Once a year, Linda Eling-Lee and her team share some of the trends that will shape the rapidly growing field of sustainable investing. Eling-Lee knows what she’s talking about: MSCI’s environmental, social and governance research outfit is one of the most influential in the world of ESG investing, with pensions, sovereign wealth funds, insurance companies and other institutions using its ESG ratings to make investment decisions.
Barron’s sat down with Eling-Lee at the Gitterman ESG Playbook iSummit this month. She talked about the problems of meeting the Paris Agreement goal of limiting global warming to two degrees Celsius, the growth of sustainable investing and why ESG ratings are all over the place. An edited version of the conversation follows.
Barron’s: Every year, your team does an outlook about ESG trends for the coming year. What are you expecting for 2021?
Linda Eling-Lee: We’re still very much on trajectory for a world that is too warm to sustain life as we know it, really for more like a four degree kind of world, rather than two degrees. In 2021, investors will realize that the easy part is over in terms of trying to decarbonize their portfolio, they will hit up against some real barriers.
In the last five years or so, a lot of investors have been more directionally correct by excluding a few fossil fuel companies, or maybe by tilting or reweighting their portfolios towards the less carbon intensive companies. But if you want to get on a path that allows us to survive, the math is going to get very tough, because only about 40% of the companies in the
MSCI All Country World investable market index
are aligned to this two-degree path.
Every year, emissions reduction needs to keep coming down. That would mean that on average, companies need to reduce their emission by about 5% every single year. The track record of companies being able to do that is actually pretty poor. And when we looked at companies who had professed targets to reduce carbon emissions, really only about half of them ever meet them. Investors are going to realize they’re going to have to ask companies to do some hard things, for example exiting businesses that are simply not compatible in a zero-carbon economy.
Acceptance of ESG investing is growing very quickly. What’s the outlook?
Growth for ESG is going to be underpinned by a new level of maturity in 2021. That wasn’t really quite the case in 2020. We’ve had very polarized views. In one corner, there was a lot of hype that ESG can do well and be all things to all people. In the other, very deep-seated skepticism that sees ESG as being inherently at odds with maximizing returns. In 2021, we’ll get beyond these simplistic views. You have much better tools and analysis about when it is that ESG adds potential value and when it doesn’t.
How will the incoming Biden administration change the outlook for ESG?
The transition team is just getting started, so we don’t know which policies will be implemented. President-elect Biden has promised to rejoin the Paris Agreement on day one. First, it sends a very important message to the world and to China, which recently committed to becoming net-zero by 2060. The message is that the U.S. is not sitting this out, and so there are fewer excuses for countries to lag on their commitments.
For U.S. companies, the most immediate implication gets back to disclosure. It’s very possible that companies are going to have to report on climate risk. A lot of attention has [also] been paid to the Department of Labor ruling around the appropriateness of ESG investments in ERISA [retirement] plans. This ruling and this whole process has prompted investors and allocators to make a distinction between ESG factors that are being used in the investment process to drive pecuniary or economic benefits, versus nonpecuniary benefits. [That] is caught up in the maturation of the market.
ESG ratings are often all over the place. How are investors supposed to deal with this?
There’s this assumption they should be correlated, because you’re comparing the issue ratings to credit ratings. Credit ratings are all trying to track the probability that an issuer is going to default. That’s not at all the case for everything with an ESG rating. Some ESG scores simply sum up the ESG information disclosed by a company, and others have an underlying model that’s trying to capture something more specific. Other big drivers of differences are what data sources are actually included and how different E, S and G factors are weighted. MSCI uses lots of inputs beyond a company disclosure.
What’s more relevant for investors is that we found is that the relationship between an ESG rating and long-term stock performance is actually highly sensitive to how much weight you give to the S and G issues in each industry. There’s confusion and maybe a little bit of frustration about ESG ratings not being standardized or correlated, because issuers and investors really have different ideas about what should or shouldn’t go into a rating. I would urge users of ESG ratings and scores to really just ask for a track record and to really actually examine the evidence, because it now exists.
This was the year in which social factors achieved prominence, because of the pandemic and because of racial justice protests after George Floyd’s death. What happens in 2021?
One of the trends we’re watching for in 2021 is how investors respond to inequality. A lot of companies have stepped up to provide more information and make commitments to diversify their workforce and leadership. Investors are going to look for new ways to try to address some of these issues, and there’s going to be more experimentation in the kinds of investment vehicles to address these issues.
We’re seeing innovation in social bonds. Right? Some companies and some investors support ways to target use of proceeds, for example, by providing more financing or education or healthcare to the underserved. With any kind of experimentation, we do run some risk of failure and reputational risks of investing in these types of vehicles. I think this is going to really take off in 2021.
In terms of your expectations for 2020, what did you get right? What did you get wrong?
One that became very, very relevant over the year was the resurgence of stakeholder capitalism. [With] Covid, a lot of companies felt very much under scrutiny this past year, and not just about how they were going to navigate this crisis financially, but really about how they were treating their workers during the crisis, their suppliers, their community. A lot of the credit goes to the investors who did ask companies a lot of questions about how they were insuring the safety and the productivity of their workforce.
One that didn’t really pan out was our relatively optimistic take about investors becoming much more savvy about using alternative data sets, like patents, to try to identify more investment opportunities for low carbon solutions. In 2020, I think investors were plenty happy with just the pure plays like a
(ticker: TSLA), rather than scouring the landscape.
Is there any reason to be concerned about greenwashing, or companies claiming to be environmentally and socially conscious when they’re not?
First and foremost, you have to know what you’re trying to get out of a particular investment. Greenwashing assumes there’s false advertising of some sort. Just because something is called a sustainable fund, or ESG fund, [doesn’t mean] that they’re actually trying to achieve the same things. I do feel some of this focus on greenwashing is a little bit overdone insofar as it ascribes poor intentions to either the company or the portfolio manager.
There are ways to incorporate ESG that may not be aligned with what I think about it, but it doesn’t mean that somebody’s trying to pull the wool over my eyes. Asking for more transparency of what’s actually in a fund or what’s driving the metrics when companies say they’re going to [adopt] net zero targets, just asking for the next layer of information will be hugely helpful.
What worries you most about this space?
Right now, the regulatory landscape is very busy, there’s some divergence, and it’s very difficult for both companies and investors to try to get a handle on regulatory requirements. It would be extremely helpful for the entire industry if there was a little bit more convergence of those requirements. There is far more convergence around climate-related measures, and I do feel like the central banks of the world are much more on the same page than perhaps other regulatory bodies.
Thank you, Linda.
Write to Leslie P. Norton at [email protected]