January 26, 2020

Monday Morning Memo: The Side Effects of ESG Investing

by Detlef Glow.

With the announcement that BlackRock will make sustainability its new standard for investing, the debate about ESG integration has reached a new level. Even as there has been a lot of talk about the integration of ESG criteria before, the self-declaration of the largest asset manager in the world to integrate ESG in all its active portfolios and advisory strategy by the end of 2020 might be a game changer, as this has a lighthouse effect and may force other large asset managers to do the same.

In addition to its commitment on the integration of ESG criteria, BlackRock will also remove all securities from companies which generate more than 25% of their revenues from thermal coal production from its actively managed portfolios by mid-2020. From my point of view, this step can only be a first move, as other producers of fossil energy have similar effects on climate change and need to be removed from portfolios as well. That said, there are other industries which may also come under pressure when investors really start to integrate ESG criteria.

But what happens to these companies when investors ditch their shares? First of all, the share price may fall over the short term, but as we will further need these kinds of energy, this might be very appealing for other investors and the price may bounce back over time. Secondly, it needs to be said clearly that shares do not disappear—if one party sells a share another party must buy it, otherwise there would no transaction.

This means that other investors who are not bonded to any ESG criteria may buy coal, oil, and gas producers, and may control them afterwards, which may lead to other risks because private companies can decide with whom they do business. Therefore, it might be better if regulated investment companies own these companies alongside private investors because they can go into a dialogue with these companies to improve their environmental performance.

A second challenge that appears when an asset manager starts to integrate ESG criteria in its portfolio management process is the quality of the respective ESG data since the different data providers have different data sets and have, in some cases, opposite opinions about the ESG performance of a company. In addition, some data providers try to fill the gaps within their data coverage with estimates. This may look good in the overall statistics, but it bears also the risk that the assumption used in the model to calculate the estimates are wrong.

Other data providers only collect and distribute publicly available data, as this is auditable and objective. The downside of this approach is that there are only limited data sets available that vary from company to company and from industry sector to industry sector. As a result, it might be hard to build an evaluation framework that represents all aspects of ESG in all industries with auditable data.

Since the data quality is one of the key factors in successfully evaluating ESG performance, the investment industry and its data providers have to put pressure on listed companies to publish more standardized ESG reports and data sets because they need more complete and reliable datapoints for their investment decisions. With regard to this, one needs to bear in mind that the investment industry has just started to integrate ESG data into its portfolio management processes and will, as it did for financial data, raise its standard for data requirements over time. This will lead to more data within the respective company reports, as public listed companies want asset managers to buy their shares.

The views expressed are the views of the author, not necessarily those of Lipper or Refinitiv.

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