Key 3 Challenges for ESG Investing: What’s Next?
By: Dabin Lee
From: National University of Singapore
What is ESG Investing?
Traditional investors have been evaluating investment performances primarily based on financial or accounting factors. Unlike in the past, making an investment based on Environmental, Social, and Governance (ESG) factors has become a trend in recent years. Sustainable finance refers to investment decisions considering the ESG factors of economic activities or projects (Bakken, 2022). Investors are now starting to apply these non-financial factors, such as sustainability, to analyze firms’ potential growth opportunities and risks (CFA Institute, n.d.). The financial sector has immense power in raising awareness for ESG issues by funding research and development in renewable energy sources and supporting firms following fair labor practices (Bakken, 2022). As the globe grapples with pressing challenges such as climate change and resource depletion, sustainable finance has emerged as a crucial tool to drive an influential change. However, despite the growth prospects of sustainable finance, this niche industry still faces challenges such as lacking global standards, insufficient availability of actionable ESG data, and difficulty financing net-zero transitions.
Key Challenges Faced by ESG Investing
1.Lacking Global Standards
We are still in a transitional stage for ESG investing. Hence, we have not yet developed standardized ESG criteria to assess companies’ performances. While the recent growth in sustainable finance has led to an increasing number of ESG rating providers, this has “only added confusion in the current market” (Laidlaw, 2020). Angel Gurría, secretary-general of OECD Paris, also highlighted that "despite the proliferation of ESG data tools, measuring ESG performance is still challenging when trying to compare between companies, financial products, and projects” (Laidlaw, 2020). This is primarily due to the fact that different types of ESG criteria are used by different countries, firms, and rating agencies (Laidlaw, 2020). As a result of such disunified agreement on ESG standards, there can be inconsistent and even contradictory results of the financial analysis of each company. This can be evidenced by the OECD’s analysis of different ESG rating providers: Bloomberg, Refinitiv, and MSCI (Laidlaw, 2020). Surprisingly, each of the rating providers showed massive differences in ESG analysis scores for the same company (Laidlaw, 2020).
Unlike traditional financial reporting systems, there is no specific regulation on the type of information required for ESG reporting, nor is there a mandatory auditing validation process (APLANET, 2023). The lack of standards for metrics, methodologies, and weightings to make judgments in ESG ratings makes investors hesitate to trust and rely on the information when making crucial investment decisions.
To counteract the inconsistency of corporate ESG data, the International Sustainability Standards Board (ISSB) has developed the first ‘comprehensive global baseline’, which includes the guidelines for climate disclosure (Laidlaw, 2020). As such, properly agreeable global standards would need to be formalized to unify the ESG reporting and rating frameworks. In this way, investors could better trust the annual ESG reports and be more encouraged to invest in sustainable finance, given the proper and transparent information on the company’s performance.
2. Lacking availability and quality of ESG data
Disclosing ESG data is not mandatory for firms. As firms tend to claim intellectual property rights on their data and are usually reluctant to reveal them to others, only a few numbers of firms reveal actionable ESG data to the public. (Laidlaw, 2020). Such an optional ESG data disclosure policy limits the availability of actionable ESG data. There is insufficient ESG data to fundamentally evaluate the company’s sustainability performances and potential material risks.
Besides, some companies even make exaggerated or misleading claims about their ESG performance to improve their image and attract investors. This makes the ESG data not only lack availability but also lack quality. There have been numerous cases of greenwashing recently, where the majority of the data revealed were found to be incomplete and biased. One famous example was from a well-known fast fashion brand, H&M. It was found that 60% of the claims from the 2021 H&M Changing Markets Foundation were misleading (Akepa, 2023). H&M has been making false claims about its sustainability efforts through the misuse of the Higg Index, an H&M sustainability certification system (Ponte, 2023). Such cases of greenwashing would make investors even more difficult to trust sustainable finance companies since the data is unreliable.
Hence, it would be necessary for policymakers to mandate firms to disclose ESG data in a more transparent way. Making the disclosure mandatory with specified standards would allow firms to be rated based on the correct ESG credentials, which would also encourage firms to make more efforts toward sustainability (Laidlaw, 2020). This would then allow sustainable finance industries to be equipped with more comprehensive and reliable ESG data, eventually leading investors to make more informed decisions.
3. Difficulty financing net-zero carbon transitions
Having that the sustainable finance industry is still in its developing stage, there is still a lacking engagement toward net-zero carbon transitions. Since such a transition process requires extensive initial costs and development procedures, it makes it challenging for firms to initiate sustainable finance projects. The prevailing short-term focus on minimizing costs and prioritizing financial returns makes the firms hesitate about ESG conversion.
Hence, in order to further encourage firms to transition their supply chain into net-zero carbon methods, more open and global collaboration efforts toward Research & Development would be necessary. Furthermore, firms should be more considerate about the long-term sustainability goals, rather than short-term profitability in front of them. More importantly, we, as consumers, should consume sustainability products more frequently so that those fast industries become threatened by the changing market trends and eventually shift their supply chain into net zero carbon methods.
While ESG investing is yet facing numerous challenges, it can indeed become a mainstream practice if we manage to overcome the obstacles. These challenges would not be fully resolved with only one or two countries’ efforts: only through worldwide collaboration can sustainable finance manifest its full potential. Cooperation among governments, financial institutions, and international organizations is essential to overcoming these challenges. Rather than seeking only short-term profitability, we should head towards long-term sustainability and value creation. It is now time to prioritize sustainability for our future generations.
References
Akepa. “Greenwashing Examples for 2022 & 2023: Worst Products & Brands.” The Sustainable Agency, 9 Feb. 2023, https://thesustainableagency.com/blog/greenwashing-examples/#hm.
APLANET. Facing up to ESG: Key Challenges for Sustainable Finance. 24 Jan. 2023, https://aplanet.org/resources/facing-up-to-esg-key-challenges-for-sustainable-finance/.
Bakken, Rebecca. “What Is Sustainable Finance and Why Is It Important?” Harvard Extension School, 9 Aug. 2022, https://extension.harvard.edu/blog/what-is-sustainable-finance-and-why-is-it-important/.
CFA Institute. ESG Investing and Analysis. https://www.cfainstitute.org/en/research/esg-investing#:~:text=What%20Is%20ESG%20Investing%3F,material%20risks%20and%20growth%20opportunities.
Laidlaw, Jennifer. “Lack of Standardized ESG Data May Hide Material Risks, OECD Says.” S&P Global Homepage, 2 Oct. 2020, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/lack-of-standardized-esg-data-may-hide-material-risks-oecd-says-60541261.
Ponte, Camilla. “The H&M Greenwashing Scandal: Has Business Learned the Lesson?” Impakter, 7 Mar. 2023, https://impakter.com/hm-greenwashing-scandal-has-business-learned-the-lesson/#:~:text=Last%20summer%2C%20Quartz%20carried%20out,Index%2C%20which%20is%20H%26M%20sustainability.
