Environmental, social and corporate governance (ESG) investing is big business today. More than $30 trillion – a quarter of the world's managed assets – is now invested in ESG assets, according to a recent State Street Global Advisors report. However, with no agreed standards as to what constitutes ESG, do investors in ESG funds really know what they are getting? The increased prominence of ethical considerations is reflected in the fact that 95 per cent of respondents to a State Street survey indicated they planned to hire more ESG specialists in the next three years. Increased regulatory pressures as well as a desire to mitigate ESG and reputational risks are the key drivers of this trend.
But there are also hindering forces pulling money managers away from ESG. Managers expressed particular frustration with the current state of ESG data, with almost half citing the unreliability and inconsistency of ESG data.
Managers are right to be confused. Index firms such as FTSE and MSCI as well as specialist companies such as Sustainalytics and financial data providers Bloomberg and Thomson Reuters offer ESG ratings. Two of the biggest credit rating agencies, Moody's and S&P Global, have recently moved into the space and now offer ESG scores as well as evaluating a firm's creditworthiness. As early as 2016 there were more than 125 ESG data providers, according to the Global Initiative for Sustainability Ratings. But a critical report last month by SCM Direct, the London-based wealth manager co-founded by high-profile anti-Brexit campaigner Gina Miller, notes that with "no agreed common criteria or benchmarks" it is "hardly surprising that there is no consensus" in the field.
Tesla: good or bad?
Both the SCM report as well as an earlier study by Asian investment bank CLSA and the Asian Corporate Governance Association give the example of electric car maker Tesla. MSCI rates Tesla as one of the top global car manufacturers when it comes to ESG, while FTSE rates it last and Sustainalytics gives it a middling rating.
“MSCI gave Tesla a near-perfect score for environment, due to its emphasis on the low carbon produced and its clean technology,” notes the SCM report, “whilst FTSE gave it a ‘zero’ on environment as it only rates the emissions from its factories”.
And just as different companies disclose different information, different ESG providers have different responses to ESG non-disclosures. While Tesla sells eco-friendly cars, it is stingy when it comes to disclosing the environmental impact of its manufacturing. FTSE heavily penalises such companies by giving them the lowest possible score for undisclosed information, thus hurting Tesla’s score. Other firms, such as MSCI and Sustainalytics, give scores that match the industry average in such cases.
In other words, depending on which expert you consult, Tesla is either a very ethical or a very unethical company. That’s not ideal for confused fund managers who are under pressure to deliver portfolios with better ESG ratings or for investors seeking a socially responsible fund.
Tesla is not an isolated case. The aforementioned CLSA report analysed some 400 ratings from FTSE and MSCI. Investors might have assumed their ratings would be similar, but there was little relationship between the scores awarded by the two companies. “The quality and comparability of [ESG] data remains hotly contested and we would caution against over-reliance on simple ESG scores,” the report warns.
That was echoed in an August report by researchers from Massachusetts Institute of Technology (MIT). When credit rating firms issue assessments for companies’ creditworthiness, their ratings match 99 per cent of the time, the report noted. In contrast, ESG ratings from different providers are aligned in only six out of 10 cases. Why?
Firstly, different ESG raters measure different things – one might include a firm’s corporate lobbying practices when assessing a firm’s ESG record, another might not consider the practice.
Secondly, they may use the same practices but weigh them differently. One firm might value human rights above environmental emissions, another might take the opposite approach.
Third, and most importantly, ESG firms can measure the same attribute using different indicators. One might evaluate a company’s labour practices by examining workforce turnover figures; another might count the number of labour cases against the firm. In other words, different firms may adopt different definitions of ESG performance, or they may measure that performance using different metrics.
There is also a “rater effect”, the MIT study found. When a rater gave a good rating to a company in one area – for example, labour practices – they were more likely to perform well in all the other categories for that same rater. “Inversely, if the same firm is evaluated poorly in one category by another rater, it is more likely to be evaluated poorly for all the other categories as well.” As a result, the possibility of wildly diverging ratings is all too real.
That’s irritating for investors. More importantly, it means optimists may be wrong when they talk about ESG ratings incentivising companies to improve their behaviour.
“Improving scores with one rating provider is unlikely to result in improved scores at another,” MIT cautions. If companies spend money in an attempt to improve ESG scores only to see their efforts go unrewarded, they may be inclined to shrug their shoulders and say: why bother? Thus, ambiguity around ESG ratings is an “impediment” to the uptake of “environmentally sustainable and socially just” practices.
Joachim Klement of Fidante Partners expresses a different but related concern, warning that the absence of universal ESG standards incentivises fund managers to "game the system and declare a fund to be sustainable even though the managers have hardly changed their investment process compared to a traditional fund".
That’s echoed by SCM, which complains about “alarming levels” of “greenwashing” in the fund industry.
How to remedy? Sustainable investing demands a universal definition and clearly defined concepts that are regulated by government authorities as opposed to being based on the approaches of individual rating providers, says Klement. Funds must “clearly explain to their investors how they manage ESG risks and what they mean by sustainable”, he adds.
SCM’s take is a similar one, calling for international agreement regarding standardised ESG data practices which can be independently audited and signed off. Additionally, it calls for industry-wide collaboration so large ESG providers work together to resolve discrepancies in their results.
Right now, however, most ESG data providers treat their methodologies as proprietary information, notes State Street. As a result, investors and fund managers who rely on a particular ESG score are “taking on the perspectives” of the data provider without properly understanding how they arrived at those conclusions.
So, are current ESG scores useless? Not necessarily, says the CLSA report. The lack of consistency doesn’t discredit ESG data or the practice of scoring, but it “underscores the danger of relying on a simple final score for investment decisions”.
Dr Florian Berg, the co-author of the MIT study, agrees investors need to be alert. “ESG rating is still a young field, and the definition of sustainability is by nature a fluid one,” he says. “What’s important today might not be important tomorrow.”