Nisha Kohli on the benefits and pitfalls of ESG investing

Over the last decade, focus on environmental, social and governance (ESG) among financial investors has been growing. Nisha Kohli from Singapore-based Nichefin Consulting explains why investment and asset managers are growing their use of ESG ratings and metrics, but also warns on the pitfalls.

Businesses that hold high rankings in ESG are considered to be better performers and value creators. There are many emerging evidences suggesting that companies that have successfully implemented strategies related to social responsibility and environmental, social and governance screening have delivered superior financial performance and shareholder returns.

However, at the same time, numerous other studies conducted using Dow Jones Sustainability Index have shown inconclusive evidences about correlation between high ESG rankings and financial performance. These criteria and metrices take into account environmental and societal considerations, board gender make up, salary differences, negative press, failures to comply etc. 

Some corporates focus on these metrices only in form and not in substance, to enhance their reputations and attract socially aware consumers, employees, and investors. That’s why over reliance on ESG rankings by investors have caused some hedge funds to short investment portfolios which are based on ESG ratings and rankings as they believe that high ratings achieved through “misrepresenting and adopting a check list approach” can boost share prices artificially.

Investors consider these metrices as a tool to identify socially responsible companies or to abate the regulatory or reputational risks of their portfolio companies.

Sustainable investments

As it stands, sustainable investments account for more than 25% of all the assets under management globally, according to the Global Sustainable Investment Alliance. Ratings and rankings not only give comfort to the investors but also save time and effort. However, using only rankings can result in lower alphas in the short term.

In our experience at Nichefin Consulting there are four key issues in using ESG ratings for investments:

1. ESG ratings and measures are not government regulated and there is lack of disclosures on the risks companies face
2. These criteria do not focus on social innovation and economic value creation which are powerful value drivers
3. ESG factors are not universal for all types of businesses. For example, carbon footprint has nothing to do with the insurance industry
4. ESG ratings encourage window dressing.

Some experts believe that when investors utilise ESG metrics and ratings for identifying and evaluating their investments they are missing out on superior alpha returns and opportunities to invest in companies that are “truly sustainable – having ability to sustain in long term” and companies that create economic value by investing in social innovation and environmental technologies.

It is the social responsibility of investors to identify their investments carefully and to allocate their capital to generate better returns for the society and economy as a whole. It should be recognised that creating competencies, innovation, beating competition, risk management, social responsibility, creation of economic value are all integrated and should be weaved into one main purpose of the corporate existence. 

Integrate ESG into strategy

Integration of ESG issues into strategy is critical but it should be done without losing the main goal of value creation. However, achieving this desired level of integration is a complex process and will vary from company to company. It requires going way beyond a checklist of material factors. 

Companies should focus on value creation socially and economically by focusing on their core competencies, combining social responsibility into their business models, value proposition and efficiencies. Integrating the ESG focus with economic value creation and financial performance focus can result into breakthrough strategies. For shareholders, investing in such companies will result in higher returns.

To identify such companies, investors will have to conduct fundamental analysis and follow active investment strategies. Adopting active investment strategies is more time consuming, requires higher engagement with corporates and hiring a large number of ESG analysts by investment management firms.

Notably, independent ESG consultants can bridge this gap and make their impact on society by helping corporate and investors in creating “shared value”. They can play an important role in building a meaningful corporate world which is not window-dressed but real. 

Nisha Kohli is the Executive Director of Nichefin Consulting She holds a PhD. in finance and accounting and has published numerous research articles and case studies in Harvard Business Review and other internationally acclaimed journals.