How useful are ESG fund ratings?
ESG fund ratings are an oft-used tool for impact investing, but lack of standardised data means other analysis is necessary. James Phillips explores their usefulness.
These rating systems assess each individual company and funds for their ESG exposure and performance, providing quantitative analysis of companies' efforts.
Yet, with ESG reporting in its infancy, regional requirements differing starkly, and this research focused on larger companies, it may not be so straightforward.
To truly reduce ESG risk exposure, those overseeing funds may need to do their own research and engage with companies to properly inform their decision-making.
The problem with ESG fund ratings is primarily that they are fairly new - and are therefore prone to criticism that they are not detailed enough, are missing information, or are failing to analyse certain aspects of companies.
These are certainly the thoughts of Kames Capital sustainable investment analyst Georgina Laird, who argues the ratings over simplify company performance and reporting.
Instead, she believes there is a need for greater standardisation globally of these ratings, which would allow for a more detailed analysis.
"Standardisation would support a more qualitative approach, but the need for a qualitative assessment would still hold true," she argues, adding that oversight of this could come from the Sustainability Accounting Standards Board.
"No two companies are exactly the same, and it's important to remember that a number of quantitative data points are often un-audited."
The weight of quantitative data in fund ratings means real world examples of poor performance or impact are missed, and a lack of standardisation and/or verification makes comparisons difficult.
However, it is not always the case that this data is missing. Morningstar director of ESG solutions Tanya Svidler explains how the rating agency builds in controversies, for example, into its overall GLOBE rating.
"We combine Sustainalytics' company-level ESG information with holdings information that companies report to us," she says."The sustainability rating is quite intuitive and is looking at how well portfolio companies address their long-term material ESG risks.
"The rating is a peer group comparison, and includes a penalty for controversies such as the Volkswagen emissions scandal, Equifax data breach and BP and Deepwater Horizon - events that have strong potential to damage financial performance.
"The overall score equals the [company-level] ESG score minus the controversies."
She adds that Morningstar takes a risk-focused approach, despite there being"multiple dimensions", as this"resonates with the majority of the investment community".
Yet, analysis based largely on reporting standards becomes somewhat murkier when the take-up of such reporting is limited.
Some reporting methods are not just unaudited but also voluntary, making this task much harder. Indeed, speaking at the Pensions and Lifetime Savings Association (PLSA) conference last month, ShareAction chief executive Catherine Howarth highlighted how companies were particularly lacking on workforce management disclosures.
"The way companies manage people is an extremely important indicator of whether they are a good firm and good investment," she said at the time."The reporting is quite variable and quite poor on the whole.
"There are a few companies that are good [but] the vast majority of publically-listed companies all over the world do a poor job on this."
Nevertheless, the ratings are a central source of sustainability and governance data, and so to ignore them completely would remove the simplest line of analysis.
For this reason, Laird agrees it would not be right to completely remove the ratings from investment decision-making; it is important to undertake additional analysis.
"Until sustainability reporting matures, this appears to be the only way to assess companies fairly," she says.
"But, smaller companies tend to have poorer preparedness and disclosure, mainly due to lack of resource, making them harder to assess and often resulting in a poorer score. It's not always the case that these companies are ‘less sustainable'; the only way to ascertain their sustainability is via a qualitative approach and engaging with the company."
There is consensus these fund ratings should not be used by themselves. Indeed, Morningstar agrees this should not be the case, as investors have varying financial views.
Svidler argues the ratings are not designed to provide the whole picture, as that might involve pushing a firm's own views onto clients. That is why its analysis focuses on risk.
"How well does a portfolio company address material risks?" she says."We need to identify those companies that better manage those risks relative to their industry peers.
"When assessing carbon risk, for example, the objective is to assess which companies are doing a better job at transitioning from the traditional model," she adds.
"When we think of ‘business involvement', which is the industry term that refers to involvement in specific unethical products such as alcohol, tobacco, gambling, etc, that is a separate dimension of sustainability."
For this reason, investors should undertake their own additional analysis to build in their own beliefs into their investment decisions.
"Instead of pushing everything into a sustainability rating, we have launched a separate tool to help investors screen companies," Svidler continues.
Indeed, that is how Kempen Capital Management approaches the issues. Its chief investment officer Lars Dijkstra explains the investment manager uses MSCI's ESG rankings, but only as a starting point.
This includes talking to clients about their investment philosophy, to ensure certain investments are excluded if the client so wishes. He adds the ratings are useful to investors as they"are familiar to them because they are used to credit ratings".
"Having said that, we are of the opinion we might take an official decision," he says."We use them as an input and then do our own research and then we make a decision.
"We all know how good the credit ratings were during the crisis, which was terrible. The warning here is, if 50 years' credit ratings ended up not being useful when you needed them, let's be careful with ESG ratings."
Yet an imperfect product can be improved, so how can this be done?
Laird believes the ratings need to focus on output, not solely on operations, while small companies need to be brought into the fold better.
"This is one of the reasons that we do not encourage use of the ratings in isolation; the products a company makes, their societal and environmental effects should be considered when assessing the overall sustainability of a company," she says.
"With small-cap companies and emerging market countries, disclosure and preparedness can be poorer, making them more difficult to assess, yet empirical evidence suggests thinking sustainability and considering ESG can add most value when investing in emerging markets."
ESG ratings may not be perfect, and so it is important individual investors or their consultants undertake additional analysis to get a broader picture.
But at the same time, they are not useless and can provide a helpful starting point for responsible investment.