ESG Investing: Practices, Progress And Challenges

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ESG Investing: Practices, Progressand Challenges


2 Please cite this report as:Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD -Progress-and-Challenges.pdfThis work is published under the responsibility of the Secretary-General of the OECD. The opinions expressed andarguments employed herein do not necessarily reflect the official views of OECD member countries. This document,as well as any data and map included herein, are without prejudice to the status of or sovereignty over any territory,to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. OECD 2020ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES OECD 2020

3ForewordForms of sustainable finance have grown rapidly in recent years, as a growing number of institutionalinvestors and funds incorporate various Environmental, Social and Governance (ESG) investingapproaches. While the mainstreaming of forms of sustainable finance is a welcome development, theterminology and practices associated with ESG investing vary considerably. One reason for this is thatESG investing has evolved from socially responsible investment philosophies into a distinct form ofresponsible investing. While earlier approaches used exclusionary screening and value judgments toshape their investment decisions, ESG investing has been spurred by shifts in demand from across thefinance ecosystem, driven by both the search for better long-term financial value, and a pursuit of betteralignment with values.This report provides an overview of concepts, assessments, and conducts quantitative analysis to shedlight on both the progress and challenges with respect to the current state of ESG investing. It highlightsthe wide variety of metrics, methodologies, and approaches that, while valid, contribute to disparateoutcomes, adding to a range of ESG investment practices that, in aggregate, arrive at an industryconsensus on the performance of high-ESG portfolios, which may remain open to interpretation. The keyfindings of our analysis illustrate that ESG ratings vary strongly depending on the provider chosen, whichcan occur for a number of reasons, such as different frameworks, measures, key indicators and metrics,data use, qualitative judgement, and weighting of subcategories. Moreover, returns have shown mixedresults over the past decade, raising questions as to the true extent to which ESG drives performance.This lack of comparability of ESG metrics, ratings, and investing approaches makes it difficult for investorsto draw the line between managing material ESG risks within their investment mandates, and pursuingESG outcomes that might require a trade-off in financial performance.Despite these shortcomings, ESG scoring and reporting has the potential to unlock a significant amount ofinformation on the management and resilience of companies when pursuing long-term value creation. Itcould also represent an important market based mechanism to help investors better align their portfolioswith environmental and social criteria that align with sustainable development. Yet, progress to strengthenthe meaningfulness of ESG Investing calls for greater efforts toward transparency, consistency of metrics,comparability of ratings methodologies, and alignment with financial materiality. Lastly, notwithstandingefforts by regulators, standard setting bodies, and private sector participants in different jurisdictions andregions, global guidance may be needed to ensure market efficiency, resilience and integrity.This report has been prepared to support the work of the OECD Committee on Financial Markets. It is partof a broader body of work to monitor developments in ESG rating and investing. The note andaccompanying analysis has been prepared by Riccardo Boffo and Robert Patalano from the OECDDirectorate for Financial and Enterprise Affairs. It has benefited from comments by members of the OECDCommittee on Financial Markets, OECD colleagues Mathilde Mesnard, Geraldine Ang and CatrionaMarshall, and has been prepared for publication by Pamela Duffin, Edward Smiley and Karen Castillo.ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES OECD 2020

4 Table of contentsForeword3Executive summary6Introduction11ESG financial ecosystem, ratings methodologies, and investment approaches14ESG investing and the investment fund industryESG financial ecosystemESG rating and indicesESG scoring results and performanceESG funds – investment approaches and strategiesCritique and empirical assessmentLiterature review about “responsible investing” (ESG and others) performanceOECD empirical research on ESG investingMarket penetration and attributesESG portfolio performance based on efficient frontiersFama-French portfolio performanceAssessing for biasPortfolio construction & tiltingReview of funds’ performanceESG and policy ry reformsConsiderations to strengthen global ESG practices5962References68ESG financial ecosystem72Methodology75Notes80ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES OECD 2020

