Environmental, social, and governance (ESG) focused investments soared in popularity over the past few years. According to Bloomberg Intelligence, global ESG assets are on track to exceed $53 trillion by 2025, representing more than one third of the $104.5 trillion in projected total assets under management.
Despite these tremendous growth rates, the metrics that funds use to evaluate ESG factors could be misleading to some investors. For example, Philip Morris International (PM) is part of the Dow Jones Sustainability Index due to its efforts to mitigate the negative impacts of its products, operations, and footprint despite its products’ negative health impact.
Let’s examine the shortcomings of existing ESG metrics, how rating firms could improve, and how investors can adapt in the meantime.
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What Does ESG Mean?
Ratings firms, like MSCI and Sustainalytics, use a variety of ESG metrics in their analyses. While most investors assume these metrics reflect corporate responsibility, they actually measure a corporation’s economic risk due to ESG factors. That’s why the iShares ESG Aware MSCI USA ETF (ESGU) holds stocks like Exxon Mobil (XOM Chevron (CVX).
These ratings can be misleading in other ways, too. For example, a company that scores well in one area, such as low emissions, can offset poor scores in other areas, like governance. In other cases, companies may perform well by their very nature and account for a large part of ESG portfolios, such as tech companies that naturally have low emissions.
Finally, exclusionary ESG funds punish bad companies but don’t necessarily have exposure to good companies. For instance, ESGU excludes firearms producers, controversial weapons, oil sands, thermal coal, and tobacco, but many of its most significant holdings are still Fortune 50 companies, like Amazon (AMZN), Microsoft (MSFT), and Google (GOOG).
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Developing Relevant Metrics
Newer and more relevant ESG metrics aim to solve these issues. For example, electric companies in the process of decarbonization might create a hybrid metric based on the ratio of EBITDA to carbon intensity, which could be compared against industry peers to find utilities that are profitably shifting to renewable energy.
In addition to new metrics, ratings companies and funds may change how they aggregate these metrics. So, for example, a company that does well in one area shouldn’t qualify for ‘ESG’ if it fails in another. Market failure metrics can also be helpful to disqualify companies for negative externalities, ranging from consumer health to deforestation.
Finally, some funds are actively investing in companies affecting positive change rather than just excluding negative companies. For example, the iShares MSCI Global Impact ETF (SDG) invests in companies that derive revenue from products and services that address at least one of the world’s most significant environmental and social challenges.
How to Invest in ESG Now
Investors looking for ways to align their portfolio with their values better have some options in the meantime. For example, the Engine No. 1 Transform 500 ETF (VOTE) invests in the 500 largest U.S. companies and uses its influence to vote proxies. Famously, the firm successfully replaced ExxonMobil board members to enforce structural change.
Impact investments, such as the aforementioned iShares MSCI Global Impact ETF (SDG), are another way to better invest in ESG. SDG’s largest holdings include Tesla Inc. (TSLA), Vestas Wind Systems (VWDRY), Umicore SA (UMICF), and other companies focused on making a positive impact rather than simply companies that aren’t making a negative impact.
And finally, green bonds are another example of impact investing rather than simply ESG exclusionary investing. For instance, by investing in municipal bonds funding solar projects, investors directly impact the affordability and implementation of solar within a community. As a result, there’s less risk of holding bonds that may have negative externalities.
The Bottom Line
ESG has become a popular theme among investors, but it’s rife with misunderstanding. While conventional ESG metrics focus on a corporation’s economic risks, new metrics aim to measure a corporation’s positive impact on the world, aligning the investments with what investors are ultimately seeking in these kinds of funds.
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