In April, Professor Jem Bendell wrote an article in Responsible Investor outlining 9 flaws in ESG analysis and ratings Link and highlighting five fixes. I disagree with almost all of the flaws that he identifies and believe that the fixes he proposes will drive SRI into a niche.
In a second article, I will outline how any problems that do exist in SRI research are plumbing problems that require practical solutions by the industry rather than policy flaws requiring external intervention. To back my conviction in these arguments, I’m going to put SRI–CONNECT’s July marketing budget behind a bar in London for any SRI analyst or portfolio manager who wants to join Professor Bendell and me on 28th July to discuss these points: Register here
Professor Bendell’s full paper can be found in the Journal of Corporate Citizenship: Link
Flaw 1: Over-reliance on companies for information
Professor Bendell argues that SRI analysts rely overly on information presented by companies. This concern assumes SRI analysts are not intelligently sceptical about the information that they receive from companies. They are!
Flaw 2: Focus on processes rather than outcomes
Professor Bendell believes that SRI analysts focus too much on the processes by which companies achieve sustainability results rather than on the results themselves.
However, past performance data is widely used in SRI research and fulfils an important role. But this has two limitations:
• First, it nigh-on impossible to establish useful and reliable comparators.
• Secondly, past performance is typically ‘priced in’ very quickly and therefore only useful for investors with very aggressive trading strategies.In order to understand longer-term future performance, SRI analysts have to scrutinise the policies and processes that will deliver this.
Flaw 3: Downside risk focus
I agree entirely that analysis of upside opportunity should be, but is not yet, an equal part of SRI analysis – not least because ‘top-line growth’ is more easily communicable than ‘bottom-line’ or ‘risk-based’ investment arguments. Interestingly much of the upside opportunity that he refers to comes from a company’s ‘economic’ contribution – the missing ‘E’ in the flawed ‘ESG’ initialism.
Flaw 4: Unsophisticated research frameworks
Professor Bendell argues that SRI research frameworks are less sophisticated than CSR practices. This is true, but it is stating the obvious and inevitable. Also, mainstream investment analysts’ models are also much less sophisticated than the internal business plans of the companies they are assessing. To expect SRI analysts to match corporate practitioners’ levels of information and understanding or that of specialist policy or campaign organisations is to misunderstand the role of the SRI analyst
• It is not the job of an SRI analyst to know more about the companies that they analyse than the companies themselves.
• Nor is it the SRI analyst’s job to be thought-leaders on best sustainability practice within a given industry
• Instead it is an analyst’s job to interpret, from the information that they can source (at reasonable cost) how a company’s share price will perform.
Professor Bendell is certainly right, however, to highlight that it is dangerous to translate sustainability information into numbers in a way that gives a spurious appearance of being investment-relevant. There is nothing wrong with unsophisticated analysis; there is a lot wrong with unsophisticated analysis that masquerades as (financially) sophisticated analysis.
This has a particularly damaging effect in SRI as it exacerbates the industry’s obsession with the ‘top-down, quantitative, data-heavy’ techniques has held back (and continues to hold back) its ability to ‘integrate’ with its ‘mainstream’ investor colleagues who typically prefer fundamental, ‘bottom-up’ methodologies.
Flaw 5: Conflicts of interest
Professor Bendell identifies four areas where the independence of analysts comes into question (favouring clients, company ownership of agencies, reverse broking by investment managers & the ‘rater pays’ model). These objections must be theoretical as there is little evidence of any of them in practice.
Flaw 6: Mixing materialities
Professor Bendell highlights how analysts confuse environmental/social and financial materialities. From a purist’s perspective, this seems ill-disciplined. However, we must not discount the positives that can come out of this mixing process. Indeed the process of integrated analysis’ involves constant exploration of how environmental/social materiality affects financial materiality and vice versa. Professor Bendell’s distinction between ‘smarter finance’ & ‘moral finance’ is helpful as it highlights how different motivations influence SRI product selection by the end investor. However, to require researchers to abide by the same polarity is to deprive them of the ability to blur the lines and draw other expertise into this exploration process (from both financially and sustainability orientated sources.)
There is, of course, a natural control on the blurring process as the exploratory phase must always crystallise into a fund manager’s decision over whether to put their money into a stock or to take it away.
Flaw 7 – Rating ‘unsustainable’ companies
Professor Bendell argues that SRI research assesses companies that some would consider fundamentally ‘unsustainable’. (He cites BP’s inclusion within SRI indices.)
This is true. However this is typically undertaken for ‘engagement’, ‘best-in-class’ or ‘integrated analysis’ strategies – the very point of which is to extend the scope of SRI beyond the limitations of sustainable theme funds and ‘positive screening strategies’Some people like these ‘dirtier’ strategies and want to invest via them; others hate them. It is not flawed to offer the choice of strategy. It would, of course, be flawed if the implications of specific strategy choices were not made clear to investors as their point of investment. However,
• SRI funds have always been much more transparent than their mainstream counterparts
• Eurosif has created a framework on which SRI funds can easily base improved transparency
Equally, it would be flawed if the judgements made about ‘best-in-class’ were demonstrably wrong. However, it is not satisfactory, given the ‘best-in-class’ framework to criticise BP’s inclusion without suggesting which of ExxonMobil, Total, Royal Dutch Shell or Chevron Texaco should replace it.
Flaw 8 – not enough integration
Professor Bendell argues that there is not enough integration with mainstream investment decision-making. I agree; but believe that the direction of travel is right and that a lot of practical work is being conducted within both buy-side and SRI sell-side research to improve this integration. We should not believe those that wail on conference platforms about integration as if it is an unobtainable utopia. There is also an inherent contradiction between Flaw 7 and Flaw 8. You can’t engage with mainstream portfolio managers if you refuse to include oil companies, coal miners, arms companies, tobacco manufacturers in the debate.
Flaw 9 – Ratings process not transparent enough
In flaws 1 & 5 Professor Bendell accuses SRI analysts of being captured by the companies that they rate; In Flaw 9, he appears to have been captured himself. The complaint against the transparency of ratings process is most commonly heard from companies who don’t want to be rated and use lack of transparency as an excuse.
There is no rating process so sophisticated or complicated that a reasonably intelligent observer cannot infer from the questions asked and the results achieved how the process works. Furthermore, total transparency would simply enable companies to game the system to achieve the results that they desire.
Real concern over the ‘obscurity of ratings’ is like ‘questionnaire fatigue’: something that companies could easily fix but love to moan about – let’s not deny them that pleasure…
Mike Tyrrell is the Editor of SRI–CONNECT and a consultant at Sustainable Investor