The Minefield of ESG Ratings

The Greta Effect

In the last year we have witnessed the Greta Thunberg phenomenon, the Extinction Rebellion global protests and a corresponding rising interest for Environmental, Social and Governance (ESG) related investments from both retail and institutional investors. ESG investments have been offered by most investment managers for several years and are finally migrating out the niche area they once occupied and into the mainstream. For most investors this is a tardive but welcome move to address the planet’s problems. 

To accommodate this trend many fund managers have simply relabelled existing equity and bond funds and slightly modified their investment criteria. The relabelling of existing equity funds many cynics would call ‘greenwashing’ but at least it is a starting point for most asset managers who are dipping their toes in the ESG water. Outside the long-only space and in the world of hedge funds ESG investing remains a minor consideration as the investor base’s primary concerns are uncorrelated returns or alpha.

Arctic Drilling but no Beers Please (especially at the Casino)

A cursory overview of most equity ESG funds, particularly in the US, reveals large-cap and tech-laden portfolios and often including most of the FANGs equities. The inclusion of so much tech is a big contributor to the much lauded recent out-performance of most ESG funds. However, most investors would be somewhat disappointed with the composition of these portfolios and would be expecting equities that are good for the planet or provide some societal benefits. If you were expecting wind-farms, solar panels, electric cars and socially respectable employers then think again. Instead you probably end up with companies that dominate the competition, sell your private data and have battery farms of employees stacking things in boxes for the minimum wage. But on close inspection you have even worse, for example, you have oil companies that are pretending to turn green, aerospace companies that develop smart bomb components to drop on tribal minorities, mining companies that are polluting vast regions but act within self-determined guidelines and high-street retailers that sell Christmas cards made by slave labour in gulags. Bizarrely many of the latter are preferred over companies that run casinos or fabricate tasty beer and liquors that many people enjoy. Apparently, while casinos and cognac are excluded (since they are gambling and alcohol sectors), drilling for oil in the arctic circle is fine provided you have an eco-friendly logo.

How did we end up with such a state of affairs you might ask? Well the problem is ESG criteria are highly subjective and open to different interpretations. Many of the World’s public investable companies have both good points and bad points and determining what is relevant for the ESG case requires analysis, judgement and some human bias. CO2 emissions for a cement manufacturer or most power companies are, although not desirable, not optional since we still need to build and power our houses. Maybe it is illogical to divest from these sectors completely but instead allow other ESG criteria to influence one’s decision such as speed to introduce renewables, equitable personnel policies, ethical governance decisions etc.

Back to the Future with the Agencies

Unfortunately, most investment managers lack the time and expertise to drill down into a company’s ESG fundamentals. Instead they want have a 3rd party ‘rubber stamp’ on their fund’s ESG credentials and easily justify to any investor the choice they have made in selecting particular equities or bonds. This has led to a rise of 3rd party ESG ratings providers which provide ratings to companies in a similar fashion to the well-known credit ratings agencies. Although originally fragmented, the ESG ratings providers have now consolidated into a handful of major brands each with software and data products sold as subscription packages.

Historically, I have a pretty dim view of ratings becoming institutionalised and investor behaviour being controlled by an ‘oligarchy’ of ratings agencies. This is because I spent a large fraction of my career arbitraging agency credit ratings. Investors bought high yielding bonds thorough instruments called Collateralised Debt Obligations (CDOs) that were specifically designed to obtain artificially inflated ratings. The agencies were not exactly non-partisan in these projects and were paid handsomely to authorise and approve these financial products. Eventually, as you know, things went greedily off the rails when US sub-prime mortgages (remember those NINJA – no income, no job, no assets … no problem loans) were crazily allowed exclusively as collateral. Despite the agencies involvement in the Credit Crisis their influence remains (almost) as great as ever but scepticism still runs high amongst the old guard of credit traders and investors. 

