ESG Investing: Practices, Progress, and Challenges
Bottom Line: Among a wide variety of institutions and firms, sustainable environmental, social, and governance (ESG) investing is rapidly increasing as a trend. For example, as of 2020, the amount of professionally managed portfolios that have integrated key elements of ESG assessments surpassed $17.5 trillion globally. Despite some current shortcomings, the evidence suggests that ESG can deliver high portfolio performance. Yet, there surely needs to be a more uniform system for ESG definitions and ratings among providers. While ESG methodologies are improving and becoming more transparent, such scoring remains in a state of transition, with some rating providers still in the way of refining their methodology through the inclusion of a variety of factors. The good news is that the ESG financial ecosystem is evolving, including issuers and investors who disclose and use information related to key ESG issues.
Forms of sustainable finance have grown rapidly in recent years, as a growing number of institutional investors and funds incorporate various environmental, social, and governance (ESG) investing approaches.
ESG investing has been spurred by shifts in demand from across the finance ecosystem, driven by both the search for better long-term financial value, and a pursuit of better alignment with values.
ESG has also recently garnered interest from the public sector, including central banks that have expressed support for ways to help transition financial systems toward “greener” low-carbon economies to combat climate change.
At a basic level, we can sum up ESG in the climate and energy space as wind and solar energy displacing fossil fuels and electric cars displacing internal combustion engine ones that run on oil-based gasoline.
This study provides an overview of concepts, assessments, and conducts quantitative analysis to shed light on both the progress and challenges with respect to the current state of ESG investing.
The analysis highlights the wide variety of metrics, methodologies, and approaches that, while valid, contribute to disparate outcomes, adding to a range of ESG investment practices that, in aggregate, arrive at an industry consensus on the performance of high ESG portfolios, which may remain open to interpretation.
Generally, there are problems to be solved but ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation.
The investment community must get on the same page in terms of what actually defines ESG.
Progress to strengthen the meaningfulness of ESG investing calls for greater efforts toward transparency, consistency of metrics, comparability of ratings methodologies, and alignment with financial materiality.
For example, while ESG methodologies are improving and becoming more transparent, scoring remains in a state of transition, with some rating providers still in the way of refining their methodology.
Further efforts are needed to strengthen ESG practices so that they are consistent and comparable at the global level involving policy-makers, the financial industry, end-investors and other stakeholders that are helping to shape ESG practices.
Read the full study here.
Drivers of ESG Integration
- ESG issues – including risks and opportunities – can affect the long-term performance of issuers and should therefore be given appropriate consideration in investment decisions.
- The growth in use of ESG disclosure, ratings, and various types of ESG related funds has invited greater scrutiny from a range of market practitioners, and there is a growing awareness from within the industry that ESG investing practices need to evolve to meet the expectations of its users and to sustain trust.
- The ESG investment community clearly needs better and more uniform methodology in terms of what actually defines ESG: ESG ratings can vary greatly from one ESG provider to another.
- Asset concentration associated with tilting portfolios toward high scoring ESG issuers can, depending on the conditions, affect volatility, risk-adjusted returns, and drawdown risk.