June 2021 | Issue 235
Opinion ESG
Technology won’t replace human judgement. In ESG a qualitative review is necessary
Fatima Hadj
Chairwoman, structured finance advisory board Principles for Responsible Investment
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The social aspect of ESG must be given sufficient weight in investment decisions
In responsible investment, the social aspect of ESG seems to be forgotten or misunderstood. Most effort is put into reducing the carbon footprint of industries, which is a good thing. But it’s worth underlining that assessment of environmental impact without assessment of social factors will lead to incoherent results.
One example, is where a tobacco company is ranked as a top ESG performer. Instinctively you can feel there is something wrong; something inconsistent with responsible investment.
Methodology makes a difference
A fund manager can hit a target and completely miss the point. Underweighting the social dimension of the responsible investment agenda is a misunderstanding of ESG’s goal of building a more sustainable, inclusive and fairer society.
Yes, tackling climate change is the fight of the century. But saving the planet and leaving more people behind does not make sense either.
In our previous columns, we highlighted that the proliferation of third-party providers, and the lack of accountability and transparency for ESG scoring, creates confusion. This is how — when the negative consequences of tobacco on health (S factor) are much bigger than any decarbonisation plan (E factor) because the product itself is dangerous for humans — tobacco companies can still score highly in ESG ratings.
Clearly, if the externalities (defined as the consequences, positive or negative, of a company’s business on society) of the tobacco industry have been ignored or underweighted in the methodology, a choice has been made. What that choice is, is something fund managers will have to address and document for each ESG score they integrate into an investment process.
This illustrates why technology won’t replace human judgement. A qualitative review is necessary. Alex Edmans, professor of finance at the London Business School, has noted that “sustainability isn’t something you measure — it’s something you assess”.
The reduction of the carbon footprint remains a key parameter in ESG assessment. A tobacco company that has a bold and detailed plan to increase use of renewable energy, reduce carbon emissions and water use, and that is doing well in the implementation of its strategies, should deserve a positive assessment.
Nevertheless, the methodology has to be detailed enough to also capture the progress of the company’s negative impact on health.
We must encourage companies to change
We do not advocate disinvestment. It will impact all the people working in an industry and leave them behind, which is also a negative externality to avoid. Instead, investors and asset managers should have an impact plan to help companies transition to a new business model.
All this demonstrates that the environmental factor can’t outweigh the impact on society, and that social factors are not only labour issues.
With sustainable development goals, the position of corporations in society has changed. There has been a fundamental shift where companies are now asked to ensure they are in alignment with society’s expectations.
Furthermore, stakeholders’ increased awareness and activism are pushing corporates to display more transparency and accountability, so companies that put the social agenda into their strategy will outperform the competition.
But setting up an ESG framework is not easy. ESG factors are multi-dimensional and assessments will vary. Asset managers and investors will have to pick their battles and take responsibility for their choices.
Co-authored by Murray Birt, senior ESG strategist, DWS
Principles for Responsible Investments is a UN-linked campaigning organisation committed to keeping market participants posted on the key milestones, industry actions and ESG tools that can help transition portfolios to net zero carbon.
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June 2021 | Issue 235
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