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ESG Investing: Practices, Progress and Challenges 1 ESG Investing: Practices, Progress and Challenges PUBE ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES © OECD 2020 2 Please cite this report as: Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris, www.oecd.org/finance/ESG-Investing-Practices-Progress-and-Challenges.pdf This work is published under the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of OECD member countries. This document, as well as any data and map included herein, are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. © OECD 2020 ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES © OECD 2020 3 Foreword Forms of sustainable finance have grown rapidly in recent years, as a growing number of institutional investors and funds incorporate various Environmental, Social and Governance (ESG) investing approaches. While the mainstreaming of forms of sustainable finance is a welcome development, the terminology and practices associated with ESG investing vary considerably. One reason for this is that ESG investing has evolved from socially responsible investment philosophies into a distinct form of responsible investing. While earlier approaches used exclusionary screening and value judgments to shape their investment decisions, ESG investing has been spurred by shifts in demand from across the finance ecosystem, driven by both the search for better long-term financial value, and a pursuit of better alignment with values. This report provides an overview of concepts, assessments, and conducts quantitative analysis to shed light on both the progress and challenges with respect to the current state of ESG investing. It highlights the wide variety of metrics, methodologies, and approaches that, while valid, contribute to disparate outcomes, adding to a range of ESG investment practices that, in aggregate, arrive at an industry consensus on the performance of high-ESG portfolios, which may remain open to interpretation. The key findings of our analysis illustrate that ESG ratings vary strongly depending on the provider chosen, which can occur for a number of reasons, such as different frameworks, measures, key indicators and metrics, data use, qualitative judgement, and weighting of subcategories. Moreover, returns have shown mixed results over the past decade, raising questions as to the true extent to which ESG drives performance. This lack of comparability of ESG metrics, ratings, and investing approaches makes it difficult for investors to draw the line between managing material ESG risks within their investment mandates, and pursuing ESG outcomes that might require a trade-off in financial performance. Despite these shortcomings, ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation. It could also represent an important market based mechanism to help investors better align their portfolios with environmental and social criteria that align with sustainable development. Yet, progress to strengthen the meaningfulness of ESG Investing calls for greater efforts toward transparency, consistency of metrics, comparability of ratings methodologies, and alignment with financial materiality. Lastly, notwithstanding efforts by regulators, standard setting bodies, and private sector participants in different jurisdictions and regions, global guidance may be needed to ensure market efficiency, resilience and integrity. This report has been prepared to support the work of the OECD Committee on Financial Markets. It is part of a broader body of work to monitor developments in ESG rating and investing. The note and accompanying analysis has been prepared by Riccardo Boffo and Robert Patalano from the OECD Directorate for Financial and Enterprise Affairs. It has benefited from comments by members of the OECD Committee on Financial Markets, OECD colleagues Mathilde Mesnard, Geraldine Ang and Catriona Marshall, and has been prepared for publication by Pamela Duffin, Edward Smiley and Karen Castillo. ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES © OECD 2020 4 Table of contents Foreword 3 Executive summary 6 Introduction 11 ESG financial ecosystem, ratings methodologies, and investment approaches 14 ESG investing and the investment fund industry 14 ESG financial ecosystem 18 ESG rating and indices 21 ESG scoring results and performance 27 ESG funds – investment approaches and strategies 32 Critique and empirical assessment 37 Literature review about “responsible investing” (ESG and others) performance 37 OECD empirical research on ESG investing 40 Market penetration and attributes 42 ESG portfolio performance based on efficient frontiers 44 Fama-French portfolio performance 48 Assessing for bias 50 Portfolio construction & tilting 52 Review of funds’ performance 55 ESG and policy developments 59 Regulatory reforms 59 Considerations to strengthen global ESG practices 62 References 68 ESG financial ecosystem 72 Methodology 75 Notes 80 ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES © OECD 2020 5 FIGURES Figure 1. Breakdown of US assets professionally managed 16 Figure 2. Drivers of ESG investing 16 Figure 3. BNP- Drivers of ESG integration 17 Figure 4. ESG financial ecosystem 19 Figure 5. Reporting frameworks referenced in stock exchange ESG guidance 23 Figure 6. SASB materiality map 25 Figure 7. TCFD materiality framework 26 Figure 8. S&P 500 ESG ratings correlation for different providers, 2019 28 Figure 9. STOXX 600 ESG ratings correlation for different providers, 2019 28 Figure 10. ESG ratings and issuer credit ratings, 2019 29 Figure 11. Fund managers’ incorporation of hedge fund strategies for ESG investing 35 Figure 12. ESG market coverage share 42 Figure 13. Market capitalisation as share of ESG by region, 2019 43 Figure 14. ESG rating shift to a different score, 2013-2018 44 Figure 15. MSCI Minimum variance frontier and price index with base value 100, 2014-2019 46 Figure 16. STOXX Minimum variance frontier and price index with base value 100, 2014-2019 47 Figure 17. Thomson Reuters Minimum variance frontier and price index with base value 100, 2014-2019 48 Figure 18. ESG top and bottom quintile Alpha by different providers, US, 2009-2019 49 Figure 19. Top and bottom ESG portfolios by provider, price index, base value 100, 2009-2019 49 Figure 20. Average company market capitalisation by ESG score and by different providers, 2019 50 Figure 21. Small and large market capitalised stocks by top and bottom ESG rating by three providers, price index, base value 100, US, 2009-2019 51 Figure 22. Provider #2 51 Figure 23. Provider #3 51 Figure 24. E,S,G pillars top and bottom quintiles comparison between providers, Alpha, 2009-2019 52 Figure 25. Annualised Sharpe ratio by rating segregation for 5 different providers, World, 2009-2019 53 Figure 26. Annualised Sharpe ratio by rating segregation for 5 different providers, US, 2009-2019 53 Figure 27. E,S,G pillars annualised Sharpe ratio by rating segregation and provider, US, 2009-2019 54 Figure 28. United States annualised Sharpe ratio by small capitalised companies ESG segregation for two providers, 2009-2019 55 Figure 29. 10 years and 5 years annualised funds’ performance to Morningstar sustainability rating, 2019 56 Figure 30. Distribution of 300 sustainable funds performances (5 stars), 2019 57 Figure 31. Distribution of 300 low sustainability funds performances (1 and 2 stars), 2019 57 Figure 32. Relative performance of selected MSCI Indexes to MSCI ACWI Index 58 TABLES Table 1. The spectrum of social and financial investing 15 Table 2. ESG criteria 21 Table 3. ESG criteria - major index providers 22 Table 4. SSGA Assessment of R^2 of ESG ratings among major score providers 27 Table 5. ESG sustainability investment styles 33 Table 6. Compounded Annual Growth Rate for different financial metrics for different providers 44 ESG INVESTING: PRACTICES, PROGRESS AND CHALLENGES © OECD 2020 6 Executive summary Environmental, Social and Governance (ESG) Investing has grown rapidly over the past decade, and the amount of professionally managed portfolios that have integrated key elements of ESG assessments exceeds USD 17.5 trillion globally, by some measures.1 Also, the growth of ESG-related traded investment products available to institutional and retail investors exceeds USD 1 trillion and continues to grow quickly across major financial markets. The growing investor interest in ESG factors reflects the view that environmental, social and corporate governance issues – including risks and opportunities -- can affect the long-term performance of issuers and should therefore be given appropriate consideration in investment decisions. While definitions differ regarding the form of consideration of ESG risks, broadly speaking ESG investing is an approach that seeks to incorporate environmental, social and governance factors into asset allocation and risk decisions, so as to generate sustainable, long-term financial returns.2 Thus, the extent to which the ESG approach incorporates forward-looking financially-material information into expectations of returns and risks, and the extent to which it can help generate superior long-term returns, is the focus of this report. Over the past several
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