ESG scores are one of the most debated topics within the sustainable investment arena.
The issues surrounding the topic were central to the third session of portfolio institutional’s ESG Club Conference, appropriately titled: ESG ratings – What’s the score?
Starting the discussion, MSCI’s Elchin Mammadov said that investors using MSCI’s ESG scores fall into one of two “investor buckets”.
The first is traditional investing, where the focus is on maximising returns. Here ESG data is used with their – financial analysis to help identify risk within a company’s valuation, profitability and competitive position.
The second bucket is a smaller and more diverse group of investors who analyse the impact assets have on society and the environment.
“They avoid companies which are making a negative impact to focus on those generating a positive impact,” Mammadov said.
There is also a methodology that uses a mixture of the two approaches. “This is what we call double materiality, where investors think about maximising their risk-adjusted returns, but also try to avoid companies that do not make a positive impact,” Mammadov said.
Addressing the criticism voiced by some investors that ESG scores are often too simplistic to be useful, the PLSA’s Joe Dabrowski said: “There is a lot of tension between what pension schemes need in practice and what is in the underlying data.”
He also noted that trustees are reliant on advisers and consultants to interpret the data, for which there are different needs across the pensions sector based on issues such as the size of the scheme.
“As a trustee you are looking for information that you can trust and readily use, as well as being reliable and comparable. But in the ratings space, we don’t have that,” Dabrowski said. “It is emerging but is a bit of a buyer beware situation presently.”
This poses obvious challenges for investors, especially pension funds, when addressing the ratings situation.
Dabrowski was keen to qualify his thoughts that investors, including pension funds, do have accessible data, but he stressed a more fundamental point. “How robust it is? How comparable it is?” he said.
Questions also surround ratings being unregulated, as well as issues concerning governance and system controls. “Investors are in a slightly difficult space,” Dabrowski added. “It is a real pickle at the moment, and we need to resolve all of that.”
Are you serious?
Moving the discussion on, Shai Hill, chief executive of data provider Integrum ESG, tackled the issue of whether investors can take ratings seriously when there is such divergence among providers.
First, he questioned if there is, in fact, a big divergence. “I suppose the answer is, yes.” Hill cited research from the Massachusetts Institute of Technology, which compared the ratings of ESG providers and concluded that they are more likely to disagree than agree on a score. Hardly a reliable starting point for investors. “That does lead to a lot of frustration,” he added.
Hill then started unpicking some of the awed perceptions about ESG scoring. “People want ESG ratings to be like credit ratings,” he said. “In my view, that is a foolish expectation, because it took decades to reach a consensus of what makes credit worthiness.”
In comparison, Hill said, ESG is an enormous range of topics, from the composition of the remuneration committee to the amount of air pollutants emitted per annum.
He, therefore, suggested that investors should not be frustrated, as ESG is too wide ranging to be boxed into a single score.
That said, there is, he highlighted, a consensus on what the material issues are for a company based on its sector, but not how material those different issues are. “And what affects ratings is the weighting you put on something,”
Hill added. “The balance between quantitative and qualitative: how you measure that is a huge issue. Do you reward a company for having a strong [ESG] policy, or do you ignore it?”
Hill’s central point being the logic behind ESG scoring is never clear. “Why are asset owners and trustees relying on ratings they cannot understand?” he asked.
Then the other Hill on the panel, Mark Hill from The Pensions Regulator, highlighted the importance of effective ESG scores. “The credibility of ESG ratings has a role to play for corporate disclosures to be effective,” he said. “So we are looking at that credibility for them to be useful. As a regulator, we are very much aware of all this and is why we are looking at how to increase that coverage and credibility,” he added.
As a result, The Pensions Regulator is undergoing a major regulatory initiative which looks at the statement of investment principles and the implementation statements. “What we are doing is looking at ESG and climate-related disclosures in relation to the financial and non-financial considerations. Hopefully, the results of that will be published in early 2024,” Mark Hill said.
“That will hopefully help drive that expansion and credibility,” he added. “The integrity of disclosures is very important.”
When it comes to corporate bonds and listed equities, the climate-related data is pretty good, Mark Hill said, but he added that private markets are a challenge. “From a regulatory perspective, we want to see an improvement in invested data and disclosures made available to trustees, service providers, investment managers and advisers in order to give them a better understanding of the risks and opportunities and how to manage that,” Hill said.
So how can the industry improve the quality of non-corporate disclosures? “There is a lot we can do for ourselves,” Dabrowski said.
