A lot of people believe that investments included in sustainability funds have great environmental performance. Oftentimes, financial firms choose investments for these funds based on a company’s ESG ratings. However, these ratings don’t weigh environmental, social, and governance issues equally. Ratings agencies each have unique methodologies and assign weight to ESG issues differently. A recent study from Lumin found environmental factors were given less weight than social and governance issues in most cases:
“ESG ratings assess the three sustainability dimensions: Environment, Social and Governance. The weighting of these three components within an ESG rating can vary depending on the company and the rating agency. Lumin’s analysis shows that the environmental dimension is typically assigned the lowest weighting. In the UK equity market (FTSE 100), for example, the environmental component accounts for around 20 percent according to MSCI ESG ratings, while the social and governance dimensions each represent approximately 40 percent.”
This means that ESG funds may not always meet investors’ expectations regarding environmental impacts. Retail investors do not always fully understand the nuances of how and why certain investments are chosen. This may result in funds unintentionally misleading investors. The study advises investors to approach ESG funds with caution and to take the time to learn what ratings the fund considers and the methodologies backing them. Fund name rules, ESG ratings regulation, and various sustainable finance laws are attempting to combat misunderstandings among investors. As sustainable investments grow, we’ll likely see more jurisdictions tackling these issues with regulation.
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