The limits to sustainable investing in times of sparse company reporting

By Niklas Pape

By Niklas Pape

 

The rise in sustainable investment

Sustainable investment has developed rapidly in the last decade. Across Europe, the United States, Canada, Japan, and Australia and New Zealand, assets under management that apply environmental, social and governance (ESG) criteria in some form reached $17.5 trillion in 2018, up from $10.3 trillion in 2016 and this trend is predicted to continue. BlackRock, the world’s largest institutional investor, forecasts double-digit growth in sustainable investment options over the next decade, driven by regulatory changes and the increasing awareness of ESG issues among asset owners.

Data challenges remain

Given this rosy outlook, it can be easily forgotten that considerable challenges remain to make sustainable investing a viable long-term option that can challenge the dominance of short-term profit maximising investment strategies.

One challenge I observe in my work is that consistent measures of ESG factors and ratings are still a work in progress. To make informed decisions about where to shift their money, asset owners need to know which companies and industries are performing well on the ESG issues that are core to their value creation, e.g. managing climate change risk. This, however, is no easy task at the moment. First, it is not always clear to see which ESG factors are relevant for which company or industry. Second, patchy and inconsistent reporting from companies makes it hard to distinguish their performance and compare it to others.

To overcome these issues, a growing number of data providers are producing company-specific ESG scores. But while their efforts are welcomed, we should all be transparent about the limitations. The process of linking ESG issues to companies and industries is often not entirely objective, with the effect that different scores effectively look at different underlying factors. Moreover, ESG scores are inherently prone to oversimplification as they try to describe complex and distinct fields within a single score. On top, like everyone else, data providers depend on a low rate of company disclosure, leading to ESG scores that rely mostly on modelled data instead of observed values.

Future implications

The identified problems have strong implications for sustainable investing, as strategies made on faulty or limited data have a higher risk of disappointing in the future. If investment decisions made today do not lead to the desired outcomes tomorrow, be it financially or in their impact on ESG issues, the boom of sustainable finance might not be able to fulfil its promises. That would be a shame. The transition to a more sustainable society needs investments on a scale that can be only stemmed with large private sector involvement as governments alone lack the financial weight. For example, look at the issue of climate change. The International Energy Agency projects that USD 3.5 trillion in energy sector investment would be required on average each year between now and 2050 to keep global warming below 2° C. Private sector funding is crucial if we are going to adhere to the Paris agreement and develop our economy and society in a sustainable way.

A way forward

To minimise the risk of sustainable finance becoming a dead horse we need to push for standardised and comprehensive reporting from companies on their ESG performance.  Governments, investors, and companies need to work together and create reporting standards as well as incentives to promote comprehensive reporting. Challenges lie ahead, as some factors are hard to measure and may always depend on subjective decisions, but if we want to finance the transition to a more sustainable society, we need to know where capital is required and where it has the desired impact.