these factors into the investment process.
The practice of reflecting ESG issues has evolved considerably from its origins in the negative or exclusionary screening of listed equities based on moral values. Some providers still focus on negative screening, where they exclude firms or sectors from investment portfolios, often on ethical or religious grounds (for example, tobacco, alcohol, ammunition, and gaming). Another common use case is limiting exposure to poor labor conditions, corruption, or other issues in the supply chain. A variety of methods are now being used that consider concerns for both purely investment-motivated and more values-motivated investors across asset classes. For example, ESG screens that identify what investors consider to be the worst-performing or “best in class” companies, in terms of their ESG score within a specific sector, are frequently applied. Yet providers don’t agree on which factors are most important, and much less data is available to help identify positive opportunities for sustainable investment. I discuss the ratings bias in more detail later in this chapter.
So, while consistency across ESG scores is needed, you also need heterogeneity of methodologies so that investors can decide what is more compelling for their ESG-related objectives. Moreover, in 2020 the EU Technical Expert Group (TEG) on Sustainable Finance published a taxonomy report for sustainable finance that aims to improve the coverage of disclosed data. Perhaps there will be a convergence of ratings, as seen in the credit ratings space since the 1960s, with agencies in that area keen to apply their current domain expertise to an ESG offering. There is also an increasing demand for real-time reporting around ESG issues to understand immediately what ESG-related risks investors have in their portfolios.
www.researchaffiliates.com/en_us/publications/articles/what-a-difference-an-esg-ratings-provider-makes.html to review how different service providers apply their ratings. The physical scores or rankings offered by service providers are proprietary, but more of the ratings agencies are now providing indicative scores on their websites without the requirement to be a subscriber. One example is www.sustainalytics.com/esg-ratings/.
Exploring the “Personality” of an ESG Company
In principle, many companies would argue that they are ESG-compliant because they have paid lip service to some of the major environmental, social, and governance issues that are the flavor of the month. However, ticking the box and engaging in a true analysis of the ESG factors that your company faces, and what they can do to mitigate those factors, are two very different issues. Moreover, some firms deliberately undertake greenwashing (see Chapter 6) to mislead stakeholders as to their real ESG credentials. This section highlights what the true characteristics of an ESG-focused company should be and how companies define the material factors to their issues to achieve such characteristics.
Determining material ESG factors
Materiality is a concept within accounting that relates to the significance of an amount or discrepancy. The purpose of an audit of financial statements is to enable an auditor to state an opinion on whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework.
Many firms consider ESG factors such as renewable energy, community relations, and political contributions to be material indicators that they are being good corporate citizens and following an ESG strategy. However, there is a difference between “doing good” and “doing well.” From an investment perspective, these factors may not be financially material to the company’s bottom line, so they don’t score highly in terms of investment-grade aspects that will impact their share price. Therefore, a company needs to consider which ESG issues present real financial risk or opportunity. This analysis should include stakeholder engagement to agree on the priority issues that need to be addressed. For example, an airline company could focus on energy efficiency, customer satisfaction, and executive compensation as core ESG factors that make a difference, but there isn’t always consensus as to what constitutes financially material ESG factors.
