Hope you are doing well and staying safe. Welcome back to our brief thoughts on ESG. This week, I want to share some insights into what are the limitations and criticisms of ESG investing and ratings?
First, are ESG branded investors truly committed to ESG?
Not always, but the brand does seem to provide benefits.
A recent paper from Soohun Kim and Aaron Yoon showed that in the US funds (only active funds were analyzed) which became signatories of the UN’s PRI saw more than a 4% increase in flows into the fund per quarter (looking at six quarters before/after signing) regardless of the fund-level ESG score before they became signatories. However, the same study found that after signing, there are no improvements in the portfolio’s ESG scores and signatories become less likely to vote on environmental issues (looking at proxy materials). This means the behavior of the signatories analyzed in this paper was not positively influenced from committing to these investment principles, while they did enjoy financial benefits from signing.
Second, are ESG ratings precise?
Not really. And they aren’t homogeneous either (so rating interpretation is very important for investors who want to integrate ESG factors into their investment process).
A few days ago, the Financial Times reported the SEC’s Chairman warned against integrating separate ESG metrics into a single ESG rating.
“I have not seen circumstances where combining an analysis of E, S and G together, across a broad range of companies, for example with a ‘rating’ or ‘score’, particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise.”
We have discussed in the past how the ESG universe is pretty vast, ESG rating agencies all have different biases (some towards E issues, some towards S issues, some towards G issues), and therefore ratings are not necessarily transparent if you don’t fully understand what is behind them. A company can have a high rating with one agency (say Sustainalytics) and a low rating with another agency (say MSCI). It therefore is very relevant that whoever becomes a user of the ratings data is aware of the underlying data, and how it is weighted, and how that aligns to its investment objectives.
Third, KPIs are still not consistent
To make this even more complex, companies are just now starting to get used to reporting sustainability key performance indicators. Some are more advanced in this process than others, but as this topic evolves, companies have had to adjust and come up with ways to source new data. This means that even if the ratings were all homogeneous and the rating users knew perfectly well what is behind those ratings, if data is faulty the output will be faulty too.
In mid-May the SEC’s Investor Advisory Committee’s recommended that the SEC establishes ESG disclosure requirements more broadly. The idea behind this is that as disclosure is normalized, data will become more standardized, and ratings will also become more consistent.
In a nutshell, ESG data and ESG ratings are not perfect. Investors who claim to follow responsible investing principles may not always be as committed to ESG as they should. But we believe this isn’t entirely surprising given ESG is just now coming of age globally. Over the next few years, as focus on ESG grows (and we think it will), companies will be pressured into providing more and better data, rating providers will be pressured into fine tuning its methodologies (or at least making them more transparent), and investors will be pressured into putting their money where their mouth is. Greenwashing will probably always exist, but backlash from doing it is likely to increase.
I hope you found this useful. As usual, if there is anything we can help you with, please reach out.
Partner, Miranda ESG
This week’s recommended reading
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