Ignoring ESG data simply doesn’t make business sense

Last month, I wrote this story about ESG data, focusing specifically on the “social” pillar within ESG—the hardest element to quantify, the least understood component, and that which, some argue, could be the most valuable of the three.

The social element of ESG covers issues like employee diversity and health, training, pay gaps, working conditions, and whether a company’s supply chain is exposed to practices like child labor or modern slavery. Some of these can be shown to have a direct link to a company’s performance. Others, such as how much time a company and its employees devote to volunteer work, for example, are harder to pin down in terms of their effect on the bottom line.

ESG data overall suffers from a lack of standardization, with data providers using individual and proprietary methodologies and definitions, making it hard to compare like-for-like ESG investments. Within that, the social pillar in particular lacks standards and struggles with definitions, has not been systematically nor quantifiably captured compared to its environmental and governance-related counterparts. Those two pillars contain vast histories of climate and corporate data, and may be reported using different formats and definitions, and is unaudited, says Kathryn McDonald, co-founder and head of investments and sustainability at RadiantESG Global Investors.

McDonald points out that ESG—and especially its social aspects—often go hand-in-hand with other good or bad activities that may be beneficial or detrimental to a company’s corporate health, reputation, and ultimately its value, as well as other companies it may be supplying or associated with.

“As investors, we should care about, say, modern slavery, beyond the fact that it is patently immoral, because it often goes along with crime rings, work stoppages, and deaths in the workplace … and that affects the whole supply chain,” she says.

Think of ESG data as just another dataset. … Even if you decide not to invest in a company on the basis of good ESG scores or credentials, it still makes sense to include that data in your evaluation.

Max Bowie

All of these can result in lost revenues, workplace disruptions, longer time to market, as well as the possibility of financial penalties from authorities. These all have a measurable—if unpredictable—impact on a company’s bottom line, and inevitably on its share price. Meanwhile, social issues like food or water shortages, or electric power grid issues can directly impact a country’s standing, and for example, its sovereign debt.

And yet, adoption of ESG principles and use of ESG data faces opposition that other, traditional datasets do not—perhaps because a moral obligation is an alien concept in capitalist markets, or perhaps more because of political shifts. It should be noted that none of the people I spoke to for my story expressed any reservations about the usefulness of ESG data as one input to a balanced research process.

Instead, the pushback against ESG appears to be coming from outside of the financial markets. This has become not only more evident this year but has become something of a cause célébre for conservative political candidates in the US. In February, Florida governor and Republican presidential candidate Ron DeSantis barred state officials from investing in ESG investments and prohibited financial institutions from discriminating against investors or borrowers based on any ESG-based factors, citing the need to “protect Floridians from the woke ESG financial scam,” and calling ESG a “direct threat to the American economy and individual economic freedom.”

Despite this—and despite ESG funds seeing significant outflows in 2022, though to be fair, so did many non-ESG funds—the decisions by funds and investment managers to invest in ESG-focused assets is being driven by demand. And if you don’t believe that, just look at the SEC’s recent proposed revisions to the Investment Company Names Rule, which is designed to prevent companies from misrepresenting their principles in order to attract funds.

In its comment letter about the rule, advocacy group Better Markets cites the example of the BlackRock Impact US Equity find, introduced in 2015, which by 2019 had attracted inflows of $78 million. So, in 2019, BlackRock changed the fund’s name to the Advantage ESG US Equity Fund. This change, Better Markets says, directly contributed to that fund attracting a further $510.5 million over the next two years. After another name change, the fund—now called the Sustainable Advantage Large Cap Core Fund—now has more than $700 million in assets under management. It has also returned more than 144% since launch, and $10,000 invested in the fund in 2015 is now worth almost $25,000.

Now, arguably, BlackRock was simply adjusting the name to better reflect its contents—and, indeed, BlackRock notes that the name-changes reflected accompanying changes to the strategy of the fund’s strategy—but there’s a clear message to would-be fraudsters: when ESG is such a hot topic, including it in your name could make a huge monetary difference, regardless of whether or not your fund actually follows any ESG themes.

Other authorities are also refining their definitions of ESG factors and processes. For example, the World Federation of Exchanges introduced ESG Guidance & Metrics in 2015, and earlier this month issued a guidance note and a public call for comment on its Green Equity Principles to set out guidelines for exchanges wanting to create offerings aligned to the principles, including designating responsibility in an exchange for overseeing the classification, establishing processes—including criteria for revoking classification, development of a classification mark and provision of public information, and establishing criteria for assessing appropriate reviewers.

If ESG-themed funds were losing money or dramatically underperforming comparable benchmarks, I could understand Florida’s concern. But the BlackRock fund mentioned earlier, for example, has closely tracked the Russell 1000 benchmark, and exceeded the broader Russell 3000—$10,000 invested in the fund in 2015 is now worth almost $25,000.

