The third challenge arises from patchy company reporting and limited resources at the ratings providers relative to the number of firms they cover. As a result, companies are often ranked less on their actual performance and impact, and more on the ‘exam technique’ of how well they present themselves to the outside world and whether they are ticking the right reporting boxes. Good disclosure is clearly important but the absence of it doesn’t mean that a company is operating irresponsibly. ESG reporting takes time and resources, which can be scarce in younger businesses, meaning more established companies tend to have higher ratings.
To be fair to the ratings providers, they have a tough challenge and they are also clear about what their ratings actually cover. It is other market players and organisations that are using risk-focussed ESG ratings as a direct proxy for sustainability, and then using the aggregated data to ‘rate’ different investment funds. Such ratings are further compromised by the absence of any attempt to evaluate the people or process behind the various funds. In the qualitative business of responsible investing, being able to ‘show your workings’ is arguably just as important as the final answer. It may seem an obvious point, but an evaluation of the impact of a company’s core products must also be at the very heart of any attempt to rank sustainability. Does it matter that companies that make life-saving microscopic heart pumps or emission-free vehicles can be deemed to be less sustainable than oil companies, fast food chains or even big tobacco? Clearly, it does, most especially if you are a responsible investor. Getting this wrong has consequences: good companies are excluded from the growing pool of capital being deployed to sustainable portfolios; investors lose the investment returns that could have been generated from investing in growing companies; and society is the poorer, because the excessive focus on risks discourages investment in the very companies that can be part of the solution to a range of pressing social and environmental issues.
So, what should investors do if they want to build sustainability considerations into their decision-making process? First, for all the reasons outlined, take the current ESG ratings for what they are and don’t assume for a second that you can outsource the job of finding sustainable companies or funds to allocate your capital to. Understand that ESG risks are at best only half of the answer, which is why ESG rating services will never be a complete solution. Instead, put your efforts into identifying the best responsible investment funds, and satisfying yourself that sustainability matters are integral to the investment process, not a side-line or after thought. Concentrated and long-term active investors are uniquely well placed to undertake the more holistic research necessary for determining a company’s overall impact on society and exploring its potential to produce innovative solutions to the challenges facing the world right now. Base your decisions on the investment philosophy and processes, and the fund’s actual track record, not a cursory, arm’s length ESG risk rating.
This article originally appeared on the Citywire website.