Thinking about what can and is being done as an industry, he cited: guidance on the issue of disclosure, shared experiences, looking at implementation statements, case study work, engagement with the regulators, setting out the industry’s stewardship expectations and uniformly pushing those as hard as possible.
Dabrowski, therefore, put a strong emphasis on investors, like pension funds, playing their part. “That will be driven by getting amongst ourselves some form of consensus on what matters to us. You hear a lot on that about corporate disclosure, or disclosure from asset managers,” Dabrowski added.
But putting the issue into context, he said that climate-change reporting has taken an “incredibly long time” to be part of corporate reports. “You need in some cases the hard rod of legislation to hold people to account.”
Nevertheless, there are discussions taking place about ratings, which left Dabrowski reasonably optimistic that it will feed through to benefit investors. “We need to be able to use all of that at any level of [pension] scheme,” he added.
An alternative view
Returning to the scoring methodology, dealing with the challenges in MSCI profiling a company and setting an accurate score, Mammadov admitted: “It’s not easy.”
But he added that the way MSCI approaches ratings is through collecting a great deal of data. “We take time standardising and structuring that data. We have over 400 analysts doing that,” Mammadov said.
“But the issue we have is a lot of data reported by companies, whether voluntary or mandatory, is not standardised, it is cherry picked,” he added.
MSCI, therefore, utilises alternative data sources, which includes regulatory data, such as has a company had any recalls or fines, as well as data from non-governmental organisations like the World Bank. “More than a third of our ratings are derived from using that third-party data,” Mammadov said.
He added that there is always a methodology behind everything MSCI does. “The way we think about the ratings is: what risks and opportunities is the company exposed to? And what is the company doing in managing those risks?” Mammadov said.
He added that MSCI focuses on six to eight financially material risks for a company, with a weighting for each one of them. “A lot of our clients are smart and don’t take the ratings at face value. What they tend to use is the underlying data. Then they can adjust the weight of the rating on the key issues they think are relevant,” Mammadov said.
Shai Hill added that materiality is important. “If you have a tight materiality framework you are looking at the seven things that are material for that company,” he said.
Mind the gaps
But what is evident is that there are big gaps in the available data. So how can these be filled? For Shai Hill, it comes back to there being transparency issues in the data.
Although, he added: “We have a phrase which is: no disclosure is valuable data. As in, don’t try to fill it with some type of estimate or proxy. Estimates are dangerous.”
And he wondered if asset owners know how much estimated data they are using. “It is a real concern, one the regulator should be concerned about,” Hill said.
Offered to come back on this, Mark Hill from TPR, retorted: “Where do you start?” He noted there is an issue of the professionalisation of trustees, in that they need to have the right tools to look at such issues and say: “That doesn’t look right.”
Comparing matters on a geographical basis, how do corporate disclosures in the UK versus the US and emerging markets shape up? “Europe is leading the way globally in terms of dis- closures on ESG and climate,” Mammadov said.
However, he also said it depends on if you are in developed or emerging markets, with disclosure better in the former. “Compared to Europe – the US, China and Canada lag,” he added. “In China there is an ESG standard, but it is voluntary. And in the US, SEC proposals are still not final.”
Although there can be regional differences on different types of disclosure. “In the US there is good disclosure on governance and business ethics. In other parts of the world there is better disclosure on diversity, but in some markets it is illegal to report that data,” Mammadov added.
The good news is that many emerging markets are looking to adopt frameworks like the Task Force on Climate-related Financial Disclosures (TCFD), which could go a long way in helping to standardise reporting globally.
So how far are we from having a compulsory framework on disclosure? “It is fair to say it is a while off,” Mark Hill said.
But there are positives. He listed a number of initiatives that have paved the way for a possible all-embracing disclosure framework. “The then chancellor in 2021 talked about a disclosure requirement regime, which was reiterated in a revamp of the green finance strategy in March, so the direction of travel in that regard has been set,” he said.
Mark Hill then added: “We have TCFD forming the framework, the Taskforce on Nature-related Financial Disclosures is based on the foundations of TCFD, we also have the Transition Plan Taskforce soon releasing its framework and sector specific guidance due out in early 2024, which includes asset owners and asset managers. We also have the green taxonomy for the UK. “The building blocks are most definitely there to deliver it.”
Mark Hill continued to note other matters that could get in the way – at least in the immediate future. “We have an election coming up, so I don’t think we are going to see anything before 2025 in terms of an integrated, holistic and sustainable disclosure requirement regime.”