The last 20 years have seen a shift from socially responsible investing (SRI) to sustainable investing. SRI was originally defined by values-based exclusions of companies with controversial issues (e.g., known violators of human rights), whole industries (e.g., tobacco), or even entire countries (e.g., South Africa under apartheid). SRI investors, who represented a tiny percentage of assets under management (AUM), did not want their money supporting companies and industries they felt were bad for society and the environment.

Sustainable investing is value-based in that investors have come to recognize that poor performance on material environmental, social, and governance (ESG) issues hurts financial performance, while good ESG performance contributes to strong financial results. Empirical evidence about the positive relationship between ESG performance and financial performance continues to mount.

Today, sustainable investing can be described in terms of seven strategies: (1) exclusions or negative screening; (2) norms-based screening; (3) best-in-class; (4) sustainability themes; (5) impact investing; (6) engagement and voting —(meaning, it is through engagement — and sometimes voting — that investors help companies improve their performance on the material ESG issues for their industry and strategy, which leads to better financial performance);and (7) ESG integration, which refers to the explicit inclusion of ESG factors by asset managers into traditional financial analysis. According to the most recent report from Eurosif, the fastest growing strategy is ESG integration (€4.2 trillion with a CAGR of 27 percent).

The increasing demand for quality ESG data among investors and regulators has seen an increased interest in ESG ratings agencies that provide assessments of a company’s ESG performance. Such ratings are increasingly influential in determining how capital is allocated, as they help index providers and fund managers understand vague terms such as “sustainability” when deciding whether to buy or sell a company’s stock or bond.

Assets invested sustainably have passed the $30tn mark, according to the Global Sustainable Investment Alliance, based on a classification that encompasses funds using ESG criteria to guide investing. Interest in ESG investment has grown in line with the increase of passive investing, and the number of ESG-focused equity indices has risen sharply. S&P Dow Jones Indices, one of the market leaders, today has more than 75 ESG indices.

Concretely, this means that indices and fund managers following an ESG mandate and using ESG ratings are likely to put more money into a company that performs well on material environmental, social and governance issues. However, ratings agencies many times have very different views, which results in conflicting rankings. A company can be rated “high” in general or in a specific category by one agency, and “low” by another.

Such confusion — even among the largest suppliers of ethical and ESG ratings — stems from the specific data points rating agencies use, as well as how much importance they place on the various characteristics of a company. “Aggregate Confusion: The Divergence of ESG Ratings” by Florian Berg, Julien Koelbel and Roberto Rigobon of MIT provides an intuitive analysis of why these ratings can vary so widely. They identify three main reasons for this: “Scope divergence related to the selection of different sets of categories, measurement divergence related to different assessment of ESG categories, and weight divergence related to the relative importance of categories in the computation of the aggregate ESG score.” They also “detect a rater effect, i.e., the rating agencies’ assessment in individual categories seems to be influenced by their view of the analyzed company as a whole.” Regardless of their measurement methods, what all ESG ratings have in common is that they evaluate a company’s activities, inputs used, and how they operate.

A thorough ESG analysis helps shed light on issues that were formerly blind spots for investors; it helps put into perspective the costs to society and the environment a company is incurring and how — if at all — these are being managed. The traditional view is that companies will not be punished for negative externalities as long as they are adhering to all laws and regulations. This is no longer true, given changing social expectations about the role of the corporation in society. For example, the absence of a tax on carbon does not mean that shareholders — and many other stakeholders — are indifferent to a company’s carbon emissions.

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