July 31, 2020

Right now, as we look at the COVID economy, there’s no question that ESG (Environmental, Social and Governance) considerations have never been viewed as more important by investors. This is a good and promising development, for the most part. But it comes with an element of “hype” that that presents new challenges for longstanding ESG practitioners.

As with so many other facets of our lives, COVID-19 has served to rapidly accelerate the application of ESG principles, and created a growing expectation that the incorporation of these principles into the operations of companies (and the evaluation of those companies as investments), will become a broadly followed standard. Such an assumption, however, ignores a swath of opinion – driven by a tidal wave of media trumpeting the importance of ESG considerations in a post-COVID world – that ESG is more hype than substance.

 Fair enough. A little skepticism and perspective can’t hurt, especially when ESG is being tossed around with authority by so many individuals and organizations that have previously shown little to no interest in the term or its applications. Longstanding ESG practitioners should welcome these challenges because our responses can help separate the wheat from the chaff when it comes to clarifying the value that ESG considerations bring to investment decisions.

Let’s consider a few of the more recent challenges:

 

  1. ESG analysis is a ‘shame game’

Here’s the challenge: Using ESG to label companies as failing to live up to ESG-related expectations is nothing more than an exercise in publicly calling out management.

Here are the facts: The notion of shaming may be traceable to BlackRock CEO Larry Fink’s 2018 letter to CEOs, where he demanded leaders of the companies BlackRock invests in operate with a sense of purpose and multistakeholder approach to their businesses. The effect was that many of those leaders subsequently declared through the Business Roundtable (though they were clearly not yet ready to pony up with action), alignment with his views. No one wanted to be caught on the ‘wrong’ side of this new business paradigm.

Nowhere, though, and certainly not among longstanding ESG practitioners, have we witnessed outright ‘shaming’ of companies for their ESG-related performance. NEI and others have identified to companies ESG-related shortcomings that we believe are legitimate risks to their businesses. And as investors we do demand that management be accountable for their responses to these risks. But we never publicly shame. We prefer instead to collaboratively engage to solve identified ESG challenges. There is a world of difference between the two.

  1. ESG wanders into non-material places

Here’s the challenge: Non-material factors driven by broader social agendas find their way into ESG assessments of companies.

Here are the facts: Do broader social trends impact what is material from an ESG perspective? Absolutely, and so they should. Take the interest in diversity and inclusion, amplified by social unrest around the issue of systemic racism. If the belief is that this social movement has no material impact on companies, then proponents of this view are clearly missing the broader context around the burgeoning “S” in ESG.

There is undeniably a seismic social shift happening, and that shift is introducing a range of new or suddenly more important risks into the system; risks that will deeply impact companies. It’s the job of smart ESG practitioners to see these risks – often before companies realize them – and to determine their materiality. Some analysts may see a given risk – like the diversity of a board, executive team or workforce – as more significant than others. Everyone sees the world differently. But to suggest that uncovering new risks based on what’s happening in the world is simply the pursuit of trendiness is misguided.

  1. ESG data and ratings are suspect

Here’s the challenge: ESG ratings are invalid because of the compressing forces of amorphous ESG data and demand for simple, specific ESG ratings.

Here are the facts: There is no denying that, although things are improving almost daily, ESG data can be spotty and inconsistent in some areas. There is also no denying the demand to simplify ESG-related company assessments.

NEI’s believes that ESG analysis is nuanced and should not be oversimplified in the name of expediency. That’s why we base our company analyses on multiple data sources and a proprietary evaluation framework that relies on our own analysis of multiple data points and sources.  Additionally (and this speaks to the differentiation around responsible how investing is practised that those who challenge the validity of ESG data fail to consider), where company disclosures are vague or non-existent, we give companies a chance to provide more information before making an evaluation decision.

The lesson of these challenges is obvious. Blanket criticisms of the relevance and effectiveness of ESG analysis fail to account for the fact that different ESG practitioners do things differently, with different philosophies and levels of rigour and commitment. As we’ve said before around the assessment of ESG-focused mutual funds, it’s imperative you take the time to look under the hood.