5FIGURESFigure 1. Breakdown of US assets professionally managedFigure 2. Drivers of ESG investingFigure 3. BNP- Drivers of ESG integrationFigure 4. ESG financial ecosystemFigure 5. Reporting frameworks referenced in stock exchange ESG guidanceFigure 6. SASB materiality mapFigure 7. TCFD materiality frameworkFigure 8. S&P 500 ESG ratings correlation for different providers, 2019Figure 9. STOXX 600 ESG ratings correlation for different providers, 2019Figure 10. ESG ratings and issuer credit ratings, 2019Figure 11. Fund managers’ incorporation of hedge fund strategies for ESG investingFigure 12. ESG market coverage shareFigure 13. Market capitalisation as share of ESG by region, 2019Figure 14. ESG rating shift to a different score, 2013-2018Figure 15. MSCI Minimum variance frontier and price index with base value 100, 2014-2019Figure 16. STOXX Minimum variance frontier and price index with base value 100, 2014-2019Figure 17. Thomson Reuters Minimum variance frontier and price index with base value 100, 2014-2019Figure 18. ESG top and bottom quintile Alpha by different providers, US, 2009-2019Figure 19. Top and bottom ESG portfolios by provider, price index, base value 100, 2009-2019Figure 20. Average company market capitalisation by ESG score and by different providers, 2019Figure 21. Small and large market capitalised stocks by top and bottom ESG rating by three providers, priceindex, base value 100, US, 2009-2019Figure 22. Provider #2Figure 23. Provider #3Figure 24. E,S,G pillars top and bottom quintiles comparison between providers, Alpha, 2009-2019Figure 25. Annualised Sharpe ratio by rating segregation for 5 different providers, World, 2009-2019Figure 26. Annualised Sharpe ratio by rating segregation for 5 different providers, US, 2009-2019Figure 27. E,S,G pillars annualised Sharpe ratio by rating segregation and provider, US, 2009-2019Figure 28. United States annualised Sharpe ratio by small capitalised companies ESG segregation for twoproviders, 2009-2019Figure 29. 10 years and 5 years annualised funds’ performance to Morningstar sustainability rating, 2019Figure 30. Distribution of 300 sustainable funds performances (5 stars), 2019Figure 31. Distribution of 300 low sustainability funds performances (1 and 2 stars), 2019Figure 32. Relative performance of selected MSCI Indexes to MSCI ACWI 1525353545556575758TABLESTable 1. The spectrum of social and financial investingTable 2. ESG criteriaTable 3. ESG criteria - major index providersTable 4. SSGA Assessment of R 2 of ESG ratings among major score providersTable 5. ESG sustainability investment stylesTable 6. Compounded Annual Growth Rate for different financial metrics for different providersESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES OECD 2020152122273344

