The missing link

Responsible investment is booming, and integration of environmental, social and governance (ESG) criteria continue to gain momentum amongst investors. They have also triggered progress at index and research providers, who have developed sustainability indexes and research capabilities around ESG. At the same time, we see a trend emerging in which investors are focussing on negative screening or best in class and they’re solely looking at ESG ratings. In our view, an investment decision is not just looking at numbers and scores, it is about understanding what the risks and opportunities are of a particular investment.

In the early stages of responsible investment, it was considered standard practice to exclude companies on the basis of a negative ESG rating. It was a means to respond to emerging ESG concerns, but it was also the reason that full ESG integration did not become mainstream in its beginning stages. Using ESG ratings as a tool to exclude companies has created scepticism around responsible investment and its actual impact. Investors classified responsible investment as a financial barrier to achieve long-term value.

Nowadays there is a lot of supporting research that demonstrates that excluding companies on the basis of a score is not the Holy Grail. The approach falls short when it comes to identifying companies that are able to create a positive sustainability impact and achieve meaningful financial performance. It also exposes investors to green washing, as research providers rely on public information from companies. The lack of standardization when it comes to ESG disclosure fails to address issues that are really material to a company and its business.

While ESG ratings have come a long way, they are primarily useful as a screening tool. Investors need to understand that an ESG score is merely the starting point for forming an investment decision. After all, ESG ratings tend to be based on what a company has performed in the past, and we are more interested in how it will affect the company’s performance in the future. Within the environment of lacking standardization which contributes to imperfect data, investors will have to move away from just basing their decisions on ratings.

Research has demonstrated a positive correlation between ESG and financial performance, and it moves investors away from seeing ESG as value destroying. The next step is moving away from full dependence on ESG data. In our view, full ESG integration provides an opening to discover investment risks and opportunities, and ESG will for sure play even a bigger role in the future than it has done in the past. When all investors start really pushing full ESG integration forward, it might even trigger that responsible investment will be so mainstream that it will just be called investment.

Faryda Lindeman, Senior Corporate Governance Specialist, NN Investment Partners

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