Disclaimer: I don’t know anything about trading. Some or all of this might be wrong. Please tell me if I’m wrong via Twitter at @chrisbernkopf
A few weeks ago I learned from a friend how many institutional investors currently factor Environmental, Social & Governance (ESG) into their investment decisions. A very basic summary:
- An investor has a list of public companies that they are considering for investments. This list is sometimes referred to as the investment universe.
- The investor will use various qualitative and quantitative parameters to decide which companies to invest in. Some parameters fall into the ESG category.
- Currently, companies are excluded from the investment universe if they fall below a certain “ESG threshold/ESG heuristic”. This could be anything from child labor allegations to an environmental scandal.
- After this removal step, ESG is not really factored into investment decisions.
As stated above, I’m not a financial or ESG expert. I assume it would be disadvantageous - meaning unlikely to happen in practice - to exclude too many companies because of ESG reasons because as a trader you’d potentially miss out on good investments. That means many companies with significant ESG risk will stay in the investment universe. It seems to me that it would be good to factor in ESG after the “exclusion from the investment universe” step since ESG violations do affect stock prices.
The current approach
- doesn’t protect investors optimally from ESG risk, meaning a drop in price due to ESG violations, and
- doesn’t optimally maximize profits by identifying which companies have very low ESG risk. (I assume lower ESG risk results in a higher expected share price)
It would be great to gather ESG data, ideally of the non-self-reported kind, which gives investors additional information (alpha) on which they could improve their stock picks after the “exclusion from the investment universe”. This ESG data has to be nuanced enough to allow integration into discounted cash flow models i.e. to calculate future share prices.
Ideally, the more actionable ESG data is added, the more investors using it would have an edge over the market. Over time, this informational edge over other investors would be arbitraged away by more & more investors seeking to maximize their profits.
This would have a very beneficial side effect: ESG posturing (= greenwashing) by companies would over time be increasingly disincentivized and actually operating in accordance with ESG standards incentivized as the market will reward those who do “the right thing”. Savvy investors using this data would be doing arbitrage for good :)
ESG data is already being offered by various financial data providers such as Refinitiv. A lot of it seems to be self-reported data (meaning the companies report on themselves). It seems there is a lot of room for improvement.