6 Executive summaryEnvironmental, Social and Governance (ESG) Investing has grown rapidly over the past decade, and theamount of professionally managed portfolios that have integrated key elements of ESG assessmentsexceeds USD 17.5 trillion globally, by some measures.1 Also, the growth of ESG-related traded investmentproducts available to institutional and retail investors exceeds USD 1 trillion and continues to grow quicklyacross major financial markets.The growing investor interest in ESG factors reflects the view that environmental, social and corporategovernance issues – including risks and opportunities -- can affect the long-term performance of issuersand should therefore be given appropriate consideration in investment decisions. While definitions differregarding the form of consideration of ESG risks, broadly speaking ESG investing is an approach thatseeks to incorporate environmental, social and governance factors into asset allocation and risk decisions,so as to generate sustainable, long-term financial returns.2 Thus, the extent to which the ESG approachincorporates forward-looking financially-material information into expectations of returns and risks, and theextent to which it can help generate superior long-term returns, is the focus of this report.Over the past several years, considerable attention has been given to ESG criteria and investing, due inpart to at least three factors. First, recent industry and academic studies suggest that ESG investing can,under certain conditions, help improve risk management and lead to returns that are not inferior to returnsfrom traditional financial investments. Despite the recent studies there is a growing awareness of thecomplexity of measuring ESG performances. Second, growing societal attention to the risks from climatechange, the benefits of globally-accepted standards of responsible business conduct, the need for diversityin the workplace and on boards, suggests that societal values will increasingly influence investor andconsumer choices may increasingly impact corporate performance. Third, there is growing momentum forcorporations and financial institutions to move way from short-term perspectives of risks and returns, soas to better reflect longer-term sustainability in investment performance. In this manner, some investorsseek to enhance the sustainability of long-term returns, and others may wish to incorporate moreformalised alignment with societal values. In either case, there is growing evidence that the sustainabilityof finance must incorporate broader external factors to maximise returns and profits over the long-term,while reducing the propensity for controversies that erode stakeholder trust.ESG investing has also recently garnered interest from the public sector, including central banks that haveexpressed support for ways to help transition financial systems toward “greener”, low-carbon economies.Numerous central banks in advanced and emerging market economies have committed to integrate ESGassessment and investing practices into some of their responsibilities, such as reserve management andsupervisory practices including stress tests. Irrespective of the actual path of climate change, the decisionsbeing made by corporations and financial intermediaries indicates that climate transition and physical riskswill increasingly affect the financial sector and warrant inclusion in the assessment of financial stability.3In light of growing demand, the finance industry is creating more products and services related to ESGratings, indices, and funds. Firms calling themselves ESG ratings providers have multiplied. The numberof ESG indexes, equity and fixed income funds and ETFs are now in the many hundreds, and arecontinuing to expand. Investors can now engage in ESG investing through low-risk products such asESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES OECD 2020

7money market funds, passive smart beta ETFs, and can even take positions through hedge funds thatcombine sophisticated synthetic strategies with ESG alpha investing. Investors seeking to positionthemselves for a transition to a low-carbon economy can invest in green transition and renewables funds.In this regard, the financial markets have proven agile in responding to investor demand in a transparentand customer-oriented manner.Notwithstanding this progress, the growth in use of ESG disclosure, ratings, and various types of ESGrelated funds has invited greater scrutiny from a range of market practitioners, and there is a growingawareness from within the industry that ESG investing practices need to evolve to meet the expectationsof its users and to sustain trust. Various bodies, among which GRI, SASB and TCFD, are now involved inassessing the use and consistency of ESG information, its materiality across industries, and how thisinformation should be prioritised and scored.In light of these issues, this ESG report seeks to bridge the gap in knowledge by exploring concepts anddefinitions; key actors in the ESG ecosystem and their functions; and, challenges with respect to theinvestment ratings, fund categorisations, and performance. It sought to identify and understand where ESGrating differences could contribute to different ESG scores that lead to divergences in high-ESG indicesand portfolios.Outcomes of the assessment in Part I include the following:The ESG financial ecosystem is evolving, including issuers and investors who disclose and useinformation related to environmental, social and governance issues. Financial intermediaries, as wellas government and international organisation institutions are influencing the emerging practises in ESGinvesting. While constructive and inclusive progress has been made to develop ESG practices by severalESG players, it has generated the spread of a wide array of investment terminology, and disclosureframeworks which resulted in metric inconsistencies and lack of comparability for investors.In this regard, while ESG methodologies are improving and becoming more transparent, scoringremains in a state of transition, with some rating providers still in the way of refining theirmethodology through the inclusion of factors such as materiality. There is a range of scoringmethodologies in terms of determining which data to analyse and include, metrics weighting, materialityand how to consider missing information. Moreover, subjective judgment is layered particularly regardingabsolute and relative scores within and across industries.Even though progress has been made, a crucial point remains on the alignment with materialityfactors. Different institutions, such as SASB and GRI among others, are focusing on the assessment ofmateriality that is applied to different industries to determine the importance of each factor in the final ESGrating. This can depend on the business model, the external environment and the industry itself. Thedifferent materiality approaches have been influential in shaping the choice of key metrics used by theproviders, but the discussion remains on the perspective on which metric is material.When the information from the issuers’ disclosure is retrieved and different key factors are weighted thefinal ESG score can be computed. Nonetheless, ESG ratings can vary greatly from one ESG providerto another. The different methodologies used to translate raw data into a more sophisticated rating suffersome level of criticism because of the wide variance in the results. This implies that if investors are usingand relying on different service providers, the score inputs that shape securities selection and weightingcould be driven by choice of rating provider. This section assesses the extent to which ESG scores ofmajor providers differ, and also how they compare to the dispersion of credit ratings across firms.The ESG score differences mentioned can occur for a number of reasons. They may relate to differentframeworks, measures, key indicators and metrics, data use, qualitative judgement, and weightingof subcategories, reweighting of scores to ensure “best in class” in industries. While differentmethodologies, judgement and data are welcome to offer investors choice of approaches and outcomes,ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES OECD 2020

