ESG Investing (sometimes called Socially Responsible Investing) is becoming a current trend, and its proponents characterize it as a modern, sustainable, and responsible way of investing. Some people love it, others see it as just another fad that will soon be forgotten. We at Quantpedia have decided to immerse in academic research related to this trend to understand it better. How are ESG scores measured? What are the common problems in ESG data? …
Introduction to ESG Investing
ESG scores and data problems
Companies, investors or academics are usually focused on the ESG scores of companies in the context of the responsibility, where E stands for environmental, S for social and G for governance qualities of firms. The scores should measure the quality and responsibility of the firm’s behavior in each of the categories.
- Various environmental practices are in the scope of the environmental score – for example, environmental management systems, pollution, carbon emissions, low resource consumption and product innovations aiming at improving environmental protection.
- The social score is focused on human rights, safety standards for workers, cash donations, protection of public health, business ethics, respect to the diversity of the workforce, etc.
- The governance dimension is a measure of behavior concerning the board of directors, shareholder rights and the integration of financial and non-financial goals of the company.
Although the ESG scores can be easily understood, there is a problem with the ESG data.
If we look at more traditional financial factors/metrics/indicators, there is only one way how to measure the book to market ratio. However, the world of ESG scores is different. Several data providers have ESG score databases. The problem is that each dimension of the ESG score can be measured differently; for example, for the environmental score, two data providers can measure different aspects of a firm to obtain the final score. Moreover, the numerical measurement of each element could be different across data providers, and the various features could form the final score with different weights. Therefore, there is no consent in a way how to measure ESG scores. As a result, ESG scores for the same company can widely vary across data providers.
The aforementioned complicates the world of sustainable investing for market practitioners, academics interested in the research and even the companies that cannot correctly evaluate their activities to become more sustainable and attractive. We would dive deeper into problems with ESG data in the later section since this is one of a key issue with ESG investing.
Mixed opinion of academic research
Despite the blurred ESG scores, this topic is in the scope of academic papers. Research is not only interested in the difference of the ESG scores, but also in the relationship of the ESG scores and the financial performance. One branch of literature is interested in the applicable strategies based on ESG scores and examining whether such addition is performance-enhancing, performance detrimental or has no effect.
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