While environmental, social, and governance (ESG) scores are valuable insights into an investment portfolio’s level of sustainability, the investors, asset managers and index providers who use them have to be careful about relying solely on these data.
The reason is there is a growing consensus in the investment and academic community, including in international organizations such as the Organization for Economic Cooperation and Development and World Wildlife Fund, that while the ESG score-based approach to responsible investing serves the commercial interests of rating providers, these ESG scores are not able to guide investors concerned about social welfare and environmental sustainability. A couple of recent studies strengthens this argument.
A recent paper published by data provider Scientific Beta, written by the its ESG and low carbon investment specialist Erik Christiansen and ESG director Frédéric Ducoulombier, underscores the danger of using average overall scores at the portfolio level, whether for investment or reporting decisions.
“In very concrete terms, the “E” dimension promoted by global ESG scores leads to decisions that may favour companies that have a considerable impact on greenhouse gas emissions," say Christiansen and Ducoulombier in their study. "More generally, the lack of consistency between the “E” score and the climate dimension favors greenwashing."
Scientific Beta highlights the additional concerns linked to averaging ESG scores across a portfolio and using such an average as a goal or constraint in portfolio construction. Portfolio optimizations based on average ESG scores magnify the estimation errors of individual ESG scores.
Richard Butters, ESG analyst at Aviva Investors, echoes the same argument saying that while the market now views ESG as an enhancer of returns, it is important to remember that not all ESG metrics are created equal. Aviva has its own proprietary ESG scoring system, but it also uses external ESG scores from third-party providers.
“Some are top-level summary ratings, while others are topic specific,” Butters explains. “Furthermore, each rating provider uses a different methodology, which results in a low correlation between ratings that supposedly measure the same thing. For instance, some firms may be labelled ESG leaders by one provider, but average by another.”
Butters further argues that compared to traditional financial reporting, ESG disclosure is not as deep, nor is it consistent between companies. Financial statements often only provide 20% to 30% of the ESG metrics investors may want to track for a particular industry.
Also, it is generally acknowledged that there is a documented lack of convergence of ESG scores across different providers. This divergence is due not only to differing objectives, definitions, methodologies and data, but also to the inherent subjectivity of assessment.
The good news is that the quality and availability of data are improving, with companies now including metrics, targets, descriptions of progress, and key performance indicators.
“Encouragingly, ESG reporting standards are beginning to converge, which should provide greater clarity for reporting companies and investors,” Butters notes.
To use ESG scores effectively, Butters argues that investors and asset managers have to use an external score consistently so that it helps their research teams develop a deeper understanding of the methodology and its limitations.
“ESG ratings do not always impact a credit rating directly, but understanding ESG risks and opportunities help credit analysts form a holistic view of a company,” Butters states.
Another important aspect of using ESG scores is to look at the momentum of a company’s ESG practices, in contrast with the backward-looking snapshots external scores provide.
“When an ESG analyst does a full assessment of a company, they will assign a point-in-time opinion (positive, neutral or negative) and a trend opinion, whether it is improving, stable or deteriorating,” Butters points out. “Some may also incorporate a rate-of-change perspective. This allows portfolio managers to not only hold strong ESG performers, but also those with a strong improving trend that they may want to ride over time.”
Another key element that can be useful with ESG scores is finding discrepancies and probing the areas or firms where ESG views differ between scoring systems.
“Assessing ESG credentials is more complex than simply avoiding companies with poor scores,” Butters explains. “For active managers that take their stewardship and engagement responsibilities seriously, there is some rationale in having exposure to underperformers, where they can use their influence to improve ESG practices.”