The Unspoken Reality of ESG
The rationale behind ESG integration is to make ‘better’ investments by factoring in unpriced risks and opportunities not captured in conventional financial analysis. Blackrock, the world’s leading asset manager, captures environmental risk in ‘Aladdin Climate’, a tool on the Aladdin platform which provides scenario analysis capabilities to see how climate-related risks and opportunities evolve under different scenarios.
Though strategies being implemented are unique and work under an effective rationale, ESG integration is fraught with issues. ESG metrics and rating agencies such as MSCI, all operate using different criteria, weights and measurements and ultimately rely on publicly available data. As such, scores are not consistent across, with little comparability and strong public concerns in regard to quality. In an OECD report, different minimum variance frontiers showed statistically significant differences under the specifications of different ESG scoring agencies. It goes on to show that at the moment, there is no clear image of what ESG factors and metrics directly impact the financial condition of a company.
A large firm bias also exists in this system. Firms with greater financial resources are able to dedicate greater resources to the reporting and subsequent disclosure of ESG-relevant metrics irrespective of their actual ESG ‘ability’. Given private markets are not obliged to disclose their financials, ESG evaluations must be conducted in an alternative manner, adding further inconsistencies and limitations to ESG integration. ESG questionnaires are often used in such evaluations but only serve to add greater inaccuracy and inconsistency to ESG implementation due to their innate arbitrariness.
Concentration risks are also a significant issue of ESG focus as a result of limited diversification. A portfolio centred around ESG products which are often correlated to one another with little covariance between assets significantly raising concentration risks. Although, there is strong academic evidence to suggest that ESG asset-based portfolios have lower downside risks than non-ESG asset-based portfolios with the IMF publishing as such. Perhaps, in this upcoming period of uncertainty and recessions, academics will have the perfect environment to test ESG portfolios, their risks and limitations.
To summarise, ESG integration has many issues, with existing literature revealing as much in their inconsistent empirical narratives. Independent meta-analyses report negative correlations between ESG integration and returns much to the contradiction of Investment Bank reports and other international body publications. What can be garnered from these contradicting publications, however, is that there is an undeniable inconclusiveness in ESG implementation. This can be attributed to the inconsistencies in reporting, strategies and biases in geographics and time frames.
In my personal opinion, ESG integration is still very much in its infancy and so long as it is plagued by inconsistent standards across the industry, it must be treated with great caution. ESG ratings by these agencies should not be taken as accurate representations of ‘financial strength’. They remain inconsistent and parallel to the 2008 crisis, without a reliable and credible rating system, there exist all sorts of dangers. Nonetheless, the fundamentals of ESG integration are solid and will undoubtedly have a strong role in defining the next generation of finance.