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The concept of ESG scores – aggregating hundreds of indicators from diverse and complex topics – is outdated, particularly when repackaged by the investment management industry as an investment signal. The time for change has come.
ESG scores limit true price discovery
Financial markets play a crucial role in price discovery. The trading activity of investors determines the true value of an asset, reflecting all publicly-available information. Such information includes anything that is material to the value of the company including its environmental, social, and governance practices.
The wide-ranging reliance of the investment management industry on aggregate ESG scores by third-party rating agencies limits this true price discovery. Uncovering as of yet unrevealed information on the risks and opportunities presented by firms’ sustainable and responsible behaviours and tying them back to corporate valuation requires detailed data and profound research; yet most investors rely solely on the high-level information captured in ESG scores.
The market ethos of ‘do your own research’ often seems to have been forgotten when it comes to ESG
Claims of sustainable alpha are often unsubstantiated
In an attempt to summarise corporate sustainability performance, ESG scores combine information from hundreds of indicators, i.e., specific metrics within the distinct E, S, and G categories. Examples might be the number of non-fatal work incidents, or the number of independent directors on the board. Given a lack of adequate knowledge, expertise and perhaps even willingness, investors have until now struggled to gather and interpret this information; rather they have relied on ESG providers to produce condensed scores.
The ongoing reliance on externally prepared ESG scores means that a large part of the investment management industry is failing to engage in the detail of corporate environmental and social practices, even when charging clients extra fees for ESG products. The market ethos of ‘do your own research’ often seems to have been forgotten when it comes to ESG. As a result, many who claim to be adding alpha through ESG will struggle to provide proof of their bespoke effort. If we accept that the market quickly adjusts prices to reflect new information – including that generated by ESG providers – then there can be little reward for individual managers from building strategies around those same ESG scores.
Unpacking ESG by moving from scores to indicators
Using a single pre-calculated third party ‘economic score’ and selling it on as a novel source of excess return would clearly be unacceptable. Why then should we accept lower standards when it comes to ESG?
Given that ESG scores are calculated according to the rating agency’s model, the scores derived naturally inherit the firm’s subjective biases having formed their own opinion on the relative importance of each indicator in the E, S, and G categories. Importantly, the use of an aggregate score also conceals useful information contained in the individual indicators.
It is only by delving into the detail that fund managers can truly add value for their clients, and the detail is rich: unpacking the ‘E’ brings forth Scope 1 emissions, tonnes of recycled waste, groundwater consumed, and much more. The individual indicators provide valuable insights themselves or open up new perspectives in combination with other data. Distilling, synthesizing and connecting the dots is the first step towards uncovering information that is yet to be priced by the market.
Using a single pre-calculated third-party ‘economic score’ and selling it on as a novel source of excess return would clearly be unacceptable. Why then should we accept lower standards when it comes to ESG?
Same language, different accents
While a vital requirement for the development of successful, truly sustainable investment strategies is high-quality data, it is well known that ESG data comes with its challenges. Considerable differences in corporate disclosure practices and the lack of common reporting standards make comparison of data across different sources highly problematic. Given that a majority of fund managers have forsaken their own data collection, one development that could help drive forward innovation in the sustainable investment space would be the standardisation of ESG data.
Reliable indicator data such as firms’ carbon emissions, or the number of women on their boards, would be readily available allowing lagging fund managers that have neglected data and expertise to focus on the unpacked ESG detail to derive their own insights – in the same way that they do with economic and financial information. Progress can be made by leveraging the industry’s intellectual and technological resources to identify relationships between indicators and establishing patterns to help address the many environmental and social challenges that need to be solved to transition to a sustainable and responsible economy; consequently, prices will more accurately reflect sustainable value.
ESG scores reflect the provider’s particular views on corporate environmental and social practices. One score, one view. Yet investment managers are paid handsomely to form their own view. The time for relying on blunt aggregation has passed. We need a more diverse set of views to help address the many challenging angles of ESG and evolve sustainable investment.
If investors look beyond the aggregates then providers will more usefully focus on their primary role: collecting and distributing sustainability data; ideally shaping common sustainability reporting standards, supported by corporate disclosure requirements. Investment managers should develop their sustainable investment strategies using models that reflect their own discoveries and judgments, thus helping to generate true ESG alpha – finally justifying their bold ESG claims.
Dr Tom Steffen is a Quantitative Researcher at Osmosis Investment Management