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Friday View: 29 April 2016

What to look for in ESG and Sustainability fund ratings

by Lisa Beauvilain and Meg Brown
Friday 29th April 2016

A number of financial information providers, including  Morningstar, Sustainalytics, MSCI, 3D Investing and As You Sow, have recently launched third party ratings with the objective of providing investors with a guide to the overall “Sustainability” of investment funds. These ratings may be helpful to fund selectors considering a broader investment process of a fund with regard to Environmental, Social and Corporate Governance (ESG) risks and opportunities. At Impax we welcome any new developments to incorporate ESG metrics and help investors to better understand the broader risk profile of their investments.

We have noticed some important differences in the underlying methodologies of these rating providers in the emphasis that they place on various aspects of the investment process. Some, such as 3D and As You Sow, are focused on whether the fund delivers a positive environmental or social outcome by directing investment towards solution providers and avoiding significant polluters. Others such as Morningstar are more focused on assessing how companies operate on a day to day basis and include a reference to Corporate Governance practices, with less reference to what they do as a business activity. By focusing only on operational aspects of companies’ activities we therefore feel that some of the ratings may be misleading to investors looking for long-term sustainable investments.

Other unintended consequences relate to company size and geography. In our experience we have found that larger companies tend to have more developed ESG-disclosures and European companies have significantly more developed reporting than US or Asian companies. The company size and geographic allocations of a fund may therefore significantly skew the fund rating results. Hence funds investing in large European oil and gas companies facing future carbon regulations may score better on ESG-quality than funds investing in smaller US water treatment or renewable energy companies, providing long term solutions in the transition to sustainable economy.  We would therefore caution against the direct comparison of funds with such different investment approaches, as other factors than actual sustainability and ESG-quality may drive the ratings.

In order to achieve more consistent and meaningful ratings are encouraging the integration of a few considerations into the ratings methodologies:

  1. Intentionality. Incorporate an explicit reference to the “intention” of a fund e.g. to invest in environmental solution providers and integrating ESG-analysis (“sustainable investing”) or specifically focusing only on companies with better processes (higher ESG-scores), across all sectors (“best-in-class”).

Funds just investing in companies with high ESG-scores have an entirely different focus than funds investing in companies providing positive environmental benefits.

  1. Peer groups. Establish the most relevant fund peer groups.

Once the “intention” of funds has been established, more appropriate peer groups can be established, allowing more meaningful and accurate comparisons across funds.

  1. Company size. Include broader ESG-ratings coverage of smaller and mid-sized companies.

Higher ESG-scores are highly correlated with market capitalisation. Larger companies can easily afford to submit the reams of data often requested by ESG rating providers whereas smaller companies can struggle to provide all the data required and often receive lower ESG ratings as a result. ESG rating firms also often lack coverage of smaller companies, further skewing results.

  1. Geography. Take into account or normalize for geographic focus of funds.

Funds that are focused on or overweight European companies are much more likely to score better, given that ESG disclosures are much more developed in Europe than e.g. in the US or Asia.

  1. Investment process. Include qualitative aspects of an integrated ESG process such as engagement.

Fund managers that have an integrated ESG process are engaging with the management teams of their companies to improve their ESG processes over time. This should be reflected in the overall scoring.

It is useful to look back and reflect on the lessons learned from the advent of individual stock ratings. These were viewed as a good idea at the time but went through a series of adjustments post launch following feedback from both the users of the ratings and those being rated. We encourage all rating organisations to engage in a similar discussion this time around and apply lessons learnt to fund level sustainability ratings. We welcome the UK Sustainable Investment Forum’s consultation on a coordinated response to the trend. We are confident that the feedback to ratings companies will encourage them to go further and improve on their important first steps in order to achieve a more representative and comprehensive ratings system to the benefit of fund selectors and their clients.

IMPORTANT INFORMATION

The information and any opinions contained in this document have been compiled in good faith, but no representation or warranty, express or implied, is made to their accuracy, completeness or correctness. Impax, its officers, employees, representatives and agents expressly advise that they shall not be liable in any respect whatsoever for any loss or damage, whether direct, indirect, consequential or otherwise however arising (whether in negligence or otherwise) out of or in connection with the contents of or any omissions from this document. This document does not constitute an offer to sell, purchase, subscribe for or otherwise invest in units or shares of any fund managed by Impax.

Lisa Beauvilain is the head of sustainability & ESG  at Impax Asset Management

Meg Brown is director of sales at Impax Asset Management

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