The ESG landscape is evolving. Is it reliable?

ESG gives investors a clearer lens for decision-making, but just how precise can it be? Kaushik Sridhar argues that ESG is valuable, but hardly foolproof.

The value of an investment is no longer just about dollar returns. Increasing numbers of investors are calling for their money to make a positive impact on society and the world at large. 

Applying an ESG lens to investments can be helpful in this context, particularly when looking at emerging market companies.

Investors in emerging market companies have traditionally had less information about the companies they invest in compared with their peers in developed markets.And, investors have naturally given greater weight to a holistic view of the company.

Why has this investment information been less available? Emerging markets, whose reputation tends to be hyped and whose parameters swiftly evolve, tend to have less formal governance and regulations.

Investors that have used ESG long before it became a buzzword in the investment industry know that ESG analysis should complement – not substitute – fundamental analysis.

ESG analysis should not be easy. It is a discipline rooted in the fact that making an investment decision is about more than analysing numbers; it is about understanding how non-financial factors hinder or help company performance.

Throughout 2020 and 2021, investors deepened their knowledge of the nuances in ESG data. In 2022, I expect the conversation to shift from “how” to use ESG to “where” – manifesting in diverse applications of investors’ portfolio strategies. The sophistication is still developing, everyone has different approaches and everyone is still learning.

But even those investors who claim to only stick to “best in class” ESG performers cannot access all the required information to accurately evaluate risk and opportunity by using ESG alone.

There are three primary reasons for this

1. ESG lacks rule disclosure
   The lack of regulation and standardisation with ESG disclosure, corporate sustainability measures and human rights issues leads to an incomplete assessment. Investors need to look deeper and ask more questions to understand the full picture if assessing options within emerging markets via an ESG lens.
2. Lack of transparency
   Companies are getting savvier about what to report. Publishing information that portrays a company in the best possible light in relation to ESG criteria neglects other information – both positive and negative – and fails to address issues that may be more material to a company and its business.
3. Data looks backward, not forward
   ESG data, ratings and rankings are creating unjustified confidence, primarily based on a company’s past performances. But investors want to know how a company views ESG factors now, and how consideration of these factors will affect the company’s future financial performance.  

Any investment environment that lacks regulation and standardisation will reflect imperfect data. So, investors must ask the pertinent question. Are those who are managing their investments taking additional steps to ensure a holistic sustainable, responsible, and impactful investment approach? 

ESG reporting and standardisation has evolved, but the data is only useful when underpinned by a thoughtful investment discipline. Investors need to understand that ESG information is merely a starting point in forming the kind of critical questions that can lead to valuable insights.There will always be an element of personal analysis and research needed to determine what information is available and whether to invest. 

The ESG landscape is evolving, in part because of different voices and entities informing the discussion. Public scrutiny, governments, supranational institutions, academics, asset owners, asset managers and corporations are all presenting unique points of view. Robust debate is healthy, and likely to lead to better ESG analysis, implementation and outcomes in the long term, just as it has in other corners of the modern economy.  

Don’t forget about the human factors: namely fear and greed. ESG investing is still susceptible to these, so it’s entirely plausible that popular stocks (or thematic funds, which focus on specific areas like climate change) could end up as overvalued if they are hyped too much. If this were to happen, then this “mis-pricing” could set the scene for them to underperform. But that doesn’t invalidate ESG investing, it’s merely evidence of human nature in action.  

This is why investors would be wise to avoid limiting their investment universe, for example by focusing on too narrow a market sector: Doing so could leave them with little choice but to buy certain stocks, even if they are overvalued.

Furthermore, in the same way that sometimes “quality” stocks over perform, and sometimes there is a “dash for trash”, markets will go through periods when companies that are lowly rated with respect to ESG have their day in the sun. As it always has been, as it always will be.