Mirror mirror on the wall (street), how fair are the ESG ratings, after all!

• Inadequate understanding of ESG Rating approaches fuels cynicism on its merits and validity to steer sagacious investment decisions.
• For integration of ESG issues into ratings – Materiality Matters and ‘One Size Doesn’t Fit All’.
• Company’s exposure to ESG related risks and opportunities not conjugated with its ability to produce an enhanced sustainability report.
• ESG Rating is not a Certificate of Virtue but a tool to flag outliers masquerading as vulnerabilities
• Do not treat ESG Ratings as settled facts isolated from their context; its an output of a research pegged to a comprehensive methodology

The popularity and acceptance of Environmental, Social, and Governance (ESG) targeted investment strategies has accelerated significantly over the past decade. But, so has the cynicism around its merit and accuracy in driving sagacious investment decisions.

Some label it as a system fraught with inconsistent and subjective methodology, while others argue over its inherent bias, and incapacity to timely predict and integrate ESG signals in to a final rating (such as BP’s Deepwater Horizon oil spill and Volkswagen emissions scandal).

Incidentally, a predominant share of this criticism is based on a myopic and often an inaccurate understanding on the workings, differences, and the premise of ESG rating approaches.

Concerns regarding “How fair are the ESG Ratings”

Some of the areas of contention targeting the ESG ratings and our assertion in defense are examined below.

• Materiality Muddle

Investment relevance of ESG considerations is often the top cited criticism against the ESG based investment strategies. A generally accepted view is that while ESG ratings ends up covering a wide array of issues, they seldom cover a material ground. Proponents of this contrasting standpoint bleat on about either too little material data or too much of immaterial information.

While, the deduction is intuitive, its logic is based on an outdated definition of ESG ratings that focused more on screening than analysis, and solely relied on company disclosures than on an investigative library of data.

The historical ‘rating’ methodology, which is the basis for the (lack of) ‘materiality’ argument, followed a all-in approach where quantity of ESG factors subjugated their quality (relevance). But the tide has turned, and now the matured ESG methodologies employ advanced analytical tools and modelling techniques covering issues in multiple dimensions over a comprehensive database.

Rating agencies and ESG investors are aware of the subjective relevance of ESG factors specific to industries and companies, which gets captured into their comprehensive ESG scoring frameworks that are sensitive to these variations. Further, their is an undeniable, unanimous acceptance and acknowledgement that less than 25 percent of the data points in the traditional ESG scores meet the criterion of materiality.

A growing share of organisations have already started using materiality maps designed by the likes of SASB (Sustainability Accounting Standards Board) to streamline a list of relevant and material ESG issues across their investment portfolio.

Industry working groups such as the Task Force on Climate-related Financial Disclosure (TCFD) and sustainability reporting organizations (GRI, CDP) are persistently working towards an expedite adoption of a set of comparable and consistent disclosure vernacular that companies can appropriate to their respective business lines.

Additionally, companies are increasingly being encouraged to identify, actively intervene, and report on material ESG issues that can potentially have a direct impact on their bottom line, and thus enable investors to make a discerning investment decision.

In a nutshell, the adage ‘One Size Doesn’t Fit All’ is succinctly applied and suggested as a clarification to the naysayers of ESG influenced investment decision.

• The Timing Argument

Another common argument against the relevance of ESG factors is around their ability to reflect the potential risks, which in turns leads to misleading financial valuation.

The alleged oversight of events can be attributed to investors’ inability to fully comprehend the differences in ESG reporting and rating approaches. Case in point, the 2015’s Volkswagen Emission Scandal.

A cursory understanding of the German automaker’s high ESG rating is argued to be a misnomer from most raters who failed to highlight the possibility of an emission evasion scandal that eventually ensued.

However, since 2007, the company was rated consistently low (amongst lowest quartile) on its corporate governance criterion by different raters such as Thomson Reuters, Sustainalytics, and MSCI.

The deception stemmed on accounts of poor governance and not environmental performance per say, which was misinterpreted by the ESG skeptics. Volkswagen’s governance issues were very much a public information, erroneously missed by the investors’ community.

Therefore, labelling such an event as a failure of ESG investing is grossly misplaced and misleading.

