Can clarity from regulators, ratings help investors grasp ESG?

ESG plays a key role in investor decisions, but a lack of clarity has stymied widespread adoption. That was the core takeaway from a recent OSC investor study. The study found that ESG rating was the second most important attribute influencing investors’ decision to invest in a particular fund, only topped by past performance. At the same time, it found ways in which ESG ratings could deter investors, with a preference for no ratings over low ratings. The study appears to have highlighted some of the confusion investors of all stripes now experience in ESG.

While primarily focused on retail investors, the study highlights a wider challenge that retail investors and pension plan members have struggled with regarding ESG: a lack of clarity. Meera Paleja, program head of research and behavioural insights at the OSC, explained some of how that ambiguity has influenced investors’ understanding of ESG while highlighting some of the efforts now underway to create greater clarity, including the role plan sponsors can play. 

“Investors are often in situations where they’re encountering a lot of new information, a lot of complexity, and they might be less sophisticated in their understanding of ESG or investing in general,” says Paleja. “There’s a lot of new, complex information and we know from the project and from a lot of the other work that we’ve done that information overload can have impacts on the way investors make decisions.”

With many investors’ time and attention pulled in so many directions, Paleja notes that there is a real propensity to latch onto one or two key factors. The trouble with ESG is that not all ratings are the same and not all ratings mean the same thing. Faced with that ambiguity an investor may prefer to ignore ESG criteria altogether. The study found, notably, that investors will prefer a fund with no rating to a fund with a low rating. Paleja says that this could be a product of negative views on greenwashing and a fear among some investors that an ESG rated fund, especially one with a low rating, has engaged in greenwashing.

The OSC study grouped investors into two broad cohorts: values-driven investors and financially-driven investors. Values-driven investors constituted 51 per cent of the respondents surveyed, financially-driven investors made up the other 49 per cent. Both groups participate in ESG investing, but they have different core goals. Values-driven investors want to affect some kind of change in the world, Paleja explains. Financially-driven investors appear more motivated by protection from potential risks. The latter group placed less of a focus on ESG factors while the former showed a willingness to pay more in management fees for a good ESG score.

One of the more interesting aspects of the survey was the fact that investors preferred star ratings for ESG scores to letter ratings. A fund with a “B” rating was far more likely to be considered bad than a four-star rating. While arbitrary, the preference for star ratings could fall in line with the way stars and letter grades are used in other contexts. A consumer might be happy with a four-star hotel, but a student might not be happy to get a B on their exam. Perhaps more importantly, the fact of a preference for the medium by which the same effective information is delivered further highlights the lack of clarity in this space.

While Paleja says that investors bear some responsibility in navigating the complexities of ESG, she highlights that other players can support them. That includes advisors and financial wellness professionals offering clearer explanations that pull from various independent sources. Greater financial literacy among ordinary investors and consumers can result in greater clarity here.

There is also a role for regulators. While securities regulators can’t set environmental or social policy, Paleja notes that the OSC’s role includes maintaining a consistent, comparable, and useful information suite that can support investors’ decision-making. She hopes that research like this can inform stakeholders in the financial services industry who will play a role in these educational efforts.

Moreover, the OSC has just announced the launch of a new Investing Academy course. Called “Investing 102: beyond the basics” the free interactive course will cover ESG investing among other topics like plans, DIY investing, stocks, and even crypto. Paleja also notes that the OSC remains involved with the International Organization of Securities Commissions’ (IOSCO) sustainability task force. Through that work they have contributed to an assessment and endorsement of sustainability disclosure standards. Whether through institutions, individual educators, or the work of regulators like the OSC, Paleja sees greater clarity in ESG standards as a potential benefit to every Canadian investor, be they an institution or an individual.

“One of the potential consequences of a lack of standardization and ESG definitions is inadvertent or deliberate greenwashing which results in a lack of clarity,” Paleja says. “Having a better level of standardization could serve as an easy and accurate signal to those who are thinking about investing in these products. Having clear and accurate ratings can go a long way and helping people to know what exactly they're investing in.”