Conway Williams, Head of Credit at Prescient Investment Management
Environmental, Social, and Governance (ESG) investing has come under fire over the past year from various fronts, being levelled as “woke” capitalism and some big institutional investors who have pushed back against the expectation that investment managers should carry the burden of responsibility for policing ESG corporate practices.
But if you strip out the noise, the evidence of the positive impact ESG has on driving long-term value is still compelling. Thus, integrating ESG into the investment process is increasingly considered a critical risk management tool.
Empirical evidence of improved long-term outcomes
Over the years, a growing body of empirical research has shown a positive correlation between strong ESG practices and improved long-term investment outcomes. Companies with robust environmental policies, strong social engagement, and effective governance structures tend to outperform their peers in the long run. By integrating ESG analysis into investment decisions, investors can gain access to valuable insights that contribute to risk mitigation and identify businesses with sustainable competitive advantages.
Two interesting studies talk about the importance of ESG in the risk sense:
- As taken from an MSCI paper entitled “How ESG affected corporate credit risk and performance (2021)”, it was found that higher ESG-rated issuers tended to have stronger cash flow metrics, lower levels of ex-ante risk, and less frequent severe incidents than lower ESG-rated issuers. Furthermore, it suggested that ESG complemented credit ratings – ESG ratings had characteristics distinct from credit ratings and delivered additional insights into risk and performance.
- A study by Chadnicka-Jaworska (2021) considered the impact of ESG on credit ratings of non-financial institutions by the two largest credit rating agencies. While credit rating agencies’ reactions varied in different sectors, the results confirmed the positive impact of ESG factors on credit ratings.
At a practical level, incorporating ESG factors into investment decision-making has been an increasing focus across both equity and credit markets due to its potential to enhance performance and mitigate risk in portfolios. In recent years, ESG considerations have evolved from being viewed as mere ethical concerns to becoming fundamental pillars of the investment landscape, with ESG integration emerging as a critical risk management tool.
Why including ESG in the investment process is essential
Including ESG factors in the investment process has become a strategic imperative for modern investors. Traditional investment approaches that solely focus on financial metrics often fail to account for a broad range of risks and opportunities that stem from a company’s environmental impact, treatment of employees, and governance practices. ESG considerations provide investors with a comprehensive framework to evaluate companies beyond their financial performance, enabling a deeper understanding of their sustainability and long-term viability.
From “nice to have” to “necessity”
ESG integration is no longer perceived as a peripheral or optional component of investment decision-making. Regulators, institutional investors, and individual shareholders view ESG disclosure and transparency as necessary. The rise of sustainable investing has created a new norm where companies are expected to address ESG issues actively. Failure to meet these expectations can lead to reputational damage, legal and regulatory risks, and ultimately, erode stakeholder value.
However, navigating the landscape of the ESG ratings that underpin sustainable investment decision-making is far from straightforward due to the lack of a globally accepted standardised rating system and general confusion around how to integrate ESG into an investment process. Some challenges the investment industry face in using and applying ESG include the following.
- Selecting an appropriate ESG rating becomes complex due to the numerous options offered by reputable agencies like MSCI, ISS ESG, and Sustainalytics.
- The lack of uniformity in ESG rating methodologies contributes to significant disparities across agencies’ ratings. Research by Florian Berg, Julian F Kölbel, and Roberto Rigobon in the paper “Aggregate Confusion: The Divergence of ESG Ratings” highlights that correlations between six prominent agencies range from 0.4 to 0.7, indicating substantial differences in their assessments. Scope, measurement, and weights are the key factors contributing to this divergence, reflecting variations in attributes considered, metrics used, and attribute importance.
- Moreover, agencies draw from diverse data sources, leading to subjective judgments that can influence rating outcomes.
The Prescient approach
As a starting point, we believe that using ESG as a risk management tool is crucial as it directly impacts a company’s creditworthiness and, thus, its long-term sustainability. We are strong proponents of long-term investing, which means we consider known and potentially unknown factors so that we can identify the best path to financial certainty and consistent long-term performance. As custodians of capital, our fiduciary duty is to consider the potential financial performance and all investment risks, both from a quantitative and qualitative perspective.
In recognition of the evolving and subjective nature of the ratings landscape, Prescient has developed an in-house ESG scoring model comprising a comprehensive 67-factor assessment tool. This model generates ESG scores for each analysed counterparty, aligning with our fiduciary duty to manage risk effectively. Employing a systematic methodology, we minimize biases and ensure data is accurate and transparent by sourcing financial information directly reported by companies. The in-house model allows us complete control and transparency over our analysis, empowering us to uphold our commitment to responsible investment practices.
What is next for ESG
The future of ESG ratings holds great promise, with growing recognition of their significance in investment decision-making. Efforts towards standardisation are underway, with regulatory bodies worldwide actively establishing robust frameworks and promoting transparent disclosure practices.
Although challenges persist, the industry has significantly improved transparency and guidance. As collaboration between regulatory bodies, organisations, and market participants strengthens, a more transparent, standardised, and informed investment environment centred around sustainable practices and responsible decision-making will undoubtedly emerge.
Notwithstanding the occasional criticism, the integration of ESG considerations in the investment process has continued to transform from a niche practice to a fundamental tool for managing risks and driving long-term performance in the investment industry. As evidence continues to demonstrate ESG integration’s positive impact on investment outcomes, more investors are embracing it as a critical contributor to their strategies. To achieve long-term success, investors are well-advised to accept that ESG factors are no longer a luxury but a necessity in navigating the challenging and evolving investment landscape.
ENDS
