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ESG ratings under scrutiny
In the wake of the pandemic, investors have continued to pile money into variously labelled ESG/sustainable funds. According to data published by Morningstar, by the end of June 2020, assets in these funds surpassed $US1 trillion for the first time on record. The number of products offering sustainable strategies is also rising sharply with more asset managers converting traditional funds into sustainable funds. Concurrently with this trend, more managers are turning to ESG rating providers to source data and ratings to assist with investment decisions. Â
And herein lies the risk.
The ESG data landscape is heterogeneous and ambiguous reflecting the challenges involved in measuring non-financial issues including lack of transparency and standardisation of data. As stock exchanges and governments don’t require companies to report on most ESG data, companies are “self-reporting” on ESG issues they deem material to the performance of their businesses. Hence, the quality of data is poor, inconsistent, and difficult to compare.
Filling in the void, the number of external data providers has mushroomed over the last few years. Some of them specialise in providing specific ESG metrics, such as carbon score (TruCost), while the majority offer ratings based on hundreds of ESG criteria. MSCI and Sustainalytics, the two most widely used data providers belong to the latter category. On top of the issues with data, ESG data providers generally use different sources of information and have developed their own research and scoring methodologies. These methodologies are quite opaque so it is not surprising to find large differences in the ratings for the same company issued by different data providers.
There are a number of limitations with ESG ratings that investors need to be aware of. The ESG rating providers have devised elaborate scoring systems, assessing a large number of ESG factors for each company relative to the companies’ peer groups established by data providers. By aggregating the scores into one number or a set of letters and reducing what should be essentially a multi-dimensional system analysis into one score, the rating becomes one dimensional and oversimplified. This means that a company that scores very well on one aspect, while scoring poorly on another, can end up with a good score. For example, a company might receive a high rating due to its low carbon footprint, despite human rights violations in its supply chain.
Also, the ESG scoring system used by these groups are typically not designed to identify companies that are providing solutions to sustainability challenges through their goods and services. Rather, the focus is on the assessments of ESG factors per se.
The issues above largely explain the relatively high exposure of ESG funds to large US tech stocks (Facebook, Alphabet, Apple, Netflix, Google and Microsoft). Morningstar reported that in the year to June 2020, on average 17% of the 10 best performing US large-cap funds’ portfolios incorporating ESG considerations were in these stocks. This compares to the average tech exposure of 23% among large-cap US equity funds. While it could be argued that the strong performance of these companies is one of the main factors for their inclusion, the reality is that they tend to rate well by ESG data providers, mainly due to their strong environmental credentials. Take Alphabet and Microsoft for example. The former has been carbon neutral since 2007 and the company matched its entire electricity consumption with renewables for the past three years. Recently, as part of a $10 billion debt offering, Alphabet has issued $5.75 billion in sustainability bonds, the largest sustainability or green bond by any company in history. Microsoft has pledged to be carbon negative by 2030 and to remove from the environment all the carbon the company has emitted either directly or by electrical consumption since it was founded in 1975 by 2050.
A good example of the issues related to the lack of disclosure and reliance on self-disclosure is the latest Boohoo scandal. Boohoo is a fast fashion UK company currently being investigated for poor labour practices in their supply chain. We wrote about Boohoo in one of the previous articles in relation to the Modern Slavery Act.
A number of ESG/sustainable funds invested in Boohoo and just a few weeks before the scandal broke, MSCI reiterated Boohoo’s AA rating, while highlighting how it scored far above the industry average on supply-chain labour standards. Based on the CSR hub database, Boohoo’s ESG rating was similar to its closest peers and when measured against a universe of more than 19,000 stocks worldwide, Boohoo was better than 71% of them. However, Boohoo scored poorly in the area of traceability as the company chose not to provide any information to investors and consumers on where they buy their clothes or source their raw materials. It is now clear that this should have been a red flag!
So what are the implications for investors?
ESG ratings should be viewed as a tool that provides a baseline analysis and a useful reference point, however, investors have to do their own research and consider carefully how ESG ratings should be used. As Christopher Greenwald, head of sustainable investment research at UBS Asset Management, said: “They (ESG ratings) are often marketed and presented as if they are investment-ready recommendations, but they really are starting points for fundamental analysis.”
