Prioritising emissions could pave the way for net zero investing success, but debate around incorporation of ESG scores continues to polarise the investment industry.
Since environmental, social and governance (ESG) investing principles were first introduced by the United Nations Global Compact in 2004, investors have increasingly included ESG factors such as carbon emissions into their decision-making processes. However, as this annual general meeting (AGM) season unfolds, there is a standoff brewing within the finance industry regarding incorporation of ESG scores in investment decisions.
ESG opponents argue against its inclusion, contending that it allows fund managers to pursue what they see as ‘woke’ goals – such as addressing climate change and promoting gender equity – at the expense of maximising returns for clients. This sentiment is particularly prevalent within US Republican circles, where scepticism towards ESG initiatives is widespread, leading to many instances of divestment. In the past two years, for example, Republican-led state investment funds have withdrawn approximately $13bn from BlackRock due to its ESG commitments.
On the other side of the debate, some proponents advocate for continued emphasis of ESG considerations but propose rebranding it, as the weaponisation and ‘culture wars’ surrounding the label has diminished its appeal. BlackRock CEO Larry Fink, for example, recently announced that he has stopped using the term “ESG'' altogether because it has become too politicised.
With this in mind there is undoubtedly a growing sense that the asset management industry may scale back its focus on ESG. This trend was exemplified by the recent departures of industry heavyweights JP Morgan Asset Management, Pimco and Invesco from the investor-led climate initiative Climate Action 100+.
It is nevertheless important that ESG is not put on a pedestal when evaluated against other financial metrics. One challenge with ESG is that it encompasses a too-wide range of objectives, making it hard for investors to choose which to prioritise, as there are inevitable trade-offs and not all factors will impact financial value. Below I discuss how refining the scope of ESG investing to companies’ net zero targets will enable investors to better assess the carbon footprint of their portfolio and choose which companies to favour.
Environmental regulations
One compelling reason to invest in companies with credible net zero transition strategies is the increasing prevalence of environmental regulations. Responsible companies are better positioned to navigate these regulations, potentially safeguarding their value against future regulatory risks. However, the challenge lies in the intangible nature of future regulatory impacts, which makes it difficult to accurately assess their financial implications. Consequently, these risks are often either underestimated or overlooked entirely by the market when evaluating a company's value, despite their potential to drive long-term value creation.
Another significant challenge faced by the investment and asset management community is the lack of accuracy in available information regarding companies’ net zero credibility. The ESG rating industry is highly fragmented, with dozens of data providers in existence. Metrics used to measure net zero strategies often fail to serve as reliable risk management tools, as they are too imprecise to effectively evaluate a company's negative externalities. For instance, large firms tend to have higher ESG ratings than smaller firms, which may be due to the fact that large companies have greater disclosure of ESG data, rather than concrete differences in ESG initiatives. Currently, approximately only one quarter of all global exchanges require listed companies to disclose ESG information, which poses a huge challenge for comprehensive ratings. Additionally, many ESG indexes lack standardised pricing mechanisms, leading to inconsistencies.
Ratings confusion
The lack of standardisation creates confusion, making it difficult to gauge the true impact of ESG frameworks on asset prices. For instance, different rating agencies often assign conflicting ESG ratings to the same company. This arises from the lack of transparency in the scoring process of rating agencies, each of which has developed its own measurement framework and model building, leading to discrepancies and subjectivity. To illustrate this, consider Tesla, which carries different ESG ratings from two of the most accredited agencies. The ESG scores range from 0-100, with 100 being the best possible score. S&P Global rates Tesla at 40, while Sustainalytics assigns a considerably lower rating of 25.3.
The reliance on metrics-driven approaches may allow companies to potentially distort their sustainability credentials, leading investors to inaccurately perceive them as having a high ESG rating. This has led to an influx of companies making ambitious net zero claims, further complicating the investment landscape.
As a result of how broad ESG factors are, it is unclear to investors which ones in particular need to be prioritised for driving long-term value creation and sustainability. By narrowing the focus to companies’ carbon emissions and the achievability of net zero targets, investors can streamline their decision-making processes. The technology for measuring these factors is highly advanced and provides investors with a better opportunity to assess the climate transition risk of their investments and adjust their portfolios accordingly.
Why ‘E’ is for emissions
Until uniformity is established in ESG scoring processes, investors will not be able to grasp climate transition risks accurately. Currently, the choice of ESG rating agencies can lead to varying portfolio returns. To obtain precise data, investors must shift away from relying on ESG indexes. Instead, they should adopt a more robust approach grounded in reliable, measurable data. A promising avenue is focusing on carbon emissions, given regulators are already pushing to make the disclosure of emissions universal. Companies will increasingly undergo significant restructuring to align with climate transition demands. One of the most effective tools for assessing a company’s trajectory towards its net zero targets and profitability implications is financial digital twinning technology.
Digital twinning is a pioneering method for modelling climate transition risks. By projecting emissions trajectories of companies and comparing them to stated climate targets, digital twinning helps companies identify disparities and decide whether to adjust their goals or increase investments to meet them and the associated costs of doing so. Unlike conventional approaches, digital twinning relies on evidence rather than labels, checkbox practices and superficial metrics.
ESG metrics have frequently fallen short as reliable measures and risk management tools. They are designed to cater to a multitude of stakeholders and often miss the mark in reflecting a company’s real-time operations. Despite these challenges, a company’s credibility in reaching net zero goals is a crucial investment factor for creating long-term value, given impending carbon emission regulations. By honing in on emissions within ESG assessment and embracing advanced technology like financial digital twinning, investors will gain a clear picture into a company’s transition risks, which ultimately, will empower them to make better investment decisions.
Per-Otto Wold is co-founder and CEO of Zerolytics, and former climate adviser to the Norwegian prime minister
