Felix Goltz (Scientific Beta): "Investors are increasingly wary about ESG metrics that boil down to subjective opinions"

To you, is “ESG confusion” (1), i.e., the large disparity of metrics across providers, directly linked to the lack of clear ESG standards?

Felix Goltz: While I frequently hear calls for standardization, the underlying issues require a more nuanced approach. We need to distinguish raw information and decision-relevant metrics. Raw information should indeed be standardised. 

Consider accounting information. When we talk about the book value of a firm or its operating income, this accounting information is established following standards. Thus its meaning is clearly defined. Similarly, some measures of environmental impact of firms are reported following standard approaches. A good example is how companies report their water usage according to established ESG reporting standards. 

Now, when using such raw information in investment decisions, investors may make different choices depending on their preferences and objectives. For example, there are different measures of profitability depending on which earnings scope an investor retains and how he measures the amount of capital employed to generate these earnings. And there is no reason to believe that there should be only one measure of profitability. 

Similarly, it is quite natural that different investors might use different ESG metrics, because they focus on different ESG issues or they measure these issues in a different way. What is more bothersome is that the raw inputs to commercial ESG ratings are unclear, as these ratings are based on analyst opinions rather than hard facts. Would investors rely on an analyst opinion of a firm’s profitability that they cannot trace back to the inputs that were used? The big problem with ESG metrics is that many commercially available data offerings provide highly subjective and therefore somewhat arbitrary measures.

What's the temperature currently like for investors: are they indeed "lost" in the ESG maze?

Felix Goltz: We have been discussing challenges with ESG data with many pension fund investment professionals. I wouldn’t necessarily say that they are lost but they are definitely frustrated with the poor quality of data offerings (2).

One important criticism we hear frequently is that ESG ratings and metrics are too subjective. This is problematic for investment professionals who have a duty to invest while pursuing the best interest of pension fund beneficiaries. Let’s say for example that these beneficiaries have a preference for avoiding companies that cause environmental harm. How can the fund’s managers justify that they use the opinion of one provider about harmfulness rather than that of another provider who would have a different opinion? Integrating arbitrary opinions in investment choices - while it could be acceptable for an individual investor - is clearly problematic when making decisions in delegated investment management.

Another criticism is that many available ESG metrics put strong emphasis on what some call “empty promises” by companies rather than concrete outcomes (3). Data providers often consider policies and stated objectives as opposed to actual outcomes. For example, ESG metrics may reflect the perception that analysts have about the quality of the policies a company has in place to manage its impact on the climate rather than its actual emissions of greenhouse gases.

So what are investors expectations for ESG metrics in the future?

Felix Goltz: Investors are increasingly wary about ESG metrics that boil down to subjective opinions. Instead of opinions, they would like to see more fact-based measures. And they would like to have measures that are linked to concrete outcomes (3). 

Another requirement investors have is that they want to go beyond purely backward-looking measures, such as involvement in past controversies and instead obtain a forward-looking assessment of exposure to ESG issues.

To move forward towards more reliable ESG metrics, do you think things are going too slow? Are the key actors playing their parts or is there something missing?

Felix Goltz: We see that things are definitely starting to move and a new generation of ESG metrics is slowly emerging. There is a host of young innovative companies that are starting to challenge the major data providers by offering ESG metrics that aim to be more fact-based.

One set of initiatives tries to build on theoretical models of climate impacts or biodiversity impacts to replace analyst opinions with tractable models. Another set of initiatives tries to exploit alternative data that is widely available, for example by using data on lobbying activity to assess company exposures to ESG issues. And finally, the new generation of ESG metrics increasingly turns to market-based signals to extract information about company exposures to ESG issues. 

This is something we are doing at Scientific Beta, where we extract a measure of climate transition risk by assessing the sensitivity of a company’s stock price to a strategy that bets on climate laggards in the sectors most relevant to climate policy like electricity and construction. High risk stocks are those that tend to do poorly when climate laggards in relevant sectors post losses, which occurs when concerns over climate change increase.

Of course, users of ESG data need to accompany this shift towards new ESG metrics. Operationally, it may feel more convenient for investors to stay with their established data provider, who offers not just ESG data but also fulfills all other data needs, and this creates a bias in favor of incumbent data providers. 

For new initiatives to make an impact, the investors who use ESG data need to put in place thorough due diligence for evaluating the risks of subjectivity and state clear requirements of reliability. If investors emphasize quality over convenience, I believe that competition and innovation can lead to substantial improvements of ESG data.

References

(1) From ESG Confusion to Return Dispersion: Fund Selection Risk is a Material Issue for ESG Investors (Feb. 2024) Scientific Beta. Giovanni Bruno, Mikheil Esakia, Felix Goltz - https://www.scientificbeta.com/factor/download/file/from-esg-confusion-to-return-dispersion

(2) Felix Goltz (Scientific Beta): "Integrating climate risk considerations into portfolios is a key concern of institutional investors around the world" (2024) EDHEC Vox - https://www.edhec.edu/en/research-and-faculty/edhec-vox/felix-goltz-scientific-beta-climate-risk-considerations-key-institutional-investors-around-the-world

(3) Green Dilution: How ESG Scores Conflict with Climate Investing (2024) Journal of Impact investing, Noël Amenc, Felix Goltz, Antoine Naly - https://www.pm-research.com/content/pmrjesg/5/1/59?implicit-login=true