The shares of PG&E, California's utility, lost nearly half their value in January after the company filed for bankruptcy protection because of its role in California wildfires. While this may have resulted in huge losses for some investors, those who carefully scrutinized environmental, social, and governance (ESG) factor—and took note of wildfire-related risk—would have seen the warning signs flashing long before then, and avoided exposure to such a high risk investment.
Taking ESG factors into account in investment decisions has become synonymous with sustainable investing—an area experiencing rapid growth in the investment industry. Morningstar found that the number of sustainable investment funds in the United States alone grew 50% between 2017 and 2018, to 351 funds with $161 billion under management at the end of 2018.
While sustainable investing is growing in popularity, not all investors are integrating ESG considerations into their decision-making—yet. A recent ESG policy statement by the CFA Institute underscores how this needs to change.
The Chartered Financial Analyst (CFA) credential is considered the gold standard in the field of investment analysis and management. CFAs are often portfolio managers and research analysts at investment management firms.
The CFA Institute manages this credential, which is held by over 150,000 investment professionals worldwide. While it stopped short of formally requiring CFA charterholders to factor in ESG, its guidance carries a lot of weight in the investment community. We wanted to highlight four takeaways:
1. Including ESG factors into investment analysis is consistent with fiduciary duty
Fiduciary duties exist to ensure that anyone who manages other people's money act in the best interests of beneficiaries. When you invest in a fund like a mutual fund, the fund manager has the fiduciary duty to invest in your best interests.
Until recently, incorporating ESG factors into the investment process was widely assumed to violate fiduciary duty. The argument was built on the assumption that incorporating ESG factors requires a trade-off in investment performance or financial returns. This is often used as an excuse for not considering ESG factors. But it turns out, this isn't true.
CFA Institute helps to put this debate to rest in its policy statement.
2. Better ESG factoring leads to better investment decisions
The CFA Institute's new statement emphasizes the need for charterholders to factor in all material information, including material ESG factors, in their financial analysis—because doing so will improve their investment decisions. Material factors are those that a reasonable person would consider important in making investment decisions.
Knowing which ESG factors are material is critical but not straightforward, since materiality is not universal. For example, water management is a material factor for a food and beverage company, but not a financial services company; data security is material for a health care company, but not a mining company. The Sustainable Accounting Standards Board (SASB) has helped to address this challenge by mapping out which sustainability issues are likely to be material to companies within a given industry.
In their push for "better factoring" CFA Institute seems to acknowledge the dangers of taking a framework or rating at face value and stopping there. Going back to PG&E—on first blush, it did well on ESG criteria. PG&E ranks among U.S. utilities with the most renewable energy, and it had received higher-than-average ratings for environmental factors by many major providers of ESG ratings, including Bloomberg, RobecoSAM and Sustainalytics.
These firms missed something. The key material factor that went unnoticed for many was wildfire-related risk. SASB's materiality map, for instance, doesn't highlight physical impacts of climate change—like wildfires—as material issues for electric utilities. But the risk was embedded in PG&E long before the bankruptcy filing, as PG&E repeatedly delayed a safety overhaul of a transmission line believed to cause the deadliest wildfire in California. Only MSCI cut PG&E's ESG rating in September 2018 in anticipation of wildfire-related liabilities.
(Although it is true that investors and ratings do not and cannot accurately forecast every crisis, the inconsistent ESG ratings of PG&E highlight weaknesses in current ESG disclosure and rating systems meant to support informed, efficient investment decisions—more on these issues in #3 and #4.)
It's not just active investors who can use ESG factoring. In its statement, CFA Institute also alludes to the importance of ESG factoring for passive products (for example, index funds and exchange-traded funds) that are growing in popularity. CFA institute encourages all investment professionals to consider material ESG factors regardless of investment style, asset class or investment approach.
3. Companies' ESG disclosures require further improvements in quality, consistency and comparability
The investment decision-making process relies on proper company disclosures. CFA Institute notes that ESG disclosures and data provided by corporations, such as sustainability reporting, are oftentimes inadequate and require further standardization and refinement to improve quality, consistency and comparability. For instance, companies may not provide robust quantitative performance indicators and instead resort to check-boxes or boilerplate language about ESG issues. We had similar insights in our own commentary on sustainability data that we published earlier this year.
In response to the data gap and investors' growing demands for ESG disclosures, frameworks and standards developed by the Global Reporting Initiative (GRI), SASB, and the Task Force on Climate-related Financial Disclosures (TCFD) have been promoting standardized disclosure.
4. ESG investment products need to provide detailed disclosures about their ESG process
ESG- and sustainable-labeled investment products and services, such as funds and ratings, have integrated ESG factors. However, they are not always transparent about how they do it. Many ESG/sustainable investment products and services rely on ESG scores, ratings or rankings in one form or another. For example, the S&P 500 ESG Index relies on scores provided by RobecoSAM, while the MSCI World ESG Universal Index uses the ESG ratings developed by MSCI itself. These ESG scores or ratings have different assumptions about what is material—and as a result, they have very low correlation between each other. In other words, ESG can mean different things, depending who you ask.
CFA Institute believes that ESG investment products must include adequate and detailed disclosures with periodic verification. Meaning, asset managers and index creators need to do more to pull back the curtain on their ESG/sustainable investing products and reassure investors about the substance behind their ESG claims.
What CFA Institute Is Doing Next
CFA Institute still gives full discretion to its charterholders to determine which ESG issues are material and exactly how to integrate ESG factors into their processes. However, it seems to have a strong focus on providing more educational materials on ESG to its members and candidates, which should help bring more rigor and clarity to ESG integration processes. CFA Institute is also working with other stakeholders like SASB and the Principles for Responsible Investment to improve the quality, consistency and availability of ESG information.
We are encouraged that CFA Institute's seems to be strengthening its focus on ESG. Their support and efforts are essential to help ensure that investment capital is deployed to support a more sustainable future while delivering better returns to investors. We urge charterholders to take heed of CFA Institute's call to action on ESG, and hope that CFA Institute will do more to focus attention on its ESG policy statement.
This blog post was edited to reflect the fact Bloomberg is a provider of ESG ratings, but not a ratings agency.