ESG rating: solution or starting point?

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By Michelle Dunstan, Chief Accountability Officer; Senior Investment Advisor — Global ESG Improvement Strategy

Environmental, social and governance (ESG) ratings are a popular way to find companies that meet specific criteria in a responsible investment program. But third-party reviews don’t tell the whole story for investors seeking a comprehensive view of how ESG issues affect return potential or how companies can improve their ESG performance going forward.

Creating a rating system can help bring rigor and precision to investment analysis for asset managers across the industry. But the apparent authority of third-party ESG scores can mask their limitations. We believe that third-party ESG services (such as climate data and portfolio-level ESG calculation tools) can be used as part of an investment toolkit, knowing that even as providers continue to refine their modeling and to ingest more data, their notations remain imperfect and provide only a partial solution.

In our view, there is no substitute for integrating the consideration of ESG factors into the fundamental analysis of securities. Rather than outsourcing ESG assessments to third-party providers, investors and analysts should conduct thorough, hands-on research and actively engage with issuers. This approach allows investors to have a real knowledge of a company and its activities, and to have a good understanding of its future prospects as well as its past.

Third-party ESG ratings

Issues with third-party ratings

Today, third-party ESG ratings represent a static look in the rear-view mirror: they do not reflect a company’s potential for improvement or its vulnerability to possible future risks. These ratings are based in part on self-reported non-financial information, so the scores are based on what a company says, rather than what it does. They also rely heavily on automated tools that extract data from websites (“web scraping”). This information may not be entirely reliable, or may even have been inserted by companies with keywords easily recognizable by search robots.

Additionally, larger companies that can afford to collect and translate all the data needed to earn a rating tend to get higher scores. And in emerging debt markets, where many companies are private, data transparency can be significantly lower than that of public companies, and coverage by ESG data providers often does not exist.

Fundamentally, corporate ESG ratings do not necessarily measure a company’s impact on the earth and society. Rather, some simply assess how well a company manages current ESG risks and opportunities in terms of impact on its bottom line. This scoring approach focuses on whether a company is protecting its finances, rather than taking substantial steps to create a greener and better world. (In contrast, ESG data points such as carbon metrics are already governed by independent standards like those of the Task Force on Climate-Related Financial Disclosures.)

Rating service coverage varies by asset class, criteria, rigor and output. There are no current industry or regulatory body standards for algorithms, metrics, data sources, or results. Each provider effectively has their own black box that boils massive amounts of data into a single assessment per company. The result? ESG ratings can vary hugely between providers: while the positive correlation for credit ratings is high at 0.9, correlations for ESG ratings are below 0.5.

Regulatory oversight of ESG data and ratings could be on the horizon, starting with Europe. Eurosif is study the role of ESG ratings and data providers in view of future regulation – tacit recognition of current shortcomings. European authorities are concerned because many small investors and passive portfolio managers rely on these ratings for their ESG vision.

We believe that third-party ESG ratings are a starting point for research into existing material issues that they uncover. Greater transparency of data and scores would help vendors improve their product. For example, reporting scores for each of the three ESG segments would give investors better insights than a single ESG score.

ESG assessments must be forward-looking

The limitations of retrospective ESG ratings have become clearer recently. The COVID-19 pandemic has raised pressing questions about business preparedness: were they prepared for the unexpected, able to adapt to deliver sustainable growth, and committed to caring for their employees and clients ? These are ESG issues, but they are also financial issues.

Think about climate change. Governments have committed to a low-carbon future, which will have far-reaching impacts: it is essential to understand how future carbon taxes or low-carbon alternatives will impact each portfolio investment.

By its nature, ESG assessment requires a forward-looking approach that static measures may miss. What is an accepted practice today may be considered unacceptable tomorrow, as rules, regulations and popular opinion continue to evolve.

ESG integration generates feedback

In a rapidly changing world, capturing ESG benefits and identifying risks requires an integrated approach. We believe that proprietary research and industry knowledge is the source of alpha in investment portfolios. Likewise, we believe that ESG opinions should not be outsourced to third-party providers, as these are also a key driver of risk-adjusted returns. Our portfolio managers and fundamental analysts, who are specialists in their areas of coverage, work in conjunction with responsible investment specialists to properly assess material ESG risks and opportunities in light of the company and sector concerned. .

Many ESG issues are current or future risks that historically have not been appreciated by the market. Yet behind every high-profile corporate scandal lies a catastrophic failure to understand and manage E, S, or G risks. By fully integrating ESG issues into an investment process, investors can recognize risks before they commit. make an investment and while maintaining this position. This approach also helps investors identify sources of return potential among ESG leaders, for example, companies offering solutions to environmental challenges.

Engagement is key to ESG assessments

Third-party ESG data and ratings are not a substitute for independent fieldwork to develop a complete picture of corporate behavior. This requires engagement with management, touring facilities, and understanding the ecosystem in which a business operates.

It also requires sufficient analyst coverage and the ability to do comprehensive fundamental homework and validate data. General assumptions about industries, countries, and risks can lead to suboptimal conclusions, misunderstood risks, or missed opportunities. Investors who rely solely on third-party ESG data and ratings forfeit the opportunity to drive change and overlook one of the key levers for improving business performance: commitment to action.

Companies that are behind the ESG curve but are striving to improve may present profitable opportunities, even if surface-level scores may be below average. We’ve seen companies with poor environmental ratings make a concerted effort to switch to more environmentally friendly equipment. Such improvements often lead to higher ratings that drive up the stock price, providing returns for investors who spot the trend early. Investing in and engaging with improvers can also lead to some of the greatest ESG benefits, for example reducing carbon emissions.

ESG integration and engagement

Rigorous ESG assessments are too complex to be represented by a single score. Asset managers who are responsible stewards of clients’ capital have a fiduciary duty to encourage companies to improve their business operations and practices. While a third-party rating can be helpful in starting a conversation with company management, it takes persistent commitment backed by thorough research to create the conditions for a positive outcome.

The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the views of all of AB’s portfolio management teams and are subject to revision over time.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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