Achieving Transparency, Risk Reduction, and Impact with ESG Investing—Part Two

Demonstrating ESG Links to Value, Controversy and Challenges, and Investment Impact

Abstract

ESG investment claims to leverage financial markets in service of society and to reduce company risk. However, considerable doubts have been expressed about how effective ESG indices and investment actually are in driving meaningful changes. How can investors make informed investment choices to further their lofty goals? Data and reporting frameworks are the mechanisms to link ESG action to impact. Addressing inaccuracies and greenwashing in data and reporting can deliver the substantial potential value to financial risk and social value of ESG investment.

Article

The explosion and continued growth of sustainable investing creates a multitude of questions and opportunities for supply chain practitioners and solutions providers to explore. Green finance, socially responsible investing, and ESG investment are related phenomena that leverage financial markets in service of improving the social good and reducing company risk.

In Part One of this article series, we looked at the various types of ESG investing, how it generates value, and how ESG is measured. Here in Part Two, we continue our exploration of the current state of ESG as a financial investment strategy. We first discuss data as an essential component of any ESG investment approach. Next, we explore the context surrounding criticism of the ESG investment movement. Greenwashing concerns and the anti-ESG platform fuel this backlash, yet ESG investment continues to thrive and is expected to expand its reach through the next decade. Part Two of this ChainLink Brief series on ESG investment sets the context for our final segment in which we will cover its impact on supply chain risk management and the social good in Part Three.

Role of Data for ESG risk reduction, shareholder returns, and social impact

A 2020 study anticipates the market for ESG data to have an annual growth rate of 20%, approaching $1 billion (USD)[1] by 2021 because the range of applications and use cases for that data continues to grow. The effectiveness of businesses’ sustainability and social practices as a risk management approach depends on transparent ESG practices, accurate measurement, quality data, and informed actors. Reporting compliance is no longer the preeminent use case for ESG data. Rather, raw, aggregated, and composite data ratings and rankings inform investor decisions at all stages of the investment process. The idea is that environmental, social, governance (ESG) investment can motivate  supply chain companies to reduce their risk and positively affect shareholder returns while advancing the social good based on the links between ESG activity and the value it creates. In order to understand these links, high quality data and measurement are critical.

In Part One of this article series on ESG investment,[2] relevant to supply chain practitioners, we noted that, in order for businesses’ ESG activities and investor actions to have meaningful impacts, we need to delve into the mediating factors linking ESG activities to value. The benefits of a company’s climate resilience activities can reduce risk associated with future weather events, for example. Improved working conditions and higher pay increases worker productivity and reduces turnover, effectively managing a company’s labor-related risk. Similarly, adherence to policies and regulations is an example of how compliance reduces company governance risk. Data is required to provide proof of the company’s activities and to link them to resulting impacts. Investors need to be confident that the funds and companies in which they are investing are actually providing the environmental, social, and governance benefits they claim, to improve the social good and to mitigate company and shareholder risk.

Source: ChainLink Research – Generated by FWCG

Ratings and Market Signals

There are two competing views advancing the purpose of environmental, social, and governance. One contends that ESG is aimed mainly at improving the social good while the other asserts that the focus is mostly on reducing company risk by addressing ESG factors that impact the company financially.[3] In all likelihood, the drivers of ESG activities within a company and ESG investments are a mix of both the desire for a positive social impact and the desire to reduce risk for a firm. In last month’s ChainLink Brief article exploring the impact of regulatory drivers on ESG and risk,[4] we discussed how regulations’ impact on supply chain companies has increased exponentially in the last ten years. The attainment of positive ESG ratings, making them more attractive to investors, are an additional driver that is compelling businesses to implement ESG activities. How can companies and funds signal, or better yet prove, to investors that they offer environmental, social, and governance risk abatement and social value?

