The Credibility Of ESG Metrics

ESG and sustainability have been around for more than a hundred years. However, the term ESG has shifted from an idealistic view to an integral investing strategy among corporations and investors worldwide over the past couple of years. ESG is now Wall Street "it" investing, and it is here to stay.

The challenge, however, is that the concept of ESG is subjective, fluid, and emotional; and the metrics are random and opaque. The ESG rating agencies rely heavily on corporate disclosures. In essence, the credibility of the rating agencies correlates directly with the credibility of the corporate disclosures. As a result, an industry of ESG "raters" has cropped up that rates companies' ESG bona fides. If you have invested in one of the 700+ ESG exchange-traded funds (ETFs) in the US, one of these rating providers probably played a hand in determining the fund's investments.[i]

As ESG gains momentum in the investing community, questions arise as to who rates these products. Are the ratings credible? It is worrisome that the ESG rating process is opaque, lacks clarity, and holds power to determine the investment worthiness of a US$30 trillion industry.

Those rating providers and the ratings face increasing scrutiny.

The Process

ESG rating providers mine public information to grade companies and sort them into ESG indexes (e.g. sustainable impact, tobacco involvement, or women's leadership). The ESG rating agencies also rely heavily on corporate reporting. Investors and financial advisers, in turn, look to the ratings and indexes to develop investment strategies or create ESG-focused mutual funds, index funds, and ETFs.

The Challenge

In theory, receiving more information can clarify the complex nature of an issue; however, according to a recent study conducted by Harvard, the more information a company discloses about its ESG practices, the more rating agencies disagree on how well that company is performing along these dimensions. According to the research, a 10 per cent increase in corporate disclosure is associated with a 1.3 to 2 per cent increase in ESG score variation among major rating providers. All interpret and process disclosures differently.[ii]

The United States is behind Europe in ESG. In the United States, enlisting securities laws to achieve ESG objectives is gaining traction among activists and policy elites, emphasising requiring disclosure of specific ESG metrics.[iii] However, on 21 March 2022, the SEC announced the release of its long-awaited climate disclosures for US public companies. For the first time, the proposals would require US companies to provide information on climate risks facing their businesses and plans to address those risks, along with metrics detailing the companies' climate footprint, including Scope 1, 2, and in some cases, Scope 3 greenhouse gas (GHG) emissions.[iv]

The Securities and Exchange Commission’s (SEC) step towards mandatory disclosures of publicly traded companies is the first step towards enforcement. However, can the SEC regulate the ESG rating agencies? Unfortunately, the answer is that we do not know.

With more than US$30 trillion in sustainable investment capital on the line, the stakes are high for companies and investors. Institutions, such as asset managers, pension funds, and endowments often rely on ESG ratings to make investment decisions. However, research findings suggest that divergent scores hurt firms, investors, and markets, and these effects worsen over time.[v]

Harvard Business School Assistant Professor Sikochi says:

"People are being sold on money being invested responsibly by using these ratings that nobody understands."[vi] 

Professor Sikochi's practical assessment is spot on.

The Murky Landscape Of ESG And ESG Metrics

The ESG rating agencies' dissonance with the corporate disclosures (mandatory or voluntary) is painfully scary. Rating agencies rely heavily on corporate reporting. Dozens of rating providers like MSCI, Sustainalytics, and other "independent" rating providers use corporate disclosures to formulate the ESG scores. Here is where the ratings get murky.

Each ESG rating agency relies on its analysts and algorithms to aggregate and synthesise the corporate disclosures, which include but are not limited to, a company's carbon emissions, board diversity, modern-day slavery, etc, and put them into "E," "S," "G" scoring boxes, which are then consolidated into a single ESG score.

ESG Rating Agencies And Metrics

According to research conducted by Harvard, when companies are more specific about the impact of their ESG policies, such as reporting how many discrimination complaints they faced during the year, these disclosures tend to stir disagreement among the raters (Sikochi).[vii]

How Do Investors Rely On The ESG Ratings?

ESG rating agencies with opaque methodologies and strategies are spread worldwide to monetise this "ESG investing" craze. As ESG gains momentum, it is wise to take a step back and understand how the metrics are formulated and, most importantly, how investors rely on the ESG scores to make their investment decision.

According to the critical findings gathered from Sustainability, Rate the Raters Survey 2020, [viii] it is evident that investors use ESG metrics as one of the many factors in making their investment decisions and rely on multiple rating agencies for each aspect of ESG.

After reviewing the Rate the Raters 2020 report (which includes interviews from 17 investment firms split evenly across North America and Europe)[ix], here are some views from the asset managers/investors:

"The biggest problem with most of these is that you can't tell where things came from. With a carbon emissions number, you know how it's calculated and what it is doing. A number or ABC score is interesting, but you don't know where it came from. So it all comes down to methodology."

"In terms of mainstream ESG ratings (e.g., Sustainalytics, ISS, MSCI, etc.), we prefer the ones with more transparency and a materiality lens — not that they've figured it out for us."

"When we judge the quality of a rating and robustness of methodology, we want to know whether it is focused on materiality if data is independently collected, whether they have methodology committees and oversight by experts. We also look into what kind of data quality assurance process they have to ensure the analysis they produce is accurate and timely."

