CPD: Don’t be fooled by most ESG rankings – focus on materiality instead

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One of the major criticisms with the current state of ESG data is the focus on backward-looking information.

Are ESG investors being fooled?

The Wall Street Journal recently ran an article about how big technology stocks dominate ESG funds. Tech companies are not usually associated with the big ESG issues like climate change, renewable energy, or diversity. So, are financial advisers and investors being fooled?

Let’s consider whether the ESG investor is still concerned about investment performance. For most of the ones we may talk to as a fund manager, the answer is yes. Big tech names dominate the market: Apple, Microsoft, Amazon, Facebook and Alphabet are five of the largest companies in the S&P 500, so not holding big tech will impact your investment return versus the broad market. And ESG funds are (understandably) judged against how they perform versus the market as a whole.

Given reluctance to sacrifice investment performance for ESG, it is not surprising that ESG funds can, at first blush, look like any other fund. Advisers and investors need to dig deeper and identify what really matters when reviewing ESG funds, including some of the following elements. Which tech names do they hold? And why did they hold them? Were tech companies selected just because they happen to be low carbon emitters? As advisers and investors Is this how we think a tech company should be judged? Or did they score well on some ESG rating methodology with a few hundred inputs? Rather than adopt a one-size-fits all approach, it pays to look at the small number of sustainability issues that have the biggest impact for that company.

When it comes to measuring ESG impact, Russell Investments and many others believe that materiality matters.  As an adviser, this paper provides an overview of what you may want to look for when reviewing funds and companies for their ESG score as well as providing three case studies/examples of how this can be applied when reviewing listed securities and or funds.

Not all ESG issues matter equally

The relevance of ESG issues varies industry to industry, company by company. For example, fuel efficiency has a bigger impact on both the carbon footprint and the bottom line of an airline than it does for an investment bank. If a bank says it has reduced fuel consumption by 50%, ESG investors should not hold their breath waiting for the bank’s share price to go up. If an airline makes the same claim, ESG investors should pay attention. Rather than looking at the same issues for every single company, Russell Investments and others have developed an ESG scoring methodology that is truly material to companies.

Why? Often, traditional ESG scores are composed of a large number of issues that are not material for every industry or company, including large tech companies. As an example, for two–thirds of all securities in the Russell Global Large Cap Index universe, less than 25% of the data items in the traditional score are considered material.

When Russell Investments first launched their materiality score in 2017, they leveraged the ESG data from the data provider Sustainalytics alongside the industry–level materiality map developed by the Sustainability Accounting Standards Board (SASB). They found that this new combined score helped to serve as a keen ESG signal for investment decision–making. But even then, Russell Investments knew they could make that score more relevant for the needs of advisers and their investors whilst also being specific and relevant to the company being reviewed.

How material ESG scores have evolved

Russell Investments have enhanced their material ESG scores to ensure advisers and investors are even more informed. For example, they have overhauled their methodology from their data provider, Sustainalytics, and an updated Materiality Map from SASB. These data changes presented an opportunity to incorporate several methodology upgrades which includes:

  • The addition of a corporate governance score for all companies
  • The use of open-sourced environmental data from multiple providers
  • More emphasis on forward-looking information where available

Incorporation of a corporate governance score

Russell Investments found their original materiality score based on the SASB framework lacked some corporate governance information that they believed mattered. Their solution was to supplement the SASB framework with an additional pillar of corporate governance for all companies.

For the governance metric, Russell Investments employed a comprehensive corporate governance assessment from Sustainalytics. The new metric more closely aligns to Russell Investment’s proxy voting practices, including an assessment of:

  • Board and management quality and integrity
  • Board structure (including independence and diversity)
  • Ownership and shareholder rights
  • Remuneration
  • Audit and financial reporting
  • Stakeholder governance

Use of open-sourced environmental data

One of the fundamental shortfalls with ESG data is data quality. Moving to a model where raw data can be used from a variety of providers allowed Russell Investments to capture unfiltered data, with a quicker time from disclosure to incorporation in the score.

Looking backwards and forwards

One of the major criticisms with the current state of ESG data is the focus on backward-looking information. A natural area to seek enhancement is addressing the question of what, if anything, can be done to make assessments made by fund managers, advisers and investors more forward-looking. What drives a forward-looking view on a company’s future sustainability varies by industry.