Source: Advantus Media Inc. from QuoteInspector.com

Financial markets serve many different purposes—e.g., connecting those with capital to those who need it, providing liquidity for securities and commodities, establishing common market-wide pricing for commodities, providing price certainty to buyers and sellers (via futures contracts), reducing transaction cost and friction, etc. More recently, ESG investing enables financial markets (at least in theory) to encourage improvements to social activities and structure, advancing society’s goals.[5] Serving this function, ESG investment is purported to provide social value by motivating companies to improve their environmental, social, and governance factors. Ratings systems have been created to inform investors on the efficacy of a company’s or multiple companies’ efforts in these realms. In the past, sustainable finance ratings were largely unregulated by legislation, but rather used indices, scorecards, and criteria developed by third party rating agencies or industry organizations. This is starting to change with regulations such as the EU’s Sustainable Finance Action Plan (SFAP)[6] and the SEC’s proposed rule, The Enhancement and Standardization of Climate-Related Disclosures for Investors.[7]

As it has become common for investment strategies to explicitly integrate indicators of companies’ impact on the environment, society, and governance, demand for non-financial data continues to expand. Collected and synthesized data are crucial to inform financial portfolio construction to advance ESG investing to benefit both society and investors.[8] Data, reporting, and ESG frameworks provide this critical link between the company behavior and the value that investors seek in participating in ESG investment strategies.

ESG Rating Frameworks

Reporting requirements for various ESG frameworks rely on data collection within and among companies throughout the supply chain. Independent agencies develop rating and ranking frameworks to provide investors report cards with composite E, S, and G scores. As these composite scores combine assessment ratings from the three ESG dimensions, a company may score lower in one and higher in another allowing for tradeoffs among environmental, social, and governance factors. ESG scores help investors manage risk in investments and to discern stocks’ or funds’ ESG activities and reputations.

Relied on by investors, ESG ratings and rankings provide market signals regarding the activities that companies undertake towards the social good and their own risk reduction. Investors choose ESG funds to support the companies’ impacts and in the hopes of higher market returns. The initial investor demand for ESG data was fragmented and led primarily by companies providing easy-to-obtain data that highlighted their own positive ESG activities. Companies were thought to be primarily focused on profit maximization with ESG activities considered irrelevant or even a liability.

Where ESG investment began as a niche approach, external events such as climatic changes, the increasing public focus on social justice, and financial market fluctuations led to a clearer recognition of the relevance of investor behavior and ESG activities.[9] The rate of ESG investing is much higher among younger investors than among older investors, indicating that growth in this type of investing is likely to endure.[10] In response to demand for more rigorous assessments and ratings standards, the industry’s evolution has come with improved and increasingly standardized ESG frameworks.[11] Commonly used ESG ratings agencies, all with their own ratings systems, include: Bloomberg ESG, Dow Jones, MSCI, Sustainalytics, Thomson Reuters, and S&P Global. Some systems use a 0 to 100 scale and some use a more categorical rating scheme. Studies reveal significant variations in agencies’ ratings assigned to various companies’ ESG performance.[12]

Data Collection and Disclosure

A survey by ERM explores how much companies spend on measuring, compiling, and disclosing ESG data annually and how much institutional investors spend in devising their ESG-related investment strategies. They conclude that these expenditures are substantial (on average nearly $700K by companies and $1.4M by investors) and that the amount spent is expected to increase[13] with the proposed US Security Exchange Commission climate disclosure rules. These costs stem largely from the demands of data collection and reporting. The report found that the cost for publicly-traded companies to obtain a sustainability rating to comply with investors’ sustainability reporting requirements, was between a quarter and half million dollars per year, while privately-held entities have reported paying up to $425,000 per year.[14] Investors pay more than companies for ESG data, and both report significant frustration with inadequate and inconsistent ESG ratings.[15]

Inconsistencies among ratings lead to questions surrounding their validity.[16] ESG data and ratings frameworks continue to evolve and will be a critical area of focus for companies that participate or are interested in obtaining ESG ratings. Similarly, institutional or individual investors concerned with ESG performance will benefit from scrutinizing ratings systems. In addition to the notable variation among the systems, there can be tradeoffs among E,S, and G metrics. A company may provide environmental benefits, but have a poor track record on employee rights, for example. As ESG investment evolves as a financial and risk management strategy, data metrics, analysis, and how ratings frameworks are structured will be an important focus of ESG investors and companies alike.

