According to the biologist Sarah O’Connor
Writing in the Financial Times (requires subscription), biologist Sarah O’Connor argues that sustainable funds must do more to vet their investments.
She argues that using Environmental Social and Governance (ESG) metrics for vetting an investment as sustainable | Learn more on Commonshare | is insufficient. These metrics refer to the three key factors that are used to measure the ethical, social, and environmental impact of a business or company, and sustainable investors have long since tended to lean on them when attempting to screen investments.
The environmental part of ESG criteria
This part is concerned with how well a business stewards the natural environment. Specifically, these metrics are concerned with waste and pollution, use of resources, greenhouse gas emissions, deforestation, and climate change.
Social criteria are concerned with human factors. Specifically, they look at how the company handles employee relations and diversity, whether it guarantees good working conditions and ensures that it is not relying on child labor | Learn more on Commonshare | and/or slavery. Other social criteria focus on funding for projects or institutions that will serve poor and underserved communities.
Finally, governance criteria pertain to how companies police themselves. These criteria are concerned with tax strategy, executive compensation, donations and political lobbying, corruption and bribery, and board diversity and structure.
The Insufficiencies with ESG
On the surface, these criteria would seem to be excellent for ascertaining sustainability. A company that does well on ESG criteria is presumably conducting itself in a way that is ecologically sustainable, socially responsible and ethical, and with good governance.
However, in her op-ed in FT, O’Connor argues that ESG systems are “pseudo-scientific.” ESG rating agencies do not follow one consistent set of standards, and as a result, different agencies may score the same company in vastly different ways.
The problem, O’Connor says, is a lack of universally-accepted standards for ESG ratings. Without one universally-agreed-upon ESG gold standard, it will be inherently difficult for index providers to assess ESG credentials.
Finding Solutions for Uncertainty
One possible solution is managed expectations; put simply, index providers should be forthright with investors and tell them that portfolios may still contain organizations involved in “brown” activities, or with supply chain issues that may prove problematic.
The alternative, according to O’Connor, is good old-fashioned research. Since one cannot take ESG credentials at face value, it is important to view the operations of portfolio companies with great scrutiny.
Of course, this also means that there is an opportunity for those managers who are willing to do extra work: any manager willing to do the extra work to investigate the ESG credentials of their portfolio companies will benefit by being able to offer increased transparency.