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FA Center: ESG investing needs to clean its own house to remove investors’ doubts

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I’m a huge fan of socially responsible investing — I’ve chosen to dedicate my career to it. But any time we draw back the curtain on so-called ESG ratings it seems like we find out there’s no wizard there.

ESG stands for environmental, social, and governance issues, a catch-all term to describe three broad themes under the socially responsible investing umbrella. This commonly used framework is under siege because the ESG ratings industry has failed to develop a meaningful language that captures the real nuances inherent in social responsibility. It’s no wonder some investors are starting to think of ESG as all talk. 

There are many problems in the ESG ratings world. ESG ratings firms struggle to come up with common standards, shake their heads bewildered at the thought of making companies across different industries comparable and shrug their shoulders if someone asks them whether climate change or board diversity is more important.

With such absent clarity of substance or standards, how could we not start to think of the whole exercise as mere greenwashing? If ESG ratings firms can’t even explain it to themselves, how are they supposed to convince everyone else that what they are doing is worthwhile? At the root of these problems is the ESG framework itself. 

For starters, using an ESG-based framework leaves room for doubt because the framework doesn’t tell you up front which of its three components — E, S or G –  is most important. When applying this framework to companies, they are scored based on how well they perform in each of those categories.

So each company ends up with three scores. A single company can score poorly on environmental issues, wonderfully on social issues and about average on governance issues. Where does that leave investors? How should we reconcile these scores? Should we invest in the company or not? How many diverse board members do you need to cancel out the air pollution that the company is causing?

The framework is too simplistic, so the calculations can’t render a full picture and, all too often, the real outcome is cynicism.

Problems, if left unresolved, beget more problems. As a direct consequence of this disjointed, non-comparable tripartite framework, traditional ESG ratings providers will tend to make their assessments only within industry. It simplifies the analysis and allows analysts to skirt some of these bigger questions of ESG non-comparability by making ESG distinctions between companies that are already extremely comparable.

This means that they can tell you which oil company is the best oil company based on ESG issues that are especially material for oil companies, and they can tell you which healthcare company is the worst healthcare company based on ESG issues that are especially material for healthcare companies, but they can’t tell you which of those — the best oil company or the worst healthcare company — is better in a heads-up comparison and that’s within a ranking system of their own creation. That’s pretty useless, and if it isn’t intentional greenwashing, the confusion and disillusionment this sort of system generates is just as bad.

Befuddled asset managers, overwhelmed by the confusion brought on by the ESG ratings framework, end up being forced to pass the buck. “It just depends what the client cares about: E , S or G” I often hear them say. It shouldn’t be surprising that they then seem to present clients with a variety of conflicting ESG investing options.

Meanwhile, clients, left to their own devices, come up with their own ESG interpretations. A portfolio including companies that score highly on ‘E’ metrics but poorly on ‘S’ metrics can be considered greenwashed by those who think social issues are most important. A portfolio including companies that score highly on ‘S’ metrics but poorly on ‘E’ metrics can be considered greenwashed by those think that environmental issues are most important.

Take this argument to its limit and too many asset managers who depend on ESG ratings to power their socially responsible portfolios appear to be greenwashing. Personally, my sense is that the lack of a consistent, comprehensive and meaningful framework for analysis is the cause of a lot of this uproar about greenwashing. 

This isn’t how it should be. Investment managers have a responsibility to gather the right metrics on issues of social responsibility and provide the proper context to their clients, so that the relative importance of all issues is made clear.

For example, a single unified framework centered on the value of human life could serve as the basis of comparison for all companies. A certain number of people get sick and die from opioid addiction (a traditional ‘S’ issue) each year. A certain number of people get sick and die as a result of air pollution coming from industrial factories (a traditional ‘E’ issue) each year. Those numbers are comparable. They give you a sense of how much human collateral damage is being caused by each and therefore, which issue you should prioritize when rating the social responsibility of companies. It’s possible to quantify and make individual issues comparable if we take a humanitarian approach. Plus, practically speaking, it shouldn’t be too hard for people to get on board with a framework that puts humanity front and center.

Investment managers must take responsibility for their social responsibility analysis by looking for concrete, comparable metrics with which to educate clients on the relative importance of individual issues (regardless of which E, S or G category they belonged to). Then the dream of a common quantitative language of social responsibility can become a reality and the flimsy and fragmented ESG-ratings framework could be left where it belongs — far away from productive conversations about human value. 

James Katz is founder and CEO of Humankind Investments.

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