Sustainability Criteria: Are ESG and SRI overhyped concepts?

Sustainability has become an important criterion for investors, especially those looking for long-term growth opportunities. But sustainability has no fixed definition, leaving companies and investment firms to use their own criteria and metrics.

A given stock, then, may be viewed as sustainable or non-sustainable depending on whom you ask. Even when investment firms agree, some sustainable companies simply make bad investment choices based on traditional measures of financial health and market performance. No company can save the environment once it’s gone out of business.

How, then, can investors assess a given company’s sustainability on terms that offer at least some of the stability represented by P/E ratios and other long-standing quantitative measures? Sustainability may always involve some judgment, but a set of criteria is emerging that help investors make informed choices.

• Environmental considerations: How do the company’s products and services address climate change? What about their production methods and supply chain? How do they mitigate and offset their greenhouse gas emissions?
• Corporate Governance: How responsibly is the company managed? How transparently does it act?
• Social Responsibility: Are the company’s employees and suppliers compensated fairly? Are employees treated fairly? Does the company do business in socially detrimental industries like arms development or fossil fuel?

These criteria can be applied negatively or positively: a stock index, for example, may include only companies that have demonstrated adherence to their sustainability criteria, or to exclude companies that manifestly violate them.

Sustainability criteria at a glance

Most sustainability criteria fall into one of two categories: ESG and SRI.

ESG—environmental, social, and corporate governance—is fairly self-explanatory. While ESG criteria tend to be consistent across rating systems, the information used to establish a given company’s ESG status is largely qualitative, and requires some interpretation. The same company, then, may receive different ESG ratings by different investment firms.

MSCI is the leading investment reseacrh firm in the ESG space. It assigns one of three ESG-related labels to companies that have earned at least some measure of recognition for their ESG activities.

• ESG-screened companies omit those that are heavily invested in socially detrimental industries, but include the vast majority of stocks listed in the parent index.
• ESG-enhanced companies meet the same low bar, with the added qualification that their CO2 emissions are 30% less than the parent index’s average.
• ESG leaders include the companies listed in the parent index whose ESG ratings place then in the 50% best-in-class of the parent index.

SRI, or socially responsible investing, typically applies a blunter set of criteria than ESG investing, and includes fewer companies. Most SRI indexes exclude alcohol, adult entertainment, civilian firearms and military weapons, gambling, GMOs, nuclear weapons, nuclear power, thermal coal, and tobacco.

iShares, for instance, begins by excluding companies listed in its parent index, then applies ESG standards to those that make the SRI cut. Only 20% to 40% of companies listed in iShare’s parent index qualify as SRI-certified.

Other approaches are a bit more demanding. Some indexes define sustainability in positive terms, and require companies to operate in green energy and other markets expressly devoted to addressing climate change. Others, like Weber Bank’s, assign different sustainability thresholds for each non-excluded industry.

What makes a company sustainable?

Sustainability ratings are fraught with ambivalence. Do low wages represent exploitation or opportunity? Is social media a boon or a bane? What about companies that produce security software?

Those questions speak to the fundamental challenge surrounding sustainable investing: investors want to do good, but defining a “good” company can be next to impossible.

Finance professor Aswath Darmodaran considers the entire concept of sustainable investing so difficult to define as to be untenable. “Overhyped” and “oversold” are the exact words he chose in this regard in a recent online webinar. The following figure from this study by QS Investors, a quantitative asset management company, demonstrates exactly how varied ratings can be from agency to agency.

The same study calculated the correlation of ratings among agencies along the four criteria it covered. Where a correlation of 1 represents perfect agreement and a correlation of 0 represents complete disconnection, no criterion reached the 0.5 mark.

The study also found a relationship between a company’s size and its ESG rating. Large-cap companies consistently scored higher than small- and mid-cap businesses.

A study by MIT Sloan School of Management offers a similar visualisation, this one based on MIT data. Some of the divergence represented here is cultural: US-based MSCI, for example, rates tobacco companies Japan Tobacco and Philip Morris very low. Vigeo Eiris and Sustainalytics, based in France and the Netherlands, respectively—two countries with considerably higher smoking rates than the US—take a friendlier view.

The false market morality of greenwashing

Amidst such uncertainty, unscrupulous actors can take advantage of investors’ sentiments, promoting stocks as sustainable when they fail to live up to the spirit of that term, a manipulation known as greenwashing.

Former Blackrock executive Tariq Fancy, who worked with sustainable investment at the world’s largest asset manager, considers the boom in sustainable investment a “dangerous placebo.” In an interview with the German magazine Handelsblatt, Fancy notes that underperforming stocks are often misleadingly labeled as sustainable simply to attract investors’ attention. In the long run, this threatens to undermine the goodwill that motivates investors to consider sustainable options in the first place.

Fancy also notes that the broader impact of “green” ETFs is currently quite small, due to the surprisingly similar makeups of green ETFs and their traditional counterparts. Investors may care deeply about the environmental impact of their decisions, but the market does not.

Green investors must go beyond labels and marketing—and their own emotions—to study what exactly lies behind each investment vehicle’s claims of sustainability. The market for sustainable investment products is still growing and still maturing. While it does so, investors must remain especially diligent.

Professor Aswath Darmodaran made an important remark on a virtual talk at the Indian Institute of Management Kozhikode this year. He said that we as retail investors should not let the financial industry decide on what is good, but should make our individual judgements and choices. And this is how Pure Climate Stocks came to life. I decided that I personally want to invest in companies that are climate pure players and developed a rigorous methodology to identify what constitutes Pure Climate Stocks. It works for me and, if you personally also consider such companies as “good”, I suggest that it can work for you as well.

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