Disentangling the value of ESG scores and classification of sustainable investment products

Confusion surrounding ESG (environmental, social, and governance) data and mislabeling of sustainable investment products complicates adoption and regulation. The sophistication of investors and regulators is necessary for the proper consumption of ESG data and development of financial products. In many ways, divergent and informed investor viewpoints often drive capital market activity; for example, a seller and buyer of a stock, often with opposing views of its future value, are matched to consummate a trade. Subsequently, research analysts assign “buy,” “sell,” or ‘hold” predictions to forecast a company’s estimated future value. Since asset managers often access data from several sources, qualitative ESG factors can be less suitable for standardization and difficult to pin down. Such attempts for standardization, in some cases, are further complicated partly due to incomparable characteristics (e.g., the maximum return of a bond is par, and the maximum return of a stock is infinite) across asset classes. Similarly, comparing ESG factors from different sectors, such as a technology company to a utility company, inherently obscures the ability to perform a like-for-like analysis.

Asset class characteristics contain different E, S, and G factors that can be isolated for a more meaningful analysis. For example, my five-year-old niece may have inadvertently completed a Social Bond transaction while lending her excess toys. When asked how she decided which friends could borrow her toys, she quipped: “It depends on how far away a friend lives and when we met.” Her reasoning is eerily similar to a risk assessment (physical distance to her home and duration of her friendship). She may be a budding future bond trader, or her reasoning for loaning toys reflects the intuition applicable to evaluating the dynamics of a credit transaction.

S&P, Fitch, Moody’s, and Kroll are nationally recognized statistical rating organizations (NRSROs) that perform credit assessments. The ratings issued by NRSROs are useful decision-making tools given the ordinal nature of credit ratings (i.e., bonds deemed to have a higher likelihood of defaulting are assigned lower ratings than bonds with a lower likelihood of defaulting). The strong correlation of ratings issued by NRSROs allow for making evidenced judgments and arriving at logical conclusions. Conversely, the level of trust in ESG scoring providers is noticeably weaker. Even the term “ESG rating” is a misnomer, given the expectations that credit ratings hold. The appropriate term for an ESG assessment that produces a numerical output is “ESG score.” The drivers used in a credit assessment (i.e., probability of the repayment and/or recovery of principal and interest payments) are mainly quantitative (ratios)—much different than qualitative factors that can influence stock prices. For example, assessing whether an ESG score of 70 (on a scale of 100) is good, bad, or fair compared to a bond rated “BB” is difficult to interpret, especially since ESG data can be subjective, self-reported, unaudited, and inconsistent.

Recently, the Chartered Financial Analyst Institute (CFAI), the Global Sustainable Investment Alliance (GSIA), and the Principles for Responsible Investing (PRI) collaborated to synchronize common terminology. The five concepts harmonized include screening, ESG integration, thematic investing, stewardship, and impact investing. Below is a taxonomy categorizing sustainable investment products by investment characteristics and objectives.

The five concepts above may be familiar to most practitioners; however, the historical development of the three overarching categories is worth noting, given recurring mislabeling (e.g., ESG is often misinterpreted as a catchall for all sustainable investment categories) of products, which ignores meaningful distinguishing categorical traits. Moreover, performance comparisons and market sizing exercises can be flawed due to double-counting and incorrectly labeled products.

The variations across sustainable investment products must be more widely understood for distinctions to be correctly interpreted. Cary Krosinsky, a Yale, Brown, and NYU lecturer highlights that, “consumers and beneficiaries alike can understand what is really happening when able to properly segment sustainable investment products—generalizations aren’t particularly helpful.” Furthermore, regulatory guidance is needed to protect investors from unscrupulous marketing agendas.

A simple taxonomy that practitioners—particularly asset managers and consultants—can use to better service clients desiring exposure to sustainable investments is indispensable, given that misunderstanding definitions have often led to avoidable disarray and sometimes division. The primary sustainable investment categories are socially responsible investments (values-based), ESG-themed investments (value-based), and impact investments (outcomes-based). Understanding these categories will significantly mitigate confusion, enhance consistency, and increase clarity to help limited partners and allocators accomplish intended investment goals.

Values-based

Screening of investments dates back to the 1800s when the Quakers, a religious group, opted to avoid investments supporting war, slavery, and other activities contrary to their values—this is widely credited as the first instance of socially responsible investing (often mislabeled as ESG, which can be a cause of unmerited friction). It is common for some investors to exclude sectors believed to be misaligned with their investment goals, such as abstaining from investments viewed to be “sin stocks.”

Value-based

In a 2004 United Nations report, (Who Cares Wins), the late UN Secretary-General Kofi Annan posited that examining and improving ESG factors could generate value for corporations—these include ESG integration (identifying material value factors), thematic investing (concentrated investments in a specific sector), and stewardship (engaging company leadership on governance decisions). Thematic investing exposes investors to a group of investments sharing similar characteristics. Stewardship is the care taken in handling resources; this tends to be the most prolific tool (e.g., proxy voting) institutional investors use to drive value and mitigate risks. It is hard to imagine a company or sector that does not have exposure to ESG-related risks and opportunities.

Outcomes-based

What distinguishes impact investing from other approaches is an intentional desire to generate and measure both financial returns (commercial/market rate to concessionary) as well as social and/or environmental benefits. Impact investing was coined in 2006, later leading to the creation of the Global Impact Investing Network (GIIN), a field-building organization dedicated to increasing the scale and effectiveness of impact investing.