Russell Investments has identified three pillars where forward-looking information is most relevant, and where data is available. These include GHG emissions, water management, and “business model resilience”. Business model resilience includes indicators of how a company is preparing their business model for sustainability issues like a transition to a lower carbon economy.

For GHG emissions and water management, we look not only at the company’s current performance but also the direction of trend for the company. Is their water management improving or getting worse? What about targets: Has the company set an aggressive target to have zero emissions by a specific year? These are the types of details that help build a picture not just of where the company has been in the past, but the direction it is heading for the future.

How did the material ESG scores change?

The correlation between the new and old scores is 0.47—in other words, the new and old scores are moderately correlated and, in some cases, score changes were significant. So, what changed? Here are the most common themes we saw in the before and after comparisons:

  • Corporate governance – Our greater focus on measuring corporate governance boosted the score of companies with strong management and lowered the score of several companies with weak corporate governance.
  • Less reliance on voluntary disclosure – The addition of more performance-based metrics meant less reliance on voluntary disclosure by companies and more balance between voluntary disclosure and actual performance.
  • Open-sourced data – Moving to open-sourced data led to better coverage, more recent data and in some cases, more accurate assessments.
  • Availability of new indicators – More data is now available on some topics whose relevance is increasingly being recognised: data privacy and security, competitive behaviour and systemic risk management.

Three company case studies to bring ESG scoring to life

1. Mining company example

Under Russell Investment’s previous scores, a multinational mining, metals and petroleum company scored a 7 out of 10. With our increased focus on performance outcomes instead of voluntary disclosures, this company’s score reduced to a 3 out of 10. In particular, sub-scores on topics including air quality, ecological impacts and water and waste management—where the company had strong disclosures but had been involved in major incidents—declined, leading to a lower score overall. This reflects the shift from disclosures to performance.

2.  Pharmaceutical company example

A multinational pharmaceutical and life sciences company’s score changed from 1 out of 10 to 8 out of 10. Changes to the materiality mapping were the primary drivers behind the change. Previously, waste, water and energy management were all considered material, and the company scored poorly on these issues for lack of disclosures. Under closer materiality scoring analysis, these were no longer considered material pillars for this specific company.

3. Financial services example

A global financial services company known for its credit cards increased its score from 4 out of 10 to 8 out of 10. The addition of data privacy indicators to the Sustainalytics data significantly helped this score, as the company was noticeable for lack of incidents related to data security and customer privacy, especially compared to its peers.

Changes of this magnitude were uncommon, but these examples hint at the overall trend we have observed: a fast-paced improvement in the ability to measure ESG performance.  It is also worth noting from this that the way in which ESG is being measured and scored is evolving and as you look to review your clients on an annual basis, it may be worthwhile reviewing the performance of your ESG Fund manager on a annual basis based on their ability to evolve their scoring methodology in line with investor and societal expectations.

The impact on investors

What does this all mean for ESG investors? It means an ESG portfolio doesn’t need to be tied to one single idea. Instead, ESG investing can be a new way of thinking about every single company in the portfolio. The beauty of this model is that the investor can simultaneously pursue other financial objectives. Are we saying that an ultra-concentrated renewable energy play is going to underperform the market? No. It’s just going to lead to a radically different return experience.

For some investors and advisers this is exactly what they are after. For others, it’s not. When it comes to ESG and performance can you have your cake and eat it too. In being transparent about what that means: there can still be names in the portfolio that to the casual observer don’t scream ESG. The key is understanding whether those companies are held because they were doing well on the ESG issues that mattered to them or was it just because they happened to have lower emissions than say, an oil and gas company. Some would argue that doesn’t tell you much about whether the tech company is actually sustainable.

The bottom line

Investors should be aware that ESG investing is still in relatively early days, especially when it comes to the data-driven accountability that is required to gain an accurate picture. Whatever the motivation for exploring the environmental, social and governance characteristics of a portfolio, a focus on materiality—on the relevance and significance of ESG issues—is one of the best ways to increase both transparency and impact for your clients.

 

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