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Responsible and sustainable investing – where ESG issues are factored into investment decisions – has grown significantly over the last few years. According to data by Morningstar, ESG-labelled funds are now approaching $2trn AUM, up from just $450bn in 2011. But how reliable are ESG ratings and could investors be being misled in some instances?

Why investors require better: The flawed world of ESG ratings

Carlota Esguevillas Carlota Esguevillas Responsible Investment Analyst
Opinion

Why investors require better: The flawed world of ESG ratings

Carlota Esguevillas

Carlota Esguevillas
Responsible Investment Analyst

Responsible and sustainable investing – where environmental, social and governance (ESG) issues are factored into investment decisions – has grown significantly over the last few years. According to data by Morningstar, ESG-labelled funds are now approaching $2trn AUM, up from just $450bn in 2011.

The number of new entrants into the ESG sphere has been unprecedented and investment houses of all sizes are rushing to market with new or repurposed products, claiming to be experts in the field. However, concerns exist that some ESG funds are not as sustainable as investors might think.

As the field expands, many groups have turned to ESG rating providers including MSCI, Sustainalytics and ISS to help with investment decisions. These agencies aggregate hundreds of indicators from across E, S and G topics and provide quantitative scores that can be integrated into the investment process.

As investor demand has grown to incorporate ESG issues into investment, the influence of ESG rating providers has grown exponentially. However, investors should be cautious of placing too much reliance on ESG scores. Recent scandals at Boohoo and Wirecard – both of which were highly rated by agencies – illustrate why.

The limits of ESG ratings

There is no single, accepted methodology for calculating an ESG rating. As a result, ESG scores are inherently subjective, based on the agencies own opinion of the importance of each E, S and G topic. Unfortunately, more often than not, rating providers focus only on the ESG topics which are deemed by them to be “financially material” – that is those which are presumed directly to impact a company’s financial performance such as revenue and profitability.

In our view, this is only one aspect of what is material for businesses, and in taking this narrow view, ESG ratings are failing to account for the full impact of a company’s activities on society and the environment. Certain ESG issues may not be financially material, but ignoring them can have serious consequences. Take ensuring workers have fair and decent working conditions – advocating for better standards may increase a company’s costs, at least in the short term, yet providing decent jobs goes a long way towards creating a more just society. For responsible and sustainable investors, decent working conditions (and indeed any ESG issue) should not need to be “financially material” to be worth promoting, yet many ESG ratings would suggest otherwise.

In addition, ratings tend to focus on the management of key topics whilst often overlooking what the business actually does – be that positive or negative. For example, according to Revinitiv data, British American Tobacco and Glencore are in the top 5 most highly rated companies on ESG in the FTSE100.1 Clearly, anyone actually looking at what these companies do – tobacco and mining – is unlikely to consider them among the most sustainable. On the flip side, we have also found that ratings often fail to capture the positive contribution of companies providing solutions to some of the biggest global challenges.

ESG ratings are attempting to quantify what, in many cases, is intangible and cannot be quantified. This is particularly true for the S of ESG. Whilst carbon emissions and diversity may be easy to measure, it is much more difficult to assign a value to topics like employee wellbeing and company culture. Further complicating matters is the fact that company reporting on some (especially social) ESG topics is still in its infancy, with limited standardised reporting requirements resulting in disclosures of varying completeness and quality. With this in mind, we believe that a qualitative assessment is always necessary.

Lastly, ESG reaches across everything from climate change and biodiversity to health and safety and board diversity. In generating an ESG score, providers combine information from hundreds of indicators into a single rating, and this aggregation can also bury significant risks. For example, a company might receive a high overall rating due to a low carbon footprint and good corporate governance, despite serious human rights violations in its supply chain.

Our approach at EdenTree

At EdenTree, our approach fully integrates environmental, social and governance factors in every part of our investment process. We have written in the past about the importance of research in our investment process, and this is a key differentiator in our approach.

For the reasons outlined above, we know that relying on an ESG rating can expose clients to unexpected risks. Whilst we receive ISS-ESG ratings and may refer to them as an additional layer of due diligence, we place a much larger emphasis on our own in-house research.

To be suitable for inclusion within our range of funds all new ideas must meet the criteria laid out by our responsible and sustainable screening model. There are three parts to this process: ethics and values, responsibility and ESG and sustainability and thematic.

EdenTree-Screening-Process

The ten values screens aim to avoid harmful activities. We then have a responsibility criteria, incorporating six different considerations which reflect a company’s management of key ESG risks. These are intentionally broad to capture all relevant topics, and are key to the way in which we consider stocks as being suitable for inclusion. Finally, we also consider the positive thematic sustainability case, with a focus on education, health and wellbeing, social infrastructure, and sustainable solutions.

Throughout this process, our fund managers and responsible investment team work side by side to analyse risks and opportunities, and we will often meet with the management team of a company to supplement our own research and provide further critical insight into the suitability of a stock.

The depth of this analysis is key to how we deliver superior ‘Profits with Principles’ for clients over the long-term, something that is simply not possible using an approach which relies solely on ESG ratings.

 

Sources

1. https://www.hl.co.uk/news/articles/ftse-100-the-5-highest-esg-rated-companies