The ESG investing opposers propagate a flawed role of ESG factors in investment decisions. ESG ratings are not designed to operate as a radar of fraud or a predictor of future. On the contrary, they should be viewed as a tool to flag outliers that masquerade as inherent system vulnerabilities with susceptibility to ethics breaches, litigation, and other adversaries.

The ESG methodology is a means to an end of ascertaining critical intangibles associated with operational integrity and risk oversight, something that is otherwise equivalent to finding a needle in a metaphorical portfolio haystack.

ESG Rating should not be viewed as an absolute objective truth when they are essentially a series of researched and thought out opinions that do not command blind following.

• Bleating About Bias

ESG Ratings are vehemently deplored for operating on an innately biased premise. Let’s look at individual arguments. It is asserted that companies with higher market capitalization and large CSR departments tend to get better ESG rating than their mid to lower market cap peers.

And, often the rationale for the critique is based on the supposed bias in the rating agencies’ methodology, which allegedly overemphasize the differences in resources devoted by respective company types towards preparation and publication of annual ESG disclosures.

However, a robust ESG Rating model does not uphold this naive approach. It maps the basic business segment information with area specific data inputs. For examples, in case of MSCI ESG Rating, biodiversity data points are mapped to information from The Nature Conservancy, and WWF; toxic waste to inputs from Toxics Release Inventory, labor statistics from ILO, and so forth.

In short, no analysis is ever conducted detached from reality and the objective facts. A company’s exposure to ESG related risks and opportunities is not conjugated with its ability to produce a bedecked sustainability report.

Similar critique is directed towards the bias of ESG Rating towards geographies with stringent reporting requirements such as in Europe, say when compared to those in North America. Here the issue is more of the quality of reporting than the qualification of ESG Rating as a guidance to drive investment strategies.

In a 2016 study by Schroders, it was observed that 58 percent of European fund managers positioned ESG factors as a critical consideration for an astute investment decision, meanwhile, only 14 percent of their US counterparts said the same.² So, in reality, it’s the investor sentiment and demand that is driving the growing heed to ESG factors in corporate reporting, and not the other way.

• Subjectivity Syndrome

The root cause of inefficacy loosely attributed to ESG Rating converges to a central theme of subjectivity in methodology and analysis.

A lack of convergence in ESG measurements is averred at a granular level i.e. how E, S, and G factors are dealt in definition and examination. And, since there are no standardized rules for environmental and social disclosures, it is alleged that companies can and they do compensate for weak ESG practices with robust disclosures that often omits critical non-financial data.

In an utopian self-serving scenario, the above argument might hold water, nevertheless, more systematic reasons are found to be at play behind observed divergence in scores for the same company or between two companies across rating agencies.

Again, one should not forget that ESG Rating does not claim to issue a certificate of virtue to a company’s performance, it is in fact an indicator of vulnerability as gauged by the methodology followed to ascertain a certain score/rating, and that is where the entire discussion needs to be steered.

Just like there is no single way to analyze ‘hard’ financials or risk-return measures of an investment, similarly, no absolute ESG score exists for a company.

Every rating agency operates on an individual understanding on different views of past and future with varied access to data, therefore, there will always be legitimate and acceptable differences in how they define, measure, evaluate, and report E, S, and G for a company.

For instance, FTSE maintains two different sets of databases, one catering to companies’ ESG performance in operation, and other to their Green Revenues i.e. their contribution to the green economy, as both can sometime be mutually exclusive realities.

Therefore, it is for the investors and the data users to determine and internalize such differences in approach and ratings, and not for the rating agencies per say. The onus of objective integration of ESG Rating into an investment decision stays solely with the investor.

By a learned mind and an experienced investor, ESG Rating should be read in the same stride as an investment analyses i.e. as a Fact-based Opinion. Essentially, ESG ratings are not advisable to be treated as settled facts isolated from their context, which is an output of a research pegged to a comprehensive methodology.

This means it is imperative for an investor to understand the backend rating process and the indications it generates. To conclude, within the context of mainstreaming of ESG ratings into investment decisions there is only one caveat –

Don’t judge ‘the score’ without understanding ‘the signal’.

Photo by: Rick Tap on Unsplash

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