The Evolving State of ESG
Despite the massive interest in ESG investing on the part of individuals and institutions, there remain some challenges for investors and advisors alike. For instance, there is no standard definition of what ESG represents.
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The Evolving State of ESG
Since the beginning of 2020 through the second quarter of 2021, sustainable investing has attracted over $90 billion in new cash flow, raising the AUM of equity Environmental, Social and Governance (ESG) criteria funds to an estimated $537 billion.1
Despite the massive interest in ESG investing on the part of individuals and institutions, there remain some challenges for investors and advisors alike. For instance, there is no standard definition of what ESG represents. Can a fossil fuel company be considered ESG eligible if it’s aggressively transitioning to renewable energy? Does the social toxicity of a social media giant preclude it from ESG portfolios despite its low carbon footprint?
There are also a host of issues with the data used to determine the ESG score of companies. While there is a range of well-regarded data providers (e.g., Morningstar, MSCI), companies often may receive wildly divergent ESG ratings. The data used by such third-party providers can also be of poor quality and non-standardized, making objective judgments difficult.
Then, there’s also the challenge of “greenwashing,” which refers to attempts by companies to manipulate data and disclosures to represent their products and services as more environmentally friendly than they really are.
Finally, while brokerages and Registered Investment Advisors (RIAs) happily offer such products to their clients, many such firms do not perform the due diligence on the funds’ underlying portfolios to evaluate how well the constituent companies actually reflect ESG standards.
Changes are Afoot
The ESG industry is fairly embryonic, so these data, processes and philosophical issues are to be expected. The complex of portfolio managers, third-party providers, nonprofits and non-governmental organizations (NGOs) are well aware of these challenges and are working to develop more credible data, greater transparency, and more standardization to reporting and analysis.
In the next several years, look for:
- Concerted efforts by regulators and private sector organizations to advance efforts for greater data integrity and standardization
- More data on climate risk exposures in company reporting; for example, the Federal Reserve (the Fed) recently joined the Network for Greening the Financial System (a group of central banks and supervisory authorities) to develop climate risk management tools for financial companies
- Expanded diversity tracking of company boards, executive management ranks and workforces to better quantify progress on social inclusion
- Greater incorporation of ESG into the investment decision-making process
- Clearer linkage of performance to financial performance, arising from more and better data and the use of artificial intelligence (AI)
- Fixed income to be increasingly subject to the same ESG investment screens that equity investments must clear
- Wealth management companies to supplement their existing investment manager research and due diligence activities to evaluate the ESG profile funds that represent themselves as sustainably managed
Please reference disclosures: https://blog.americanportfolios.com/disclosures/