Understanding, Measuring, and Applying ESG preferences: What We Currently Know from the Literature

“The main questions remain how we can understand, measure, and effectively utilize sustainability preferences”

What is the focus of the paper?

This literature study provides an overview of scientific papers on (understanding, measuring, and applying) sustainability preferences. Sustainability is broadly defined as ESG (Environmental, Social, and Governance), the three aspects that relate to the environment, the social domain, and good governance, respectively. First, motivations and characteristics of ESG investors are explored. Next, literature on measuring sustainability preferences is discussed. Finally, the incorporation of sustainability preferences into investment policy is examined. The fact that ESG ratings from different rating agencies often do not correspond is also discussed.

What are the key findings?

ESG investors are not a homogeneous group: some are driven by financial motives, such as an assessment of higher expected returns or diversification potential, while others pursue moral values, such as social impact. The latter group is willing to sacrifice returns in order to achieve sustainable goals. In order to effectively implement ESG in investment policy, it helps to adequately measure sustainability preferences. This can be done in various ways, for example based on actual (investment) choices or stated preferences. The scientific evidence on how sustainability preferences influence securities prices and corporate decisions is mixed; divergent ESG ratings make consistent implementation and comparison difficult. An important aspect in understanding, measuring, and applying sustainability preferences is sustainable financial literacy; individuals’ knowledge of sustainable financial products is still limited.

What are the implications?

• Sustainability preferences are heterogeneous and cannot be explained solely by demographic characteristics such as gender and age. Pension funds and insurers ideally take this heterogeneity into account, as well as the distinction between financially motivated individuals and morally motivated individuals. There is also heterogeneity between the various sustainability goals (E, S, or G) that individuals pursue. Finally, it may be valuable to enhance sustainable financial literacy and identify the groups for whom this could have the greatest impact.
• It is valuable to investigate the relationships between the dimensions of sustainability, return, and risk; this can provide a more complete picture when surveying participant preferences. Pension funds and insurers are therefore encouraged to experiment with simultaneously measuring sustainability and risk preferences.
• More research is needed into portfolio strategies that combine different investment motives. In addition, combining ESG ratings can help limit measurement errors.