The Florida law doesn’t outlaw using ESG data but does prohibit certain actions based on decisions one might logically take as a result of using it.

Think of ESG data as just another dataset. Ignoring it means you are less informed and puts you at a disadvantage against other investors. Even if you decide not to invest in a company on the basis of good ESG scores or credentials, it still makes sense to include that data in your evaluation.

Even if you doubt the veracity or consistency of ESG data, think of it like Twitter: certainly not every statement made on Twitter is an accurate statement of fact. But in aggregate, even inaccurate statements can sway public opinion and move markets—and that can make it an important indicator. In addition, ESG reporting laws and guidelines mandate more transparent reporting, which will result in better quality data.

You can show that looking at those factors makes you a better investor. For example, ESG could factor in to calculating a discount rate for discounted cash flow analysis.

Berenice Lasfargues, BNP Paribas Asset Management

Berenice Lasfargues, sustainability integration lead at BNP Paribas Asset Management, likens ESG to any financial factor that an investor might consider when making a decision. “You can show that looking at those factors makes you a better investor. For example, ESG could factor in to calculating a discount rate for discounted cash flow analysis. So, you can argue that ESG helps you make better decisions and get better returns for clients,” she says.

In addition, she notes that sustainable business and investing goes hand in hand with client focus. And she doesn’t just mean that contributing to factors which may kill or endanger potential customers isn’t a sound strategy for winning repeat business. “If you’re a fiduciary, investing money on behalf of clients, you have a duty to take into account all risk factors. So, we wouldn’t be doing our job if we didn’t consider it.”

It’s easy to forget that financial firms are also usually public companies and subject to the same market forces and ESG issues as any other company. So, while they are identifying ESG data on other companies for good risk management, they also need to be implementing ESG practices within their own walls for good business. And there are resources readily available to help firms do this.

For example, Sustainable Trading is an industry network created to help develop best practices around ESG that the financial industry can easily adopt and incorporate into its everyday business. Founder and CEO Duncan Higgins, who previously held senior electronic trading roles at Virtu Financial, ITG, Turquoise and UBS, says the group stemmed from his desire to do something that would have a positive effect on the planet, and the realization that while ESG principles were becoming well adopted in investment methodologies, they were lagging in terms of internal adoption by financial firms—for example, simple changes such as running servers at a lower state while markets are closed.

For the social element, its best practices focus on recruitment and diversity in the hiring process, to ensure a firm is best placed to attract and retain a diverse array of applicants—for example, everything from how a job ad is written, where the job is posted, what university education an employer looks for, training managers, and changing the makeup of interview panels based on individual candidates. Higgins says he’s been pleased with the industry response so far, and also pleased that social elements appear to be already well understood in the financial sector.

“In the areas we’re looking at, we found that the social priorities were the most developed within our member organizations, and there’s been a lot of progress on diversity over many years,” he says. “By rethinking how you hire, you can draw from a bigger pool of talent—and those benefits are well understood within many firms.”

Higgins launched the organization in February 2022 with 30 members, and now has 56. In its first year, the group surveyed its members to determine priorities, and distributed a resulting set of best practices that firms can integrate into their operations. The group is now putting the finishing touches on a measurement framework that allows firms to measure their progress in adopting these ESG best practices and benchmark themselves against their peers.

And for reporting ESG and social metrics in line with new emerging standards, help is also available. Vendors such as ESG Book provide platforms that provide data on companies and also help those companies manage their disclosures. ESG Book employs 150 data analysts to collect a variety of ESG metrics—including 130 metrics dedicated to social factors—on around 10,000 public companies. Once the data is loaded into its platform, companies can view and verify their data, can “claim” their entity and use the platform to manage disclosures—for example, to understand the regulations they may be subject to, which social-related disclosures may be voluntary or mandatory in a specific jurisdiction, and how their ESG profile compares under different regulatory frameworks.

Todd Bridges, head of ESG research at ESG Book, says 9,000 corporations are already using the platform to disclose ESG data.

But at the end of the day, what’s the point of benchmarking performance if we aren’t all making a concerted effort to improve? Whether you call it ESG or not, better business practices and efficiencies are a good thing. So, even if you don’t believe in climate change, consider that energy-saving measures don’t just reduce reliance on fossil fuels, but also help a company reduce its electric bills, be more efficient, and ultimately make more money. If you have an aversion to seeing different genders or races represented on a board, consider that different backgrounds and experiences will help a company grow—and make more money. And if you find governance issues like reporting and properly disposing of toxic waste burdensome, just remember that doing things properly generally avoids the potential of fines and penalties that could impact a company’s bottom line or damage its reputation.

At its core, ESG is about people—and for the “S” in ESG, this is especially true: how we treat them, how companies treat employees, and how the financial markets and investors can continue to make money while knowing that their returns come from contributing to safeguarding others. If, given the choice, we choose to ignore that, what does it say about us?