ESG-focused assets — increasingly ubiquitous in the global investment landscape — have grown exponentially over the past 10 years. Currently in the United States, ESG investing is over 20 percent of all professionally managed assets and is valued above US$11 trillion. Globally, ESG fund launches increased from 140 in 2012 to 564 in 2019.
This surge in ESG investing has been accelerated by investors’ beliefs that ESG strengthens financial performance, improves brand image and addresses societal imperatives while helping to manage long-term risks. Additionally, a review of 1,000 corporate ESG studies found that more than half saw a positive relationship between ESG and financial performance.
Yet, at best, ESG provides a weak signal of an investment’s full environmental or social performance or risk; at worst, it allows for greenwashing diverting attention of companies from effective solutions to social and environmental challenges. Many companies with negative impact but ESG facades are rewarded for good practices but don’t deliver meaningful outcomes. According to one recent ESG rating provider, for example, the businesses of five of the top ten ESG-rated companies are alcoholic beverages, industrials, metals & mining, oil & gas, and tobacco. Worse there is often no or low correlation among leading ESG rating providers which compares sharply with credit rating agencies that have high correlation.
Further, the ESG investing boom has yet to show it can contribute meaningfully to desired outcomes such as reduced carbon emissions. Global CO2 emissions continue to climb even as hundreds of ESG funds launch. While a time lag between deploying ESG strategies and reducing carbon emissions may be unavoidable, unreliable and incomparable ESG ratings and insufficient auditing contribute to underperformance on these goals.
So, how can investors move beyond the ESG label to achieve meaningful impact for people and the environment? At Dalberg, we think there are at least four good places to start:
#1: Choose to invest in companies with the intention to measurably contribute solutions, not just to reduce harm. Investors can start by better understanding the difference between ESG and impact investing. While ESG strategies provide an entry point for companies looking to become more stakeholder-driven, there are more measurable, higher impact solutions. Impact and SDG investing can help companies meet systemic challenges. Companies and investors can also leverage tools such as SDG credit rating to remove potentially harmful investments from their portfolios.
#2: Use hybrid metrics that link social and environmental performance with financial performance. Instead of treating ESG performance and financial performance as two separate silos of performance it would be desirable to use metrics that make the material connection between the two explicit. Potential hybrid indicators like EBITDA/CO2 intensity for energy or EBITDA/yield per hectare for agriculture are two examples but there are others.
Hybrid metrics could help not only to improve ESG reporting but also allow for easier analysis of performance that rewards companies that perform best in both social and financial dimensions.
#3: Create feedback loops that interrogate practices and improve ESG rating methodologies and reporting standards. Investors should continue to use ESG rating methodologies and tools already available, but they should also proactively punish greenwashing and raise the bar on ESG standards. For example, additional ESG metrics around worker power or community wellness programs could provide more refined filters and better align with a focus on stakeholders rather than shareholders.
Additionally, investors should require portfolio companies to report disaggregated indicators such as female participation in management and not allow companies to opt out of reporting those underlying metrics showing sub-par performance even when overall ESG rating is positive. The SEC’s efforts this year to develop new reporting requirements for ESG assets is a promising development; however, investors will almost certainly require additional reporting to accurately track the true breadth of companies’ impact.
#4: Recognize that without government leadership and regulation for broader climate solutions, ESG investing strategies will remain partial solutions. Thwarting rising emissions and temperatures are vast undertakings that require governmental action. Investors should support public investments by paying their fair share of taxes, and they should not invest in companies that intentionally evade taxes.
ESG investing has grown, and so too have legitimate critiques of the assumptions about what it can achieve. Yet rather than accept the critiques as reasons to divest and return to old ways of investing based solely on financial return, we have the opportunity to use those critiques to improve ESG investing, transforming it into something better.
Let’s start by putting more capital into companies that contribute measurable, effective solutions and by recognizing that ESG investing alone will not be enough to effect the needed changes. Rather than attempt to replace governments, investors must work alongside them in the common search for solutions.
Kusi Hornberger, Kristina Kelhofer and Christelle Umubyeyi are Partner, Consultant and Analyst in Dalberg Advisors Washington, DC, San Francisco and Kigali offices respectively.
