As many investors increasingly want their investments to reflect their values, responsible investing principles have become foundational in the investment decision-making process. Performance ratings tied to environmental, social and governance practices, which assess how mainstream companies act as sustainable and ethical agents, are influencing how and what gets invested across the globe.
The actual or potential impact of companies’ sustainability performance on the environment, relationships with employees and communities, as well as how companies govern themselves are all encompassed in responsible investing metrics. These metrics can provide investors with a new layer to consider when assessing risk and opportunity beyond traditional financial information.
The components of ESG scores
Environmental, social and governance scores — or responsible investing criteria — are critical tools for assessing how well a company is able to affect sustainability and ethical behavior. Each of these categories explores various dimensions of the company’s policy and practices to offer a more holistic view to investors of the company’s performance independent of financial outcomes.
Environmental criteria take into account a company’s operational performance as it relates to natural resource stewardship – energy usage/efficiency, waste disposal, pollution, animal treatment, etc. One measure might be greenhouse gas production, energy efficiency or the percentage of waste products that are recycled versus landfilled.
Companies that have good environmental practices are minimizing their carbon footprint and will likely be in a better position for changing market and regulatory environments, as well as changing consumer preferences.
Social criteria take into account how the entity manages relationships with its employees, suppliers, customers and the communities in which it operates. Potential metrics might include the management of labor, health and safety, diversity and inclusiveness, or community involvement.
Companies with better social statistics can also create better employee morale and productivity, as well as community and customer commitment, yielding better profitability.
Governance criteria encompasses a company’s management, executive compensation, disciplinary procedures, risk management, internal controls and stockholder rights. These factors include: board diversity, board structure, executive pay policies, and accounting fidelity. Good governance aims to curb corruption and mismanagement so that a company serves all kinds of investors and stakeholders.
Standardized frameworks for assessing these components exist, such as Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), and the Task Force on Climate-related Disclosures (TCFD), which assists to ensure that the information utilized to create sustainability scores is trustworthy, connected, and relevant.
How ESG scores are calculated
Determining responsible investing scores is not straightforward — each rating agency conducts the assessments very differently, and uses its own methodology. A firm grasp of the methodologies is vital for investors who want to apply values-based criteria to their investment analysis.
Sustainability evaluation organizations such as MSCI, Sustainalytics and Bloomberg ESG Data Service, employ a mixture of data collection, stakeholder surveys and public disclosures to assess the practical level a company addresses ESG concerns. The process will often begin with the collection of quantitative and qualitative data.
This data can vary in its public availability, but is often supplemented by a detailed questionnaire distributed to the companies themselves. The analysts will then parse the data and will likely weigh certain factors higher than others based on its relevance to the sector or specific real estate business model.
The style of scoring can differ significantly. Some organizations assign a numerical score to each component of sustainability performance, which is then totaled into an overall score. Others may use a relative ranking format in which companies are assigned a percentile based on their performance relative to their peers.
In either case, the scores or rankings are intended to give investors a sense of the company’s values alignment and sustainability profile fairly easily and to be able to evaluate it compared to competition.
One of the major issues facing responsible investment ratings is there is no standardization. Without a set of universal guidelines surrounding which metrics should be used or what the proper weighting of the various metrics should look like, impact scores can vary tremendously from one rating agency to the next.
This has the potential to create a substantial amount of confusion for investors looking to analyze sustainability performance since they would likely have no way of accurately comparing scores across two different platforms or sources.
The inconsistency across approaches and the sometimes subjective nature of values-based factors, for instance social impact, complicate the work of establishing a uniform scoring system.
However, comprehensive bodies like the International Organization of Securities Commissions (IOSCO) are making strides in consistency and reliability, giving us hope that responsible investing scores will be revised into more consistent formats in the future.
The influence of ESG scores on investment choices
Investment practices today are paying greater and greater attention to scores reflecting responsible investing principles, which can serve as important filters for investors assessing potential investments based on sustainability practices and ethics.
These scores raise investor awareness of a firm’s long-term outlook, risk factors, and coherence with broad sustainability objectives, and are a necessary conduit for incorporating values-aligned dimensions into an investment decision-making framework.
Impact-based ratings are provided to the investor to identify organizations that could provide profit and factor responsibility related to environmental and social values, and strong governance.
An investor could be risk averse and want to invest relatively less in organizations that scored poorer on these factors (due to regulatory response, reputational risk and other risks associated with relatively poor performance on sustainability indicators). Organizations that scored relatively better compared to their peers on responsible investing metrics implied they would outperform the investment in the long-term.
A prominent example of the impact of values-based investing is when major investment funds divest from non-renewable energy companies. The New York State Common Retirement Fund, one of the largest public pension funds in the U.S., announced that it would be monitoring fossil fuel companies with a possibility of divesting.
The fund’s decision was clearly influenced by the environmental responsibility scores of the companies which were impacted primarily due to the high environmental risk associated with the companies’ business activities.
Likewise, BlackRock, the largest asset manager in the world, has gradually added sustainability metrics to its investment process, resulting in portfolio holdings that accommodate companies with better impact-driven practices. This effort is consistent with an investment strategy focused on mitigating risk while addressing the growing demand for socially responsible investing.
The future of ESG investing
Incorporating responsible investing factors into the traditional investment approach is more than a trend; it is changing the financial system. As sustainable investment focus and awareness grow, the future of values-based investing is shifting once again with new innovations in technology and changing investor preferences.
We will see more technology, including artificial intelligence, and big data being deployed. AI algorithms can analyze vast amounts of information containing responsible investing data, and do so quickly, and increasingly accurately.
This will allow the creation of complex evaluations using a wider base of impact risk factors. The result is that investors will be able to perform increasingly sophisticated analyses of potential investments and their immediate and longer term implications.
It is likely that values-aligned scoring and investing will become more standardized and integrated into the wider investment universe. Availability of data will continue to increase, while regulatory frameworks improve and responsibility-focused scores will benefit from increased assurance and legitimacy.
This transition would lead toward a more sustainable global economy, with impact-focused investing transitioning from a small niche to the standard in active portfolio management.
Ultimately, values-based investing is not only about understanding values but also about maintaining long-term profits and stabilization in a world that is very social and environmental driven. Investors, key stakeholders and communities are encouraged to think about how sustainability scoring can not only help make better decisions around investment choices but support building a sustainable global economy.
Read more: ESG innovation is thriving — outside the U.S.