OECD Report Outlines Challenges Facing ESG Investing

A new report from the Organization for Economic Co-operation and Development (OECD) said that while “loosely defined” metrics seem to indicate that environment, social, and governance (ESG) investing provides superior returns, “a more in-depth analysis suggests that financial performance based on ESG ratings is mixed and there is little evidence of consistent over-performance in recent years.”

The 2020 edition of the OECD’s annual business and finance outlook focuses on the ESG factors that it said are “rapidly becoming a part of mainstream finance.” The report evaluates current ESG practices and identifies priorities and actions to align investments with sustainable, long-term value, such as the need for more consistent, comparable, and available ESG performance data.

“ESG ratings and investment approaches are constructive in concept, and potentially useful in driving the disclosure of valuable information on how companies are managed and operated in reference to long-term value creation,” said the report. However, it added that “current market practices, from ratings to disclosures and individual metrics, present a fragmented and inconsistent view of ESG risks and performance.”

The report said that while institutional investors looking to manage ESG factors often rely on external service providers of indices and ratings, the lack of standardized reporting and low transparency in ESG rating methodologies “limit comparability and the integration of sustainability factors into the investment decision process.”

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The wide discrepancy in ESG practices is among the biggest challenges in assessing ESG performance, said the report. It also said ESG practices are often combined with other investment strategies that could include a thematic focus, which makes it difficult to determine which particular ESG approaches are successful in generating long-term value.

“Current approaches to ESG assessments and ratings appear highly inconsistent and incomparable, and risk undermining their potential value,” said the report.

However, the report noted that these challenges “do not negate the benefits, in principle, of considering ESG criteria in the investment process.” It said the additional information provided by ESG criteria “offers further valuable insights on how companies are managed and operated to support long-term investing.”

Improving ESG practices worldwide would be needed to help ensure that disclosure and ratings are transparent, consistent, and comparable, said the report.

“This fragmentation and incomparability may not serve investors in assessing performance against general ESG goals,” said the report, which added that the relationship between environmental scores and carbon emission exposures is highly variable within and between ratings.

In fact, the report said that because of the slew of diverse metrics on different environmental factors and how they are weighted, environmental scores in some cases correlate positively with high-carbon emissions.

“This illustrates the broad challenges in ESG investing, but also the specific difficulties facing investors looking to consider both financial and environmental materiality,” said the report. “It also underlines how current ESG tools cannot be relied on to manage various climate risks.”

The OECD said the challenges facing ESG investing could undermine investor confidence in ESG scores, indices, and portfolios.

“Progress in ESG practices to date are promising, and they have the potential to be valuable, mainstream tools to manage risk,” said the report. “They can also be a valuable input into policymaking, by better articulating what the market can and should deliver in terms public outcomes,” but it added that “more needs to be done to fully harness this potential.”