ESG investing is becoming extremely popular, but it’s also facing more scrutiny within the sector. Regulators and investors alike are starting to question the validity of ESG scores, and even accusing funds of greenwashing to attract investment opportunities.
In fact, greenwashing – whereby organisations make false or exaggerated claims about the sustainability of a product or service – is now one of the main areas of concern for investors. But what can be done about it? And how are we tackling the issue at CIRCA5000?
ESG investing is a form of sustainable investing whereby environmental, social and governance factors are considered alongside a fund’s financial returns. An ESG score measures the sustainability of an investment in relation to these three things. The specific criteria for each can be seen in more detail below:
Governance: This looks at how well a company is managed, with specific reference to political contributions, board composition, lobbying and bribery. It flags companies that are corrupt, poorly run or come with a reputational risk.
Once shunned as being too restrictive and hindering returns, ESG investing has exploded in recent years. The EU’s sustainable finance disclosure regulation – which came into effect in March 2021 to improve transparency in the market for sustainable investment products – has further escalated the rise of ESG.
But more broadly, people are increasingly looking to invest their money into companies whose values align with their own. The climate crisis is a growing concern for many, and the private sector has responded to this.
In 2021, an estimated $425B was invested in ESG funds, rising from less than $150B in 2017
The spotlight has recently been on MSCI, the largest global provider of financial analysis indices and ESG rating systems.
An ESG rating measures a company’s management of ESG risks and opportunities. These risks have financial implications, but are not usually highlighted in financial reviews. MSCI uses a framework to identify industry leaders: these are the companies that are effectively and proactively managing ESG risks. Companies who manage ESG risks adequately or poorly are rated as ‘average’ or ‘laggard.’
Analysis of MSCI’s indices by Bloomberg found that they consider 90% of the US S&P 500 index of companies to be ESG compliant. Or, to put it another way, only 10% of companies are thought to pose any kind of environmental, social or governance risk.
But take a closer look at the MSCI Global ESG Index and you’ll find that companies such as BP, ExxonMobil and Chevron – some of the largest oil companies in the world – are included. It’s fair to say that you wouldn’t expect to see these types of companies in a sustainability index.
Morningstar, another key index provider, recently hit the headlines after cutting the list of funds that it recognises as sustainable – removing more than 1,200 funds with a combined $1.4T in assets from its European sustainable investment list. The move was triggered by European regulators, who are becoming increasingly concerned about what is and what isn’t sustainable.
As mentioned above, the aim of ESG analysis is to assess the exposure of a company to environmental, social or governance risks. It isn’t designed to measure the positive impact a company is having on the world, which is something that many people have come to think.
But ESG risk can be very subjective, with many different interpretations. And this, it seems, is where the problem lies. For example, some ESG methodologies might assign a high ESG rating to BP because, relative to companies like Shell, it has few stricter policies in place. However, this doesn’t make it an inherently sustainable company.
Companies have built entire teams who focus solely on improving their ESG scores, but they usually look at the messaging, instead of making any operational improvements – essentially, playing the system.
Not all sustainable investment approaches should be tarnished with the same brush; there are many companies out there executing sustainable strategies effectively.
Often, a truly sustainable strategy uses ESG as a foundation on which to build upon because, as we’ve seen, ESG isn’t as clear-cut as it initially seems. If all sustainably minded investors relied solely on ESG, we wouldn’t get very far in creating positive change in the world. That’s why it’s critical to understand your fund provider’s interpretation of ESG and sustainability.
At CIRCA5000, ESG screening is just the first step. For us, it’s about screening out companies that have a materially negative impact on the world – it’s not about seeing which companies are doing a slightly better job than others. We think of ESG as a ‘first line of defence,’ to try and ensure no companies that have a negative impact on the world make it into our themes. Once we have validated the ESG screening and verified the output, we can focus on our main pursuit: investing in companies that are positively impacting the environment and society.
You can find out more about our investment process here.
The information provided above does not constitute financial advice. You should fully understand the products you intend to invest in before making an investment decision. As with all investing your capital is at risk.