Demand for ratings on corporate ESG performance is rising, but how do you fit so many factors into a single score?
Investors like numbers. They let them see things more clearly and help them to make decisions on whether to buy or sell a particular asset.
“There is an inherent attractiveness in boiling something down to a number or rating, so as to provide a signalling mechanism,” says Lloyd McAllister, a responsible investment analyst at Newton Investment Management.
Yet times are changing and so are the type of numbers investors are demanding. “The investment industry is in the middle of a tidal wave of change in that there is a demand for integrating sustainability into all investment portfolios,” says Mark Lewis, global head of sustainability research at BNP Paribas Asset Management.
The non-financial aspects of a company are becoming just as, if not more, important as what’s written in its latest financial results. Factoring environmental, social and governance (ESG) aspects into investment decisions is no longer considered niche as long-term investors look for sustainable and, therefore, better-behaved companies. And for good reason.
Not only are the causes of floods in Britain and bushfires in Australia being labelled “man-made”, but it would have been difficult to spot the upcoming scandal at Facebook by simply looking at its profit and loss account or credit rating.
A range of organisations are rating companies on the strength of their ESG credentials, from data providers to index compilers, consultants and even asset managers. “Constructing frameworks for ESG is important for investors’ to have clarity on how to incorporate issues, such as climate change, into their mandates,” says Margaret Childe, director, ESG research and integration at Manulife Investment Management.
“If we go back 10 years, the focus for reporting would have been on sophisticated financial instruments, such as derivatives,” Childe adds. “A huge shift has taken place. ESG is now in the spotlight and we need to pay attention.”
The question is, how do you turn a company’s harmful gas emissions, water usage and how it treats its staff into a nice, neat number. “It is difficult to accurately reflect the sustainability profile of a company in a simple score. It is not an exact science,” says Masja Zandbergen, head of ESG integration at Robeco.
With ESG being such a broad church, it’s best not to treat these ratings as an all-encompassing assessment of a company’s sustainability profile. They measure a certain aspect, be it the quality of disclosure or the level of harmful gas emissions. Then you need to understand how that rating is constructed and if the methodology behind it aligns with what you are trying to achieve.
“It is important to look under the bonnet,” says Tim Manuel, head of UK responsible investment at Aon. “You have to take the output [the rating] with a pinch of salt, or with an awareness of the limitations that you are looking at.”
Don’t forget the fundamentals
Lewis warns against seeing these ratings as an accurate reflection of a company’s ESG profile. “It is not simply taking the numbers and the ratings you get from third-party data providers at face value.”
Research published by academia and the financial services industry shows that companies with greater ESG credentials generate higher risk-adjusted returns over the long term, but perhaps it is not the best strategy to blindly pile into companies with high ESG scores.
“The danger with investing in companies with the highest ESG ratings is that you can overpay for an expensive stock that has a green premium or a halo,” McAllister says. “This approach is more effective when the market has yet to appreciate a best-inclass company, thus making it a good time for us to invest.”
A popular strategy appears to be looking for companies with an improving ESG score that could positively impact its future financial performance. “Recognising that there are many different investment approaches, it won’t always pay to focus on companies with a high ESG rating,” Childe says. “If you have a value-driven, fundamental equity approach, maybe you should look at companies that could benefit from positive ESG momentum.”
So investors should not forget the basics when using ESG ratings to pick stocks. “There are many assessment strategies you can take with ESG,” McAllister says. “For us valuation is key, but to make sense of that within the context of ESG issues, the fundamentals, the macro-economic picture and the thematic long-term drivers of the economy all need to be considered too.”
Newton does not use ESG ratings as a trading signal, rather, they are part of its wider research process. “We don’t use them to give us the definitive answer, we treat them as providing material information that we deconstruct to understand how we could apply it within our own investment process,” McAllister says.
This pro-active approach is shared by Robeco. “Ratings are important, but they are a starting point,” Zandbergen says. “We apply our own view through a fundamental analysis based on the information behind the rating and remove size and sector biases.”
One issue to consider is that ratings tend to focus on larger, multi-national companies. “There is an inherent bias in the ratings because larger companies are typically better resourced to respond to the questionnaires and the disclosure requests,” McAllister says.
A lot of the issues being measured here, such as equality and climate change, are global issues, which may be another reason why such analysis typically focuses on larger businesses.
The starting point to selecting a ratings provider is to decide what you want to measure. Are you interested in the impact ESG has on valuations? Or, the impact a company has on the planet.
It appears that taking an individual approach could be the best option, as using a rating that combines several factors may not work. “This can make it generic and meaningless, because different variations produce different outcomes,” McAllister says. With so many different metrics being considered and by so many providers, it is no surprise that you get different viewpoints.
