Stockholm (NordSIP) – As ESG factors continue to rise in popularity, the task now facing sustainable asset managers is how to sort the wheat from the chaff. To this effect, ESG ratings have proved to be a popular, albeit not uncontroversial, short-cut. Some worry that instead of fighting greenwashing, ESG ratings may instead accidentally facilitate it.
The foremost issue that is raised against ESG ratings remains their subjectivity and the inherent lack of cross-rating agency correlation, which contrasts with the reality of credit ratings. Methodological quirks can also confuse investors who watch transformational companies such as Tesla receive a similar ESG rating as British American Tobacco (BAT). Tesla is a prominent example of a company contributing to the green transition, but its successes are often tarnished by its controversies and the result can be counterintuitive decisions by ESG gate-keepers. BAT is just a prominent example. There are others like it.
In a recent note, Flora Wang, Director of Sustainable Investing, and Jenn-Hui Tan, Global Head of Stewardship and Sustainable Investing, at Fidelity International attempt to deconstruct this issue. Using the decision to drop Tesla from the S&P 500 ESG index in May 2022 as a motivating example, they argue that perhaps the right way forward would be to follow a two-pronged path.
Two ESG Ratings
Inspired by Tesla board member Hiromichi Mizuno’s criticism that rating providers often give too much weight to negative impacts and not enough to positive ones, the sustainability specialists argue in favour of multiple ratings. “At a minimum, there need to be two distinct ratings: one to reflect a company’s positive impact and another its negative externalities. Attempting to capture both in one score dilutes the informational value of the final rating – as the positives and negatives inevitably cancel each other out, resulting in a rating that fails to represent either and can’t be relied upon to guide capital allocation decisions,” Wang and Tan say.
Desagregating ESG Scores
Another issue that the authors highlight is that combining E, S and G scores into a headline rating, assigning a weight to each pillar and averaging them out can be misleading. Although the methodology is good for extremely high or low performers, the aggregate score does not do justice to the majority in the middle of the distribution.
“For most companies that fall in the middle, however, the headline ESG rating could be misleading. A company with poor ‘E’ practices could still be included in an ESG fund if its environmental score is sufficiently smoothed by an above-average performance on social and governance goals. This explains why fossil fuel companies with little interest in the energy transition may score unexpectedly highly on ESG, even as a company like Tesla falls down the rankings, and why investors need to pay close attention to ESG fund holdings,” Wang and Tan add.
Relative or Absolute Scores?
The authors also remind investors of the importance of the scoring methodology and whether companies are scored on a relative or absolute basis. “Relative scoring is essentially a ranking within an often questionable ‘peer group’ rather than a true assessment of sustainability. It can lead to a company that performs poorly on ESG on an absolute basis getting a top rating because its peers are doing even worse,” they add.
“At a portfolio level, such an approach can be meaningless. A portfolio of best-in-class coal mining companies, for example, judged by relative ratings, could appear better on ESG than one with an average range of finance companies,” Wang and Tan continue.
A Journey, Not a Destination
Ultimately, the authors argue that experienced analysis of the data is required. “To get a complete picture requires a deeper type of company-specific analysis. This is not always possible for ESG analysts who run the quant models and apply the overlays, as they generally lack the depth of knowledge required to make sense of the ESG data in the context of a company’s business,” they say.
“Over time, we expect to see further standardisation and more complementary use of different rating types, though qualitative insights will remain essential. Integrating ESG into the investment process isn’t so much a destination as a journey – one that gets better as more people undertake it” Wang and Tan conclude.
