We need to talk about ESG ratings

In the decade since the financial crisis there has been rapidly growing awareness of the importance of ESG factors in business.

Concerns about climate change and inequality in society have prompted more people to think about which companies they should be supporting with their capital, and the coronavirus (Covid-19) pandemic will only intensify the scrutiny of companies on responsible business matters.  Such issues are therefore no longer niche. Indeed, many believe that sustainable products and good business conduct are increasingly central to delivering long-term investment returns. With this shift in asset allocation underway, pension funds and other investors are looking for a reliable method for ranking a company’s performance on ESG issues. But the current off-the-shelf ratings services aren’t the solution, for three main reasons.

 

The first methodological stumbling block is the sheer diversity of ESG issues. How do you weigh up workers’ rights and environmental impact against governance arrangements and tax policies? Turning a range of complex issues into a number and then aggregating out the result risks obscuring important underlying details. Compounding this, because ratings analysts often do not have an investment background, they are not well placed to determine whether an ESG issue is genuinely material to a company or its long-term performance.

 

The second issue is even more profound – how do you also rate a company on the benefits of its products and the impact its operations have on people and planet? The answer will always be subjective and open to challenge, and for this reason ratings agencies tend to focus on the narrower task of identifying ESG risks. However, for investors, concentrating on just ESG risks rather than benefits is like measuring football teams based on their track record of conceding penalties, while ignoring their ability to score goals. When considering whether to invest in a business, investors should be predominantly focusing on its potential for growth and success, not every conceivable mistake it could make along the way. A more holistic ESG analysis of a company must evaluate how its core business model contributes to society, but most external ratings services do not attempt to cover this.

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.

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.

Andrew Cave

Head of governance and sustainability

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