Solely relying on ESG data and ratings to assess a firm’s sustainability practices can introduce risk and bias into fundamental analysis and may limit ESG to just yet another “quantitative and exclusionary” tool, contends Maria Egan, a portfolio manager at Reynders-McVeigh Capital Management.

This comes as ESG tools and ratings are gaining momentum and becoming more mainstream, and as board interest in sustainability reporting is rising.

Risky Business

The Risk Exactly

Without quantifying the exact risk, Egan suggests dramatic oversimplification of ESG analysis can fail to identify companies that deliver on both sustainable earnings growth and positive impact.  Many recent adopters, she also suggests, are using a check-the-box approach when evaluating ESG scores for candidate firms.

“ESG analysis should not be this easy,” she asserts. “It is a discipline rooted in the fact that making an investment decision is about more than analyzing numbers; it is about understanding how non-financial factors hinder or help company performance.”

Three Reasons

ESG analysis is in its infancy in other words, and to treat it as such.  Egan cites three contributing factors:

  • Regulation and standardization of ESG disclosure is lacking – ESG analytics isn’t and shouldn’t be the only set of measures to assess a firm’s ESG rating. A fuller picture of what could materially impact a company going forward should accompany an analysis.
  • Materiality is missing – As firms get more sophisticated in how to report ESG, other material data, positive or negative, may sometimes be omitted.
  • Backward looking data – Investors often analyze performance data in the past when they often should analyze future performance data.

Dig Deeper

Reported data by firms and their analysis is often far from perfect and deeper scrutiny should always accompany analyses. Egan suggests asking more probing questions, in addition to just checking off boxes, such as:

  • Is there ongoing dialogue among company managers on their approaches to ESG risks?
  • Does a firm have a short-term or long-term horizon and does it consider its environmental footprint as well as its social impact throughout its business operations?
  • Has feedback and analytics from industry peers and external stakeholder organizations been considered? How comparable is a firm’s ESG practices to its peers?
  • Is there a sound process for obtaining outside perspectives relative to employee satisfaction, employee pay, and how a company treats and values employees, customers and other stakeholders throughout the supply chain? How comparable are those to its industry peers or other organizations?

Bottom line

“There will always be an element of [human] personal analysis and research needed to determine what information is available and whether to invest [in a firm].

Read More

“ESG Incomplete Investors Perspective,” GreenBiz, September 2017.

“Board Interest in Sustainability Doubles,” CFO, September 2017.

“Closing the Confidence Gap in Sustainability Data,” CFO, September 2017.

“Pain as Green Reporting Takes Root,” CFO, June 2017.

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