ESG ratings
Investors like numbers. They let them see things more clearly and help them to make decisions on whether to buy or sell a particular asset.
“There is an inherent attractiveness in boiling something down to a number or rating, so as to provide a signalling mecha- nism,” says Lloyd McAllister, a responsible investment analyst at Newton Investment Management. Yet times are changing and so are the type of numbers inves- tors are demanding.
“The investment industry is in the middle of a tidal wave of change in that there is a demand for integrating sustainability into all investment portfolios,” says Mark Lewis, global head of sustainability research at BNP Paribas Asset Management. The non-financial aspects of a company are becoming just as, if not more, important as what’s written in its latest financial results. Factoring environmental, social and governance (ESG) aspects into investment decisions is no longer considered niche as long-term investors look for sustainable and, there- fore, better-behaved companies. And for good reason. Not only are the causes of floods in Britain and bushfires in Australia being labelled “man-made”, but it would have been difficult to spot the upcoming scandal at Facebook by simply looking at its profit and loss account or credit rating. A range of organisations are rating companies on the strength of their ESG credentials, from data providers to index compil- ers, consultants and even asset managers. “Constructing frameworks for ESG is important for investors’ to have clarity on how to incorporate issues, such as climate change, into their mandates,” says Margaret Childe, director, ESG research and integration at Manulife Investment Management. “If we go back 10 years, the focus for reporting would have been on sophisticated financial instruments, such as deriva- tives,” Childe adds. “A huge shift has taken place. ESG is now in the spotlight and we need to pay attention.” The question is, how do you turn a company’s harmful gas emissions, water usage and how it treats its staff into a nice, neat number.
“It is difficult to accurately reflect the sustainability profile of a company in a simple score. It is not an exact science,” says Masja Zandbergen, head of ESG integration at Robeco. With ESG being such a broad church, it’s best not to treat these ratings as an all-encompassing assessment of a company’s sus- tainability profile. They measure a certain aspect, be it the qual- ity of disclosure or the level of harmful gas emissions. Then you need to understand how that rating is constructed and if the methodology behind it aligns with what you are trying to achieve.
“It is important to look under the bonnet,” says Tim Manuel, head of UK responsible investment at Aon. “You have to take the output [the rating] with a pinch of salt, or with an aware-
ness of the limitations that you are looking at.” Don’t forget the fundamentals
Lewis warns against seeing these ratings as an accurate reflec- tion of a company’s ESG profile. “It is not simply taking the numbers and the ratings you get from third-party data provid- ers at face value.” Research published by academia and the financial services industry shows that companies with greater ESG credentials generate higher risk-adjusted returns over the long term, but perhaps it is not the best strategy to blindly pile into companies with high ESG scores. “The danger with investing in companies with the highest ESG ratings is that you can overpay for an expensive stock that has a green premium or a halo,” McAllister says. “This approach is more effective when the market has yet to appreciate a best-in- class company, thus making it a good time for us to invest.” A popular strategy appears to be looking for companies with an improving ESG score that could positively impact its future financial performance. “Recognising that there are many different investment approaches, it won’t always pay to focus on companies with a high ESG rating,” Childe says. “If you have a value-driven, fun- damental equity approach, maybe you should look at compa- nies that could benefit from positive ESG momentum.” So investors should not forget the basics when using ESG rat- ings to pick stocks. “There are many assessment strategies you can take with ESG,” McAllister says. “For us valuation is key, but to make sense of that within the context of ESG issues, the fundamentals, the macro-economic picture and the thematic long-term drivers of the economy all need to be considered too.” Newton does not use ESG ratings as a trading signal, rather, they are part of its wider research process. “We don’t use them to give us the definitive answer, we treat them as providing material information that we deconstruct to understand how we could apply it within our own investment process,” McAllis- ter says.
This pro-active approach is shared by Robeco. “Ratings are important, but they are a starting point,” Zandbergen says. “We apply our own view through a fundamental analysis based on the information behind the rating and remove size and sec- tor biases.”
One issue to consider is that ratings tend to focus on larger, multi-national companies. “There is an inherent bias in the ratings because larger companies are typically better resourced to respond to the questionnaires and the disclosure requests,” McAllister says.
A lot of the issues being measured here, such as equality and climate change, are global issues, which may be another rea-
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