It now seems likely that ESG-based asset allocation will develop a place in the ecology of global financial markets. Properly executed, it can add to the range of choices available to investors. This certainly fits the current Zeitgeist of “stakeholders”.
ESG (environment, society and governance) featured prominently at Berkshire Hathaway’s annual meeting last Saturday, as major institutional investors, themselves seeking to attract and retain more high-margin funds from clients motivated by ESG, pushed for a greater focus on sustainability through Warren Buffett. -run conglomerate, including the composition of its own board of directors. Management does not seem convinced.
Indeed, the point is that ESG metrics continue to rest on sand, not granite. There is still a lot of work to be done to identify and track ESG effectiveness, including a real consensus on separating “best” from “worst” results, and what is behind ESG ratings.
The focus today on ESG is a continuation of advocacy over the years to better align business conduct with improving social welfare, but this time with new labels, new institutions, worldwide application and greater attempts at precision—all with a generous dose of hype.
Many ESG objectives remain complex and controversial. Those concerning the natural environment [E] at least offer the benefits of the natural sciences to help define and measure results. But even widely shared goals like the fight against global warming leave a lot of room for controversy. They range from the rate of climate change, the costs of clean-up and the reversibility of damage to the fair price of carbon emissions.
On the positive side, there is a good chance that market-based approaches will work in favor of a viable solution, not against it.
The social impact is less credible [S] goals such as income and wealth inequality, systemic racism and gender discrimination – all of which reflect the vagueness of the social sciences. They clearly raise the difficulty of reaching a consensus on “better” and “worse” outcomes. People differ widely in their preferences, so forced changes in corporate behavior will inevitably leave some people better and others more disadvantaged.
Governance attributes [G] are hardly less controversial. There is a great deal of literature on corporate governance and its reflection in management performance, the responsibilities of boards of directors, the fiduciary role of institutional investors such as pension funds and mutual funds, and ultimately the individual investor. Many governance loopholes have had to be corrected over the years in response to corporate scandals – through laws and regulations or simply through market intolerance of bad governance. It is a persistent problem. Stay tuned for the next governance controversy.
While it is difficult to achieve agreed-upon and measurable ESG results, it is even more difficult to identify the types of metrics that generate “better” or “worse” ESG results.
There are many published indicators and information available that may or may not predict ESG outcomes. However, digging through readily available information requires intensive and expensive research into the conduct of thousands of business ventures, investigated by an army of analysts with unknown skills.
Each indicator then needs to be assessed and weighted to achieve composite ESG scores – a Herculean task reminiscent of grandma’s chicken soup before she found out about Maggi. What rating scale should be used and how should the weights be set? And to be fully credible, the entire process must be repeatable, so that others can verify the integrity of the work and compare ratings between vendors. The lack of transparency underlies the dramatic differences we see today between competing marketers when it comes to ESG ratings.
While the credit rating industry has been the subject of much controversy over the years, the ratings of publicly issued bonds by Moody’s, S&P Global and Fitch show a high degree of consensus in assessing the capacity of creditors. issuers to honor their debt obligations in full and on time, using roughly the same data and rating methodologies. Such a consensus does not exist in the ESG ratings sold to investors.
Certainly, the sale of ESG ratings to investors is a growing and highly competitive business. There is money to be made. There is also more than enough obscurity and inconsistency in the “fabrication” of summary scores. Rating clients, human being, much prefers simple reports like numbers or letters, and don’t worry too much about the details. The ESG rating industry provides its ratings in a user-friendly manner, and the investment industry uses them to create portfolios and present them to ESG-sensitive clients.
A large disagreement among ESG reviewers does not seem to produce many sleepless nights. Except for opportunistic false statements (“greenwashing”), everyone is happy. Even individual investors. If ESG labeled funds outperform (often in the sales pitch), that’s great. And if they underperform, these investors see it as the price to pay for doing good.
The impressive surge in assets under management of ESG funds suggests that this dynamic is working. It lowers the cost of capital for ESG positive companies and encourages others to join the club. It helps limit access to capital for ESG negative companies. This increases investor satisfaction and earns money for intermediaries. No wonder there is no shortage of appraisers on the road to consolidation.
The hype will continue for some time, even as providers and users try to clean up the ratings industry and national governments (and the European Union) try to define how to identify ESG results. definitive measures and reporting standards as a means of promoting a new definition of “efficient” capital allocation. Better to wait a few market cycles to see what sticks.
Ingo Walter is Professor Emeritus of Finance at the Stern School of Business at New York University.