The idea that the ‘virtue bubble’ – ESG investing – has peaked has certainly garnered headlines, but it is often based on flawed perceptions or a misunderstanding of the risk role ESG plays in fundamental investment analyses. There are certainly challenges, conflicts of interest and complexity - but don’t be too hasty to write off the role of Environment, Social and Governance on our investment landscape, says Daniele Cat Berro, managing director at MainStreet Partners.

At its core, ESG investing is about better managing risks and opportunities not directly observable on financial statements. This involves integrating considerations about environmental, social, and governance (ESG) practices into the investment process; a historical blind spot in traditional financial analysis.

In relying solely on a company’s financial statements, you would hardly find insight into environmental risks, regulatory changes, regional transition plans, strikes due to poor safety conditions, or the absence of independent directors for example. These are factors that could significantly impact a company's medium/long-term revenue and cost performances. All keen financial risks of high importance to investors.

Clean Energy Stock Conflation

Too often oversimplistic assumptions are made about ESG integration and financial performance. For example, say the S&P Global Clean Energy Index, an index designed to measure the performance of companies in global clean energy-related businesses, under performs. This does not mean that ESG integration is the cause or a problem for which investors should be wary.

There is a tendence by those keen to present a counter-argument to ESG investing, to only focus on short-term performance during phases of sector rotation in the market. This is a huge oversimplification.

Firstly, the S&P Global Clean Energy Index is a thematic index that naturally aligns with ESG criteria (particularly environmental) compared to a traditional index. Yet, this index is exposed to a significant structural sectorial bias; companies operating similar businesses or supply chains can be affected by the same variables, which are different from traditional index (S&P 500) or other sectorial index (S&P Energy)

Comparing those indexes in a short time horizon is therefore a risky exercise. The majority of the S&P 500's performance in 2023 was driven by a small number of companies (The famous Magnificent 7), while the S&P 500 Energy price is correlated with the oil price, influenced by global supply and demand factors. How this is positioned as a comparison to discredit the validity of integrating environmental, social and governance practices into company analysis is a mystery.

The ‘Bubble’

We have also seen claims that ESG is a ‘bubble’, often supported by quoting temporary declines in the share prices of asset managers focused on sustainable thematic investments. ESG is not the same as thematic investing. Using a single asset manager's share price decline as proof that ESG investing as a whole is losing momentum, is an overly simplistic generalisation.

Greenwashing

Greenwashing within investment funds is due to the complexity and lack of clarity in key areas of sustainability regulation. In many cases, it’s due to negligent approaches rather than premeditated planning, in our opinion. Several global investor surveys, including PwC’s and AIC/Research in Finance, show very high levels of scepticism about ESG claims from Asset Managers.

While this is an important issue, it is being addressed. Regulators across jurisdictions – in the UK, most recently the FCA’s new Sustainable Disclosure Requirements – are taking action, itself a sign of the commitment and expectation that ESG practices will continue to integrate deeply into mainstream financial practices.

Challenges for ESG Ratings

Rather confusingly, there are ESG Ratings, which measure and reflect a company's absolute or relative risk or performance from ESG factors and are often used for risk analysis or portfolio construction; and there are ESG Scores, which use underlying themes and pillars to calculate corporate ESG exposure.

Equity side ratings often conflict. ESG ratings are no different. Bias within ESG ratings – larger companies typically have deeper pockets and resources to engage with rating providers and therefore, some claim, benefit from improved ESG ratings – is well catalogued. However, the correlation between ESG ratings and the size of companies appear not to be solely attributable to their 'communication' abilities according to a recent study.

Some rating agencies not only assess companies' ESG performance but also market index products based on these assessments. Research has revealed that certain agencies tend to assign higher ESG ratings to companies with better stock performance and to those included in their ESG indices. Again, regulators are responding. The European Commission proposed a regulation on June 13, 2023, focusing on transparency and integrity in ESG rating activities that should be active from 2025.

Inhomogeneity and lack of transparency in ESG ratings are long standing, and well-placed, concerns. Variability in ratings arises from diverse factors: input, evaluation, and output. Significant variations between ESG ratings from different providers casts suspicion on their veracity and adds complexity to integrating ESG measurements into financial analysis.

Rating providers have different input data based on company disclosure levels, often resorting to estimations or assumptions if data is unavailable or incomplete. Additionally, they employ distinct normalization approaches tailored to specific sectors and regions when evaluating information. The process of determining the importance and weight of each individual datapoint before finalizing the rating, introduces further disparities.

Addressing these complexities is undeniably challenging. As ESG Rating providers ourselves, we agree ESG ratings are effectively an analysis and opinion on a company's ESG profile rather than standardized credit ratings. Simplifying ESG ratings, aligning them with regulations such as SFDR, which emphasizes a limited number of data points, will facilitate understanding as well as drive the European market.

Conclusion

This not an argument that the practice of ESG investing, or products used such as ESG Ratings, are perfect. Instead, we believe calm, informed analysis of the ESG landscape will lead to increased education among financial participants, which will in turn go some way to mitigate risks such as Greenwashing. The real danger, it seems to me, is in the inflamed language around ESG and gleeful media dichotomy between painting an ESG utopia or ESG dystopia, neither fairly reflecting the reality. ESG investing is continuing to evolve and mature – only fools would write it off now.

By Daniele Cat Berro, managing director at MainStreet Partners