Nevertheless, it is still interesting to investigate the challenges involved in designing ESG strategies. One of the most common issues can be traced back to the fact that there is not a universally agreed definition of ESG. The rule of thumb is to do good to the environment, society and governance. But what does this mean in practice?
To make matters more complex, there is also no universally agreed approach to integrate ESG criteria. The composition of ESG indices or ETFs can differ depending on the chosen definition and screening approaches. Systematic sector exclusions can give quite a different outcome from best-in-class approaches. And in the end, this can result in companies with questionable sustainability records being included in ESG indices.
In addition, nonfinancial performance can be difficult to gauge and, even when you think you’ve done a pretty good job assessing it, mistakes can always happen. There have indeed been examples of high-profile companies that seemed to be ESG leaders in their sectors that then fell from grace due to scandals of mismanagement. BP’s “Beyond Petroleum” campaign designed to promote the company as environmentally-friendly culminated in the Deepwater Horizon Oil Spill in 2010. In 2015, the Volkswagen Group, formerly considered an industry leader in clean-diesel technology, was hit by the carbon emissions scandal. More recently, a number of tech giants – usually top components in ESG indices – have been accused of poor labor conditions in China.
In order to neutralize the risk of potential pitfalls, there is an ongoing trend towards transparency and standardization. As environmentally-conscious customers are increasingly demanding more transparency, new regulations are pushing companies to systematically report nonfinancial information.
This is for instance the case of the European Union Non-Financial Reporting Directive requiring large companies to annually report performance on environmental protection, social responsibility and other such matters. Similarly, with the implementation of the Gender Pay Gap Regulations in 2017, companies in Great Britain are obliged to publish gender pay information on an annual basis. This regulation has already exposed large gender pay gaps in some of the biggest firms active in the UK.
ESG investing is here to stay
The concept of ESG is not static but is evolving, influenced by new regulation, consumer expectations, and increased information. If initially the movement was mainly about protecting the environment, responsible investment has now expanded to embrace a more comprehensive definition, with themes such as gender equality gaining increasing importance. Improvements in transparency & reporting will make ESG screening more effective. Nevertheless, mistakes in judgement can always happen and it’s important that investors are aware of the limitations of the different screening approaches.
This article was republished with permission from Solactive. The original version can be read here.