A new way of investing
Sustainable investing appeared a few years ago, as younger investors are willing to invest their money in companies that align with their values.
But for someone to invest in such a sustainable company, one needs to be able to compare the different companies that make up his investing universe, based on sustainability criteria. Just as companies are ranked according to their credit rating by specialised companies such as Moody’s or Standard & Poor’s, they are also ranked based on their ESG score. ESG stands for Environmental, Social, and corporate Governance.
Thus, for a company to have a good ESG score, it needs to have good scores in each of these three categories (which are themselves composed of many subcategories). Of course, it is difficult for a company to perform well in all three categories. An investor might have to decide which category is the most important for him.
Financing a sustainable growth
ESG investing or sustainable investing appears as a way for financing sustainable growth, promoting companies with a “sustainable” behaviour.
Moreover, ESG score tends to discriminate against companies which are involved in businesses such as tobacco, weapons, gambling or animal testing amongst others.
Thus, ESG score is a way for an investor to decide in which company he should invest, according to his values.
But ESG ranking also works the other way around, as it motivates companies to adjust their actions towards more sustainable ones. ESG ranking creates some challenge between companies and accelerates – or at least motivates – the sustainable transition.
Not only individuals invest according to these sustainable criteria. Now, many ETF (Exchange Traded Funds) are composed of companies with high ESG scores, pointing out the appetite of the financial world for sustainable investments. Moreover, these ETF are among the best performing ones.
Still facing some challenges
As stated earlier, ESG rankings are breaking traditional ways of investing, making the new rules not clearly defined. And just like it is the case for credit rating, many specialized companies give out ESG score. The problem is that not all these companies are evaluating the same criteria with the same weight, or with the same methodology. Thus, an investor may find himself comparing companies with respect to their ESG score, which were not determined through the same methodologies, nor based on the exact same criteria.
Moreover, many companies claim that they are socially responsible, while they simply are not. Take for example the Volkswagen emissions scandal a few years ago, the company had been cheating for almost 10 years during regulatory testings, in order to meet US standards. This is a clear demonstration that these ESG scores can be manipulated, as the Volkswagen ESG was very high before the revelation of the scandal, and then fell instantly (charts below).
Obviously, ESG rating appears as a response to the market appetite for sustainable investments. Although it is an interesting way of ranking companies, it remains more qualitative than quantitative as there is still no consensus on the methodology to use to compute these scores. Thankfully, this new market is growing fast and major financial institutions are working towards some unified ESG rating methodologies.