In November we published a blog highlighting deep flaws in ESG research that focuses exclusively on how companies operate, while ignoring the impact of products and services. In this article, we take aim at another part of the ESG industry that has become popular in recent years – ESG ratings.
ESG issues are clearly material to company performance – the question is which ones
It is important at the outset to underline that our investment process at WHEB utilises environmental, social and governance (ESG) information as a core part of our investment analysis. To quote from our Responsible Investment Policy, ‘We have strong conviction in the impact of ESG issues on company performance either in their own right or as a wider proxy for the quality of a business franchise, especially over a multi-year investment horizon.’
More and more studies are confirming that this is the case. But an important nuance is that not all ESG issues are always material to every company. The importance of this distinction has been underlined recently by researchers at Harvard who concluded that, ‘firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues. In contrast, firms with good ratings on immaterial sustainability issues do not significantly outperform firms with poor ratings on the same issues’. It is perhaps surprising that such a self-evident point needs to be empirically proven! Nonetheless, the realisation that only relevant ESG issues matter to performance, is still one that several ESG rating systems continue to struggle with.
Standard setting at SASB
Greater nuance in the understanding of which ESG issues matter to which businesses has been given a significant boost by the work of the Sustainability Accounting Standards Board (SASB). This group has set out proposed standards on what ESG issues are material by industry sector. The work of the sell-side has also helped promulgate this approach with several large sell-side brokers including Morgan Stanley, Societe Generale and UBS also publishing global frameworks that set out what they consider are the material ESG issues by industry sector.
Unfortunately ESG rating agencies typically still take a much broader approach to assessing ESG quality. This approach captures a very wide range of issues, most of which are not relevant, and under-emphasises those that are. The ESG ratings of Volkswagen, many of which highlighted it as a strong performer before their emissions scandal, are a case in point.
ESG ratings contain significant biases
This approach tends to reward companies that produce a lot of ESG disclosure and tick the long list of boxes that ESG ratings focus on. But this in turn introduces a range of biases into ESG scores.Larger companies, for example, typically produce more comprehensive sustainability and corporate responsibility reports and so are better positioned to garner high ESG ratings.
Geographical biases are also introduced. European companies, for example, tend to have a culture of greater disclosure on ESG issues and in some countries ESG disclosure is mandatory. As a consequence, ESG ratings and ESG disclosure ratings tend to be much higher in Europe. In one case, the average percentile score for European companies is nearly 20 percentage points higher than the average percentile score in the US [based on WHEB analysis]. Perhaps European companies are actually better at managing ESG issues, but this gap is so huge that at least some of it is likely to be due to differences in disclosure.
So what is the point of ESG ratings?
Clearly, the rating itself is just a convenient tool to summarise a complex area of company performance. But the methodologies behind the ratings contain significant value judgments that render the rating itself as much art as science.
The essential problem is that a particular company’s ESG profile is not an objective truth. Different ESG rating agencies produce different ESG ratings. This is of course how it should be. Sell-side researchers use broadly the same information, and reach radically different conclusions about the same stock. Goldman Sachs’ ‘Conviction Buy’ list is very different from Credit Suisse’s or Barclays’.
Compounding the problem with ESG fund ratings
Most investment managers use sell-side company ratings as the starting point for further research and not the key determinant of their investment decision. The same should clearly also be true for ESG ratings. Instead, ESG ratings are increasingly used by asset owners to determine whether a manager integrates ESG into their investment process. The latest iteration of this trend has been the publication of ESG fund ratings based on the ESG profile of stocks held in the fund.
This is dangerous and overly simplistic. Nobody ranks investment funds based on the number of Goldman Sachs Conviction Buys they hold and the same should be true of ESG ratings.
Clearly the increased interest in ESG is welcome and long overdue. But it is key that investment managers and asset owners view ESG rating as an input into the recipe of investment decision-making and fund manager selection. In other words, ESG ratings should represent the start of a conversation and not the end.
Seb Beloe is Head of Research at WHEB Asset Management.