuns’ pension fund invested in gun companies to seek a change in their behaviour.
Research in this area has shown that investors can affect companies through such shareholder engagement, especially when the costs of demanded reforms are low, investors wield influence, and companies have prior experience with engagement.
Overcoming these hurdles to sustainable investing is no easy task, yet there is an important and growing demand for investing in a sustainable manner. Improvements in data gathering and analysis may well be one of the most important practical ways in which this can be advanced in the coming years.
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