Investors rely on a massive amount of ratings, research and data on ESG for their core focus – constructing and investing in a portfolio that adds value to their investors. Is the magnitude of opaque, subjective ESG data and metrics distracting investors and corporations from doing fiduciary duty to their investors? If so, at what cost?

The Dangerous Path Forward

Michael Baldinger, Head of Sustainable and Impact Investment at UBS Asset Management, said, "The demand for ESG investment options is so high that many asset management firms are rushing to pull together new offerings."[x]

According to the Sustainability Survey, "almost all investors interviewed described sophisticated approaches to ESG analysis, where ratings inform rather than drive investment decision-making. Especially for active managers, having a strong sense of which ESG factors are most important in a sector and developing their company evaluation is critical. They want to rely on their thinking, not someone else's. To support this, several have developed their own KPIs, tools, processes, and scores to evaluate corporate ESG performance and "find our answers fully." This in-house investment research primarily forms the foundation for any buy, sell or hold decision, not anyone externally sourced ESG rating”.

ESG investing based on thorough research and data analysis appears to be a proper due diligence step before investing in an ESG firm. But unfortunately, whenever there are good intentions, it is accompanied by creative "investing" – the emergence of ESG securitised financial products.

Client demand, risk management, and a desire to have a more positive environmental and societal impact are driving ESG considerations in securitised products. Investors' fixed income ESG policies are expanding, but they are not tailored to securitised products. Most investors are exploring how they can adapt and apply the ESG incorporation practices used with other types of debt instruments to these products. Negative screening remains the most widely adopted incorporation approach for European ESG-labelled Collateralised Loan Obligations (CLOs). The legal documentation accompanying them is not harmonised; CLO managers' ESG evaluation processes are vague, and – for now – a slight price differential versus mainstream products exists.[xi]

As investors comb through options available in responsible investing, due to erroneous, opaque data, it is easy to get lost in the nuances of understanding the "good" in every aspect of the investing process. The crux of the problem is how ESG ratings, offered by "reputed" rating firms such as MSCI, are computed. The problem involves how rating firms assign weights to each ESG factor. To compute a company's ESG score, rating firms score every company on various ESG factors. Then they assign weights to each factor, aggregating the results into a composite ESG score. For example, a strong ESG performer might get a triple-A composite score, while an ESG laggard might be assigned a triple-C score. These scores form how ESG indexes and ESG funds construct their portfolios.

Contrary to what many investors think, most ratings don't relate to actual corporate responsibility related to ESG factors. Instead, they measure the degree to which a company's economic value is at risk due to ESG factors. So, for example, a company could be a significant source of emissions but still get a decent ESG score if the rating firm sees the pollutive behavior as being managed well or as non-threatening to the company's financial value. This could explain why Exxon and BP, which pose existential threats to the planet, get an average (BBB) aggregate score from MSCI, one of the leading rating companies. It could also be why Philip Morris made it onto the DJSI. This is because the company recently committed itself to a "smoke-free" future, which rating agencies might perceive as reducing regulatory risk even though its next generation of products remains addictive and harmful.[xii]

The Illusion Of ESG

ESG is a fluid, subjective, and a very emotional topic. An emotional topic (of any kind) involves a dose of irrationality accompanied by basic human nature.

On the other hand, investing requires careful analysis of facts comprised of reliable data and analysis. The challenge is that a large volume of research[xiii] has been published using ESG rating data to demonstrate a positive relationship between ESG performance and financial performance. Unfortunately, the challenge persists and continues to compound, especially when ESG rating agencies have a very low bar for "good" ESG scores.

The solution for this is to create a robust rating system that measures the economic, human, and environmental costs caused by corporations. But unfortunately, the ratings of that magnitude are expensive to corporations' bottom line. So, are we ESG compliant because we check the boxes? Or are we genuinely going to enforce the principles of ESG in our investing?

 

Footnotes:

[i]   https://news.bloomberglaw.com/esg/who-regulates-the-esg-ratings-industry

[ii]   https://hbswk.hbs.edu/item/what-does-an-esg-score-really-say-about-a-company

[iii]   https://www.sec.gov/news/public-statement/rethinking-global-esg-metrics#_ftn1

[iv]   https://www.sec.gov/files/33-11042-fact-sheet.pdf

[v]   https://hbswk.hbs.edu/item/what-does-an-esg-score-really-say-about-a-company

[vi]   Ibid

[vii]   Ibid

[viii] https://www.sustainability.com/globalassets/sustainability.com/thinking/pdfs/sustainability-ratetheraters2020-report.pdf

[ix]   Staff from 17 investment firms split evenly across North America and Europe were interviewed to gain an understanding of why and how they use ESG data, which research firms they use, and trends they see in the space. Interviewees represented a variety of positions including analysts, senior portfolio managers and heads of sustainable investment research to gain a breadth of viewpoints on company approaches, structures and mechanisms to ESG ratings and analyses. All quotes throughout the report are anonymised.

[x]   https://www.sustainability.com/globalassets/sustainability.com/thinking/pdfs/sustainability-ratetheraters2020-report.pdf

[xi]   https://www.unpri.org/fixed-income/esg-incorporation-in-securitised-products-the-challenges-ahead/7462.article

[xii]   https://ssir.org/articles/entry/the_world_may_be_better_off_without_esg_investing

[xiii] https://www.stern.nyu.edu/sites/default/files/assets/documents/NYU-RAM_ESG-Paper_2021 Rev_0.pdf