Andy Howard: The performance horse must drive the ESG cart if it is to be taken seriously!

ESG research has too often been a woolly compromise between business analysis and social goals, argues the former GS Sustain head.

Responsible investment is facing another transition. Since the United Nations-supported Principles for Responsible Investment (PRI) was launched, huge strides have been made in raising its profile and acceptance across the industry. However, that success presents new challenges. The need to persuade industry colleagues of the value of ESG analysis is giving way to questions of what this actually means in practice and how it is done? The idea of ESG integration is one thing; digging into the details of its analysis and its role in investment decisions is another. Answering those questions is going to require head scratching, hard work and some good arguments. The transition of ESG analysis from a pleasant but eccentric oddity in the corner to a desk with other investment professionals is well beyond a tipping point. Over 80% of the world’s 50 largest asset managers have signed the PRI, committing them to integrating ESG factors into investment decisions, ownership and reporting. How stringently they are doing so is debatable. But the issue is clearly on radar screens across the industry. With reporting and evaluation getting tougher, and more scrutiny on what institutions are actually doing, the industry has little choice but to take the topic more seriously.
However, a recent report we released at Didas Research concluded that far too little attention has been paid to the details of what ESG analysis actually means, how it contributes to investment returns or how it should be done in practice. ESG analysis has too often been treated as a concept or an exogenous ‘number’ acquired from a rating agency, rather than as the considered analytical approach we believe it should be. Its application has too often been a woolly compromise between business analysis and social goals, tacked onto investment processes rather than at their core. To reach fuller integration needs us to think harder about exactly what investors and analysts should do differently.
For one: what is ESG? Despite its success in attracting investors to ‘integrate ESG’ and to be measured in how well they are doing so, the closest thing we could find to a definition from the PRI is: “An ESG factor is an issue that is qualitative or quantitative in nature, which may be material to financial analysis. Such factors manifest at a macro, country, sector or company level.”
This doesn’t help too much.The question is not trivial. Society and the environment span a broad field of topics; pretty much everything that companies do involves dealing with ‘people’ or ‘stuff’. Indeed, generating revenue usually involves selling stuff to people. Companies with stronger brands tend to generate more revenue. Consumer perceptions of brands are partly influenced by their perceptions of how ethically the products were produced. Which of these are ESG factors? Revenue? Brand value? Ethical standards? What about all the other things that influence pricing power that aren’t usually categorised as ESG, such as advertising effectiveness or product development? The lack of a consistent view of what constitutes ESG analysis should make assessing its contribution to investment returns difficult. This hasn’t stopped academic research, the vast majority of which focuses on the role of ESG as a generic concept. The publication pace of academic articles examining the relationship between ESG or sustainability and financial performance has tripled since 2006. The conclusions – typically a modest positive relationship – have been held out as evidence of the value of the approach.
However, it is at least as telling that academic research makes almost no attempt to detail how ESG performance is measured. The focus has been squarely on whether ESG analysis creates value rather than on differences in the benefits of different areas and types of analysis. We examined 20 of the most downloaded relevant research papers from the Social Science Research Network (SSRN), of which only three provide any detail on how they measure ESG performance, beyond referring to the rating agency that provided scores to plug into regression models. (1) Many highlighted distinctions between ethical and ESG investing, yet the same ratings are typically used for either approach.
Academia is not investment practice, but there are parallels. To date, the focus has been more on whether to incorporate ESG factors (interpreted as the climate change/corruption/labour standards, etc, topics that form the basis of most lists of ESG factors) as much as what that means. We think the priorities are the wrong way round and will change. A company’s abilities to adapt to social and environmental change is obviously important. The only important question is how to measure how well it is doing so.

Framing the discussion around “ESG integration” rather than “changing investment processes” puts the cart before the horse. It assumes we know how the analysis should be done and need only prove it answers the question (that it helps investors). The lists of ESG factors that proliferate, however, are normally formed by shuffling the same topics other ESG analyses look at. This creates a self-perpetuating view. Unfortunately, defining analysis this way is unlikely to yield great investment insight and will struggle to convince mainstream fund managers; even those who recognise the effects social and environmental change can have on their portfolios.
Turning to the most commonly used tools – ESG ratings – doesn’t help too much. We asked an independent consultant, SustainInvest, to look at the main rating agencies. (2) The conclusions are telling:

  • Improving investment returns was the least mentioned goal across the organisations examined. Uses directly or indirectly related to PRI compliance were at the top of the list.
  • Ratings for the same companies differ significantly; they examined the correlations between the way different organizations scored the same 100 global companies. Fewer than 15% of those correlations were statistically significant. On average, companies’ sector and regional domiciles explains twice as much of their scores as other companies’ ratings of the same companies.* Differences would be valuable if they are understandable, but under one-fifth of the organisations provide visibility into the way metrics are scored or the information used to determine them.

An alternative approach is to start with a different goal. Investment goals are a more logical starting point than ESG integration. At Didas Research, we start by examining the drivers of long-term equity returns and end with a framework that spans a wide range of business characteristics: financial, strategic, industrial, competitive, as well as stakeholder measures. That final component examines trends in each sector’s stakeholders and identifies objective measures to compare companies’ abilities to adapt. Starting with performance goals, rather than ESG analysis, makes demonstrating materiality and investment logic easier. On the other hand, it leads to analysis that overlaps with the most commonly used metrics but also includes a number of other factors, and combines them in ways many practitioners may not recognise. Which gives us problems answering questions on whether our analysis is ‘PRI compliant’?
But then again, who can tell?

Andy Howard is the Managing Director of Didas Research