Backlash

While the amount of money invested in ESG continues to grow, there has been some political pushback in some (primarily Republican) states. According to a report from Pleiades Strategy in June 2023 (as cited in a 6/28/23 S&P Global article), “at least 165 bills and resolutions against environmental, social and governance investment criteria were introduced in 37 states between January and June 2023 … So far, 83 — or just over half — of the anti-ESG initiatives have failed while 19 bills have become law and six resolutions were passed.

Beyond the political backlash, many have questioned the ability of the ESG investment movement to have real impact on risk management or on-the-ground environmental, social, or governance factors. Some suggest that nearly meaningless ESG ratings incentivize poor performance in the areas they are supposed to be rating. Critics suggest that ESG ratings are overhyped and allow companies to convey falsely positive contributions to E, S, and G and to use an ESG rating to avoid actual performance improvement.[17]

Potential for Greenwashing and Lack of Improvement

Source: Mike Langridge from fotdmike.me.uk

Because firms have an interest in soliciting investment based on a risk management proposition and intended social impact, there is an incentive to present positive reports of ESG performance. Also called “green sheen”, the potential for greenwashing is a fundamental critique of ESG investment. ESG metrics are primarily self-reported. Increased scrutiny of institutional investors has been shown to mitigate greenwashing in environmental, social, and governance reporting.[18] The plethora of attention paid to the potential for and efforts to mitigate greenwashing suggest that the many investors and asset managers who are selecting their funds and structuring their portfolios with ESG impact in mind are increasingly concerned about exaggeration or dishonesty regarding ESG ratings and practices.

Disincentives for Social Good

One of the often noted turning points for the exponential interest in impact investing and ESG ratings as a measure of companies’ contributions to the social good was BlackRock’s CEO, Larry Fink’s 2018 declaration that companies both have an obligation to deliver financial returns to shareholders, but also to contribute to the social good.[19] Since then, despite the prominence of ESG investment, vocal critics have noted their skepticism of the impact ESG investing can actually have on the social good. Their skepticism is rooted in the relative nature of the majority of ESG ratings systems that often reward improvement in ESG practices as opposed to absolute contributions to social good. A similar concern surrounds the fear that ESG investors may feel absolved of a moral obligation to alter their own behavior. In short, there is opportunity for improvement in ESG ratings for investment decision-making in terms of improving correlation with actual ESG performance as well as with financial risk.

Source: Image by 6689062 from Pixabay

A Financial Times study suggests that ESG ratings are fundamentally relative to companies’ and industries’ past ESG performance as opposed to focused on measuring actual impact.[20] For example, coal companies can obtain impressive ESG ratings, encouraging investment money, for relatively positive environmental performance. Coal combustion, however, is reliant on fossil fuels and externalities include carbon and other climate change-causing greenhouse gas emissions. Some would argue that this tie to climate change renders the coal industry in direct contradiction to the goals of ESG and its inclusion in ESG funds, harmful.

ESG investment dissidents contend that companies are primarily profit-seeking and despite the purported benefits of ESG ratings, the incentives to provide social value cannot compete with the bottom line.[21] Despite the criticisms of ESG performance, company interest and investor activity in the ESG space continues to grow. An optimistic assessment would highlight the ever-increasing interest in ESG investing and, in particular, investors’ strong desire for improvements to ESG ratings to make those ratings a more accurate indicator of actual ESG performance. One can hope that the demand by investors for more accurate ratings will push rating agencies to do a better job, in spite of potential pushback from the companies they are rating who might resist that additional scrutiny.