But low correlation of opinion is also evident when assessing companies on mainstream issues. McAllister points to there being 100 years’ worth of accounting standards, auditing and infrastructure on the traditional financial metrics, but you still end up with broadly half of the analysts saying “sell” and half saying “buy”. “There are long-term and complex sets of issues to analyse in ESG, so it should come as no surprise that there can be a wide variety of views on the same company,” he adds.
It appears that the differences in this area run a lot deeper. “Low correlation not only comes from rating companies looking at different issues, there is no consensus on which metrics to use to measure performance on the different topics,” Zandbergen says.
So there are many issues to consider when employing such scores in your research. “If you run data from one provider on a company’s ESG profile, you will get a different picture from running another provider’s data,” Manuel says.
“You can’t just pick one off the shelf believing that rating systems A, B and C are pretty much the same, because they are very different.” This could be where additional expertise might be useful. “This is where an active manager may have an advantage in that they can unpack the ESG rating or score and focus on what is material to their investment decision-making process,” Childe says.
Aware of the awareness
Putting an ESG score on companies is not a new initiative. The SAM ratings that Robeco use were originally developed by RobecoSAM more than 20 years ago. Their creation was a response to a general absence of ESG data, and over time they filled in the gap left by the lack of focus on financially-material sustainability issues in subsequently launched ESG data sets.
“We want to be sure that we are focused on the ESG topics that are financially relevant,” Zandbergen says. Also setting its own scores is Aon, although its ESG ratings are for fund managers. They assess a manager’s awareness of ESG risk and how well they factor that into building portfolios.
The system is simple. Managers with low awareness are giving a 1 rating and those with high awareness are awarded a 4 rating. The firm has 100 people across the world spotting the most suitable managers for its clients’ needs.
“Our ESG ratings process is an extension of that broader research process,” Manuel says, who describes assessing the capabilities of fund managers as the firm’s “bread and butter”.
“We want to see ESG considerations feature throughout what a manager does, from their investment philosophy, to their process, to the way they incentivise their people, to the way they assess risk and demonstrating that through to the portfolios that they build.
“Our ESG ratings are an assessment of process,” Manuel adds. Significant revisions to ratings are usually made annually, when companies typically disclose information about their operations. There are also quarterly tweaks based on newsflow, such as a scandal, but the main changes are made annually.
“Quant investors find ESG the slowest-moving dataset in the world,” McAllister says, adding that resilience is a characteristic that sustainability-focused investors need because it is difficult to accurately reflect the sustainability profile of a company in a simple score. It is not an exact science.
Means driving positive change through voting and engagement. often deals with long-term criteria, such as climate change. “It is a slower-moving beast,” he adds. Give us more Of course, these ratings benefit from companies releasing updates on the non-financial performance of their business, but this is still in its infancy.
Corporate disclosure on ESG issues is “getting better”, according to McAllister. The main areas where disclosure remains an issue is in emerging markets and small and mid-sized companies. Employee and client satisfaction are metrics that, McAllister believes, have been correlated with future performance.
“These are the areas that I look for, but often find lacking,” he says. Understanding what senior management are incentivised by is also of interest. Other areas that need improvement include environmental disclosure.
There is criticism that this is backward looking, rather than stating what the future environmental-linked risks to the business are. So access to suitable data is an issue when setting ESG ratings. “The underlying data is extremely sporadic and of low quality,” Manuel says. “That means that company level ESG rating systems rely a lot on estimations and extrapolations. “So there is a low correlation between company-level ESG ratings that are applied by different providers,” he adds.
“The methodologies are so substantially different because they trying to get around these data challenges in different ways.” It could take pressure from shareholders to change how companies report information. “My guess is that we will end up with a two-pronged approach, one for financial reporting and one for ESG reporting,” Childe says. Early days ESG ratings are predominately a gauge of risk and it appears that when it comes to assessing opportunity there is a lot of work to do.
McAllister says that assessing opportunities in ESG is usually based on simple statistics, which is a problem. He gives an example of an agency rating an emerging- market bank’s ESG opportunity as ‘high’, because a large proportion of the population are unbanked.
Opening an account would enable them to manage their finances better. “What the rating will not say,” he adds, “is how much competition the bank has, how much pricing power it has, what regulatory issues it faces and, crucially, is growth already priced in?
“That is a good example of a blunt assessment of opportunity expressed via an ESG rating, which highlights where the ‘buy side’ has to do a lot of work,” he adds. Childe adds that risks and opportunities in ESG ratings should be treated as “two sides of the same coin” when integrating sustainability factors into your investment decision-making.
Manuel concludes by referencing research that Aon released that highlights why ESG is important, not just for the planet and society, but for those looking to make a return, too. “One of the most important findings for me is that companies who are getting better at ESG are the ones who are showing some of the best financial performance.”