8 large differences in ESG ratings across providers may reduce the meaning of ESG portfolios that weightbetter-rated firms more highly.ESG ratings can be used in a multitude of different investment approaches, which tend to conformto five distinct forms. On one side, the least amount of complexity is through excluding certain firmscategorically (e.g. moral considerations), and on the other side is full ESG integration into the very firmculture of investing, such that it becomes an integrate part of the investment processes. Approaches suchas ESG rebalancing, Thematic Focus and ESG Impact can be found in the middle. The choice of thestrategy will greatly influence the final performance of the investment.Notwithstanding the progress to move forward sustainable investing through broader use of ESG factorsand scoring, there are a number of challenges that may hinder further development in this rapidlygrowing and promising area of the market. Key issues for further consideration relate to: (i) ensuringrelevance and consistency in reporting frameworks for ESG disclosure; (ii) opacity of the subjectiveelements of ESG scoring; (iii) improving alignment with materiality and performance; (iv) overcoming themarket bias; (v) transparency of ESG products alignment with investors’ sustainable finance objectivesrelated to financial and social returns; and, (vi) public and regulatory engagement.Part II of the report endeavours to complement the industry developments and assessments presented inPart I, by providing an assessment based on academic literature and OECD analysis of ESG scoring andbenchmark performance, based on ESG databases of different providers.In terms of descriptive statistics, the size of the ESG investable shows market penetration of ESGscoring is still low based on number of companies, but is much higher when measuring it by marketcapitalisation, which better represents the investable universe. This suggests that there is ample roomfor investing using exclusion and tilting approaches while maintaining a sufficient level of diversification.Also, there is evidence of an ESG ratings bias against SMEs for some providers, such that firms withmuch higher market capitalisation and revenues consistently receive higher ESG scores than those withvery low market capitalisations.The predictive power of ESG scores is inconsistent, and there is evidence that while some highESG indices and portfolios can outperform the market, the same is true for low-ESG portfolios.Using different providers’ data, OECD secretariat found an inconsistent correlation between high ESGscores and returns, such that different providers lead to different results. This does not mean that all ESGportfolios underperformed the traditional market: however, many high-scoring ESG portfolios didunderperform, and a number of low-scoring ESG portfolios outperformed the markets.The analysis also found that asset concentration associated with tilting portfolios toward highscoring ESG issuers can, depending on the conditions, affect volatility, risk-adjusted returns anddrawdown risk. Various combinations of constructed portfolios based on tilts that provide greaterexposure to higher-scoring issuers often performed at or below traditional indices for periods of time. Theresults are consistent with portfolio theory in that, greater concentration of exposures in a given portfoliocan increase volatility, all else equal On the contrary, the analysis of maximum drawdown risk showed thatESG portfolios have a lower drawdown risk when compared to non-ESG portfolios.The

ESG investing has evolved from socially responsible investment philosophies into a distinct form of responsible investing. While earlier approaches used exclusionary screening and value judgments to shape their investment decisions, ESG investing has been spurred by shifts in demand from across the finance ecosystem, driven by both the search .