Consequently, we should be vigilant over any ESG rating agencies and their future influence and control over the ESG funds sector. Recently I studied the ESG ratings of 3 major providers and I concluded that fortunately, for the moment, it seems there is little to worry about. In my view, near total confusion and chaos reigns over ESG ratings and it remains predominately a ‘brown field’ site. Importantly, there is a lack of general consensus and methodology in ESG ratings. Whereas for credit ratings well established metrics such as leverage, debt/ebitda, cashflow etc. are used and been finely honed over the years, there are no such metrics for ESG. For example, what is more relevant gross or net CO2 emissions (an Environmental factor) or the diversity of the board (a Governance factor)? There is a high level of subjectivity and this is magnified by the problem of reducing a multi-dimensional space of potential ESG variables into one simplified overall ESG rating or ranking factor. One of the ratings providers boasts around 1200 possible ESG variables per company (although most are sparsely populated at present). Distilling this amount of information into a rating that is relevant and meaningful to a particular company, and allows comparisons with other companies, is probably near impossible on any rational basis.

The Disclosure Bias

This lack of consensus is evidenced in the correlation between ratings. For the STOXX 600, which is the equity index comprising 600 of Europe’s leading companies, we find a correlation between ratings of less than 30%. This means they are weakly correlated with many disagreements of opinion between agencies. In addition, we observe strange contradictions since the ESG ratings are mainly based on ESG disclosure of companies. Unfortunately, most of the published disclosure is produced or controlled by the companies themselves. The rating agencies take little or no account of how fundamentally bad a company performs on ESG issues but just the amount of disclosure and how the ESG risks are managed (in theory). Thus, a mining company with a high level of ESG disclosure and flashy public relations can rank close to 100 and an internet company who believes they have no ESG exposure worth noting and thus no disclosure can rank at a lowly 10. There was interesting recent court case between ESG ratings provider ISS and a German image processing company Isra Vision which was rated D- on the basis of lack of disclosure and was (correctly in my view) granted an injunction against ISS. This reliance on disclosure is clearly an absurd state of affairs and at least one agency has taken steps to try and remedy this by recently revising their rating methodology. This is timely since the more one delves into the details and the vague, unscientific and poorly documented methodologies used the more one can cast doubt over the validity of many ratings. 

ESG Investment Strategies

Obviously, one could either ignore these inconsistencies or embrace the diversity of opinion and build your own proprietary ESG rating methodology. Starting from raw ESG data is however difficult and requires dedicated internal resources. Instead, building a composite rating system based on several different ESG rating sources, including other alternative ESG data and adding a sprinkling of common sense, is an efficient and practical alternative. The final goal is obviously how ESG will be used in the investment process. If it is purely based on hard exclusions by ‘outlawed’ sectors (e.g. oil/gas, coal, weapons …) then no ESG ratings are usually required. A ‘soft-exclusion’ method would require industry sector diversification and then allocations based on these composite ratings. Lastly, ESG can be included as an investment signal within a systematic process but this requires extensive historical datasets for analysis and backtesting. There is much published academic work on higher ranking ESG companies or companies with higher ESG ‘momentum’ out-performing, particularly when Governance factors are considered. However, in my experience the highest alpha is derived from the inconsistencies between ratings and ESG ‘event-driven’ signals (e.g. VW emissions scandal, Danske bank money laundering …) which are better served by news-feed analysis than slower moving 3rd party ESG ratings.

Responsible Managers and Curious Investors

Investment managers should be ready to question ESG ratings and how they are derived. If they are only using one 3rd party provider they should delve into the methodology used rather than simply employing them as a rubber stamp. Engagement with ESG ratings agencies will eventually provide rankings that are more meaningful and meet with investor expectations. Equally, the investors themselves should question how ratings are used in the investment process. Are they looking for a passive ESG portfolio that is screened merely on the basis of rating or are they looking for portfolios that have ‘impact’ and are genuinely compatible with their individual beliefs and ethics?

An opinion by Dr. Richard D. Bateson of Bateson Asset Management Limited.