ESG in 2021: Closing the Expectations Gap

Closing the ESG Expectation Gap

Efforts to codify, standardize and regulate ESG within the investment industry will be a dominant discussion topic in 2021. This is important work. One of the reasons for the rapid market adoption of ESG has been its ability to mean all things to all people. An expectations gap has opened up however, fueled by a rising demand for ESG-related investment products, a lack of good ESG data, and an unwillingness to address the complex and sometimes contradictory factors underlying ESG investing. To close the gap and build greater trust throughout the investment chain, it seems apparent the industry needs improvements in ESG reporting alongside a more realistic and contextual approach to company evaluation.

The Promise of Standardization

Growing standardization of ESG reporting is essential to narrowing the expectations gap and tackling “green-washing” (unsubstantiated claims to deceive consumers into believing companies’ products are ESG friendly). Common metrics and key performance indicators (KPIs) are required to allow investors to compare and differentiate between companies on ESG criteria, and at the same time allow clients to better evaluate the ESG claims made by portfolio managers.

Significant progress has been made in 2020. Companies have become more conscious of the increasing weight placed on ESG factors by investors and have responded by committing much greater resources to reporting. At the same time, there has been real progress with efforts to bring global ESG reporting standard setters such as the Sustainability Accounting Standards Board (SASB), the International Integrated Reporting Council (IIRC) and the Global Reporting Initiative (GRI) into greater alignment. Regulations emanating from the European Union on the green taxonomy for classifying companies and investment products according to detailed criteria is proving hugely influential in Europe and beyond.

All of this is to be welcomed as an important part of reducing the ESG expectations gap. However, improved reporting is no panacea. To realize the promise of standardization, we need a step change in the quality of ESG evaluation.

Not Everything that Counts Can Be Counted

The saying “not everything that counts can be counted and not everything that can be counted counts” is particularly relevant to ESG. Efforts to ascribe numerical scores to companies inevitably focus on what can be more easily measured and standardized, while ignoring more difficult but ultimately more meaningful terrain. The problem comes when scoring systems are relied upon excessively and influence investment outcomes devoid of context. The downside of standardization is an increasing over-reliance on the results.

Corporate governance is a case in point. Board composition scoring systems are entirely dependent on objectively measurable governance features such as director independence, longevity or over-boarding, where a director over-commits his or her time by sitting on too many company boards. More important factors underpinning director performance such as knowledge, experience and competence, as well as evidence of effectiveness, are largely ignored. Consequently, checklists of best practices can become a shorthand for corporate governance evaluation, with proxy voting advisors becoming judge and jury.

At the heart of meaningful ESG analysis is an evaluation of intangibles such as human capital, corporate culture and stakeholder relationships, and an assessment of the fit with a company’s underlying business purpose. ESG scoring systems bringing environmental, social and governance data points together are at best a proxy measure of this and need to be complemented with company specific knowledge recognizing that no two companies are ever the same.

Ratings Limitations

The overuse of quantitative dominated scoring systems is frequently accompanied by an overconfidence in the results and a failure to recognize their limitations. Translated into investment products, this can serve to undermine trust where ESG branded funds are found to include companies involved in serious ethical controversies. An excessive focus on scoring at the investment product level also encourages the misperception that companies can be easily classified into the good and the bad, the sustainable and the unsustainable. Such a message ignores the inherent subjectivity of ESG and the tension between its different underlying components. It is unsurprising that ESG ratings from providers are found to have a high degree of variance. What is surprising is that anyone should expect convergence over time.

Events in 2020 have revealed in stark terms the limitations of ESG scoring frameworks and the importance of a flexible approach. The COVID‑19 crisis has in many ways been a litmus test of corporate responsibility but is understandably absent from ESG scoring systems. Adaptable analytical frameworks utilizing deep company specific research and company engagement are the only way to respond in periods of rapid change where priority ESG issues can change overnight.

The Tech Sector Challenge

The rise to dominance of the technology sector poses particular challenges for traditional ESG evaluation systems. The valuations of the companies that now dominate the economy are made up chiefly of intangibles, whereas scoring systems frequently appear to have been designed for an older generation of companies. Technology companies have therefore received a relatively free ride from ratings firms, which have been behind the curve on recognizing the potentially negative impact of technology companies on issues such as privacy, mental health, democracy, addiction and broader well-being. Furthermore, they have had little to say about anti-trust and the growing societal backlash against the dominance of technology companies and lack of effective regulation.

Working to evaluate the ESG credentials of the big technology companies further highlights the redundancy of a simple good/bad spectrum of analysis. Frequently, these companies have interrelated positive and negative characteristics, delivering products that are life enhancing for many people while simultaneously contributing to what is widely recognized to be serious societal harm.

Supporting Sustainability Pioneers

It is also important to recognize that established ESG metrics can misrepresent fast-growing innovative companies, many of which offer the best hope of disrupting incumbents and putting the economy on a more sustainable course. ESG assessments are particularly damaging when sustainability pioneers find themselves rated poorly due to their inability to commit the required resources to ESG reporting. A failure to make ESG evaluations more flexible and realistic is likely to lead to some of the most innovative sustainable companies seeking to remain private, to the detriment of public company investors.

Ultimately, closing the expectations gap means better educating all parts of the investing chain in the complexities of ESG investing and the dangers of standardization and oversimplification.