Next Steps

Early on, investors relied solely on companies’ self-reported information on environmental or socially-related activities. As we have discussed, discerning the mediating factors between companies’ ESG activities, investor engagement, and resulting social and shareholder value helps illuminate the impact of ESG investment and the opportunities it provides companies and supply chain practitioners. The evolution of ESG ratings systems and third-party agencies added more rigor to its reporting and the ability of investors to be more discerning. That said, there is substantial room for additional improvement and standardization to foster ESG investment impact. How impactful has this movement been? What material effects can be attributed to ESG investment? In Part Three of this series, we cover the current state of ESG investment and assess the impact it has had on company behavior, the social good, and on shareholder returns.


[1] ESG Data Market: No Stopping Its Rise Now. opimas. 2020. www.opimas.com — Return to article text above

[2] Achieving Transparency, Risk Reduction, and Impact with ESG Investing – Part One. ChainLink Brief. clresearch.com — Return to article text above

[3] ESG Ratings: A Compass without Direction. Harvard Law School Forum on Corporate Governance. corpgov.law.harvard.edu — Return to article text above

[4] Regulations’ Impact On ESG And Supply Chain Risk Management – Part One. ChainLink Brief. clresearch.com — Return to article text above

[5] Capitalism and Financial Innovation. Financial Analysts Journal. Schiller, 2013. tandfonline.com — Return to article text above

[6] SFAP encompasses the EU Taxonomy Regulation, the Sustainable Financial Disclosure Regulation (SFDR), the Corporate Sustainable Reporting Directive (CSRD), the EU Climate Transition Benchmark Regulation and Paris-Alignment Benchmark Regulation (2020/1818), Markets in Financial Instruments Directive II (MiFID II), and EU Green Bonds Standard. — Return to article text above

[7]For more on regulations for ESG investment see the section titled Socially Responsible Investing in the article Regulations’ Impact on ESG and Supply Chain Risk Management—Part One — Return to article text above

[8] ESG integration and the Investment Management Process: Fundamental Investing Reinvented. Journal of Business Ethics. 2015. link.springer.com — Return to article text above

[9] Inside the ESG ratings: (Dis)agreement and performance. Corporate Social Responsibility and Environmental Management. 2021. onlinelibrary.wiley.com — Return to article text above

[10] The ESG Generation Gap: Millennials and Boomers Split on Their Investing Goals. Younger investors are more willing to put money behind environmental and social goals — even if it’s costlier. 2022. www.gsb.stanford.edu — Return to article text above

[11] Evolution of ESG Reporting Frameworks. Values at Work: Sustainable Investing and ESG Reporting. 2020. theesgexchange.org — Return to article text above

[12] Inside the ESG ratings: (Dis)agreement and performance. Corporate Social Responsibility and Environmental Management. 2021. onlinelibrary.wiley.com — Return to article text above

[13] Costs and Benefits of Climate-Related Disclosure Activities by Corporate Issuers and Institutional Investors. The SustainAbility Institute by ERM. 2022. www.sustainability.com — Return to article text above

[14] Companies pay up to $500,000 for sustainability ratings – report. Reuters. 2023. www.reuters.com — Return to article text above

[15] The Benefits And Costs of Climate-Related Disclosure Activities For Companies and Investors. Forbes, 2022. www.forbes.com — Return to article text above

[16] ESG ratings: relevant information or misleading clue? Evidence from the S&P Global 1200. Journal of Sustainable Finance & Investment. 2020. www.tandfonline.com — Return to article text above

[17] The ESG Mirage. Bloomberg, 2021. www.bloomberg.com — Return to article text above

[18] Greenwashing in environmental, social and governance disclosures. Research in International Business and Finance. 2020. www.sciencedirect.com — Return to article text above

[19] For more on the evolution of viewpoints about the core purpose of corporations, see the section titled Attitudes About Corporations’ Roles and Responsibilities in Society Are Evolving, within the article The Ethical Supply Chain Practitioner – Part One: The Social Responsibility Imperative — Return to article text above

[20] Companies with good ESG scores pollute as much as low-rated rivals. Financial Times. www.ft.com — Return to article text above

[21] The fundamental contradiction of ESG is being laid bare. The Economist. 2022. www.economist.com — Return to article text above

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