Disaggregating “ESG”: a tale of two concepts

Reading headlines recently, you’d be forgiven for thinking that the concept of ESG investing was on its way out, following successive scandals and changing attitudes amongst investors.

Deutsche Bank and DWS, for example, were recently raided by German police as part of an investigation into DWS for alleged greenwashing and prospectus fraud. In the US, the Securities and Exchange Commission is investigating Goldman Sachs’ ESG claims, having recently accepted a $1.5 million settlement from BNY Mellon for allegedly misleading ESG-focused investors.

Meanwhile, the Ukraine conflict and consequent boycott of Russian companies have reopened debates around whether “E”, “S” and “G” really ought to sit under the same umbrella.

In this post, I evaluate proposals to “disaggregate ESG” and unpick two distinct approaches to ESG investing which businesses could seek to adopt.

What is “ESG investing”?

In its broadest sense, ESG investing means any investment strategy aimed at generating not just financial, but also environmental and social returns or benefits. More narrowly, ESG investing involves selecting companies based on their performance under various ESG metrics. BlackRock, for example, describes “ESG integration” as “the practice of incorporating ESG information into investment decisions to help enhance risk-adjusted returns”.

What criticisms have been levelled at ESG?

Recently ESG investing has come under increasing fire as its honeymoon period wanes. It is difficult to pinpoint the exact source of the malaise, but possible causes include a lack of credibility regarding providers of ESG investment products; confused and sometimes fragmented definitions and terminology; inconsistency amongst different ratings providers relied on by investors; and the limitations of compliance-driven box-ticking approaches to managing complex trade-offs between competing ESG issues.

The treatments prescribed by market commentators vary, from abandoning the concept altogether to introducing standardising regulations for the investment ratings industry. One proposal gaining traction, spearheaded by Gillian Tett at the FT, is the idea that ESG should be disaggregated into its constituent “E”, “S” and “G” components.

The benefit of using more granulated metrics focusing on just one or two ESG factors at a time should be greater clarity around what is being measured and how decisions about “trade-offs” between ESG issues should be made—all of which will bolster the legitimacy of ESG investing and increase transparency for investors.

Will disaggregating ESG work?

Whilst greater clarity around ESG ratings is clearly desirable, separating ESG into its components is not the solution in and of itself—and is unlikely to provide an adequate solution for businesses and investors seeking to strengthen the credibility of their ESG investing activities.

Although proponents of disaggregating ESG suggest this will reduce confusion, they do not set out how this will be achieved. Disaggregation does not inherently increase clarity, as there will still need to be some means to analyse and assess each component. Separating out ESG does not offer a road-map to resolving trade-offs between ESG issues (which may arise where a company performs strongly in one ESG area, say, environmental issues, but poorly in others because, for example, it is has weak labour protection policies or operates in a country with a controversial human rights record).

Splitting elements of the ESG-related risk assessment into silos opens the exercise up to the criticism that trade-off decisions would be dealt with simply by being ignored (“out of sight, out of mind”). This is because such an approach arguably allows investors to focus on single ESG factors at the expense of others, rather than taking a more holistic view.

A different take on “disaggregating” ESG

An alternative approach could instead include more targeted solutions to improve clarity—through, for example, industry regulations which impose harmonised transparency standards and definitions on ESG rating providers. Recent promising initiatives include the European Union’s recent Sustainable Finance Disclosure Regulation and the International Sustainability Standards Board (discussed here).

The root cause, however, of the present confusion arguably lies in the interchangeable usage of two quite different understandings of ESG investing, rather than difficulties generated by bringing together “E”, “S” and “G” under one analytical umbrella. It is these two concepts of ESG which could helpfully be disaggregated.

“ESG as tool”:

ESG investing as a strategy that relies on ESG metrics as a tool for analysing specified categories of risks and opportunities to identify, as BlackRock describes, “financially material sustainability [etc.] insights” with the ultimate aim of improving, or safeguarding, the financial performance of investments. If a company adopts this approach, conflicts between ESG factors can, plausibly, be evaluated as a balancing exercise between financial risks and opportunities—an approach familiar to those engaged in other types of financial analysis.

“ESG as values”:

ESG investing as an approach that uses ESG metrics as a values-based framework through which to make investment decisions, with the goal of generating social or environmental benefits (which may or may not maximise financial returns). If a company adopts this approach, assessing trade-offs involves a more qualitative, less structured exercise, requiring each investor to reflect carefully on its values and ethical priorities.

Specifying how and when these different notions of ESG investing are being deployed will help provide clarity for those in the investment community and could provide a more coherent framework for balancing thorny conflicts between ESG issues. Separating these concepts out will improve transparency and accountability, more so than simply separating “ESG” into its constituent parts without clarifying the methodological approach.

Businesses wishing to achieve a coherent, and therefore more credible, approach to ESG should seek to adopt tailored ESG strategies that clearly differentiate between broad and narrow understandings of ESG investing. Whilst there is space for more than one concept of ESG, the way in which each is used must be articulated clearly and applied consistently.

In this rapidly shifting landscape of ESG concepts, it may be that things must become more nuanced before they can become clearer.