If reducing carbon emissions matters to you, take some time to understand ESG rating methodology. That’s the strong advice from Mike Mount as he explains why investors and advisers might need to reassess their thinking as to exactly what constitutes ESG when considering the path to Net Zero.
After a summer where climate risk has made headlines – extreme heat breaking records across the US and Europe, evacuations of Mediterranean holidaymakers, wildfires across Canada that have released more carbon into the atmosphere than the entire annual economic output of Canada – investors are realising that climate risk sits alongside economic, political and security risk as a major consideration.
Those aiming to align their portfolios with the goal of the 2015 Paris Agreement to reduce global emissions to keep global warming well below 2ºC above pre-industrial levels (and ideally at no more than 1.5ºC), may be forgiven for assuming that an investment into a portfolio comprised of companies with a high ESG (environmental, social, governance) rating could be a practical way to achieve such an alignment. Thanks to marketing efforts reminiscent of the active vs. passive debate of a decade earlier, ESG as a label has become a catch-all environmental comfort blanket. There is a presumption that a high ESG rating signals that a company is reducing its’ emissions – adopting a Net Zero strategy – while also tackling other environmental, social and governance issues.
It is true that the E stands for ‘environmental’, but it is jostling against the S and G for attention. In 2022 ‘The Economist’ published an article suggesting that when it comes to climate risk only the E in ESG really matters, and that the E should ideally stand for ‘emissions’ not ‘environmental’. The extreme weather events that we have witnessed this summer, exacerbated by emissions warming the atmosphere, make it hard to argue with this.
Method (f)actors
The demand for ESG information has seen investors become reliant on firms providing ESG rating services, prompting a need to do some homework on what goes on beneath the bonnet. Unlike credit ratings, which have a high correlation across different rating agencies, correlation across ESG rating providers is much lower. In the world of credit, only a few factors are considered: credit history, previous default record, interest rate risk, capital adequacy to name a few. Having a standardised list of criteria leads to high correlation. However, in the ESG ratings world correlation is lower due to a lack of standardisation regarding methodology and, secondly, too many factors accumulating under the ESG umbrella.
ESG ratings firms have different approaches and objectives. Some look to identify the impact a company has on the environment and stakeholders (employees, local community), advising management to improve their ESG rating by withdrawing from activities that are harmful. Most investors assume this ‘doing good’ definition of ESG predominates, but many ESG rating providers aim to reduce investment risk for the company being rated. They provide a set of risk factors that the company can plan for and recommend actions that management could take to reduce any environmental, social and governance factors that pose a risk to the company’s business model and share price. Not so much about improving the environment, but more about reducing the risk of regulatory violations or litigation that might affect the company’s market value.
This is the crux of the matter. Climate-conscious investors should understand that, under this definition, a firm could improve its ESG score by simply divesting itself of dirty assets (for example a coal mine) to a new owner who continues to run them as before. No net improvement for reducing global emissions, but the company’s ESG rating has improved. With such a framework, upgrades to a company’s ESG rating may occur for tick box improvements to business practices – introducing an annual employee survey, for example – rather than more substantive operational improvements in line with the Paris Agreement.
Also consider the sheer number of factors that can be included for assessment. ESG ratings agencies provide letter or numeric scores; to compute these, a ratings firm assesses the three components of ESG, looking at a variety of sub-factors in each category selected on a subjective basis. These assessments are aggregated into an overall score for the firm, with the data being sourced from a mix of public and private data, perhaps supplemented with company responses to a questionnaire.
The problem is that the number of sub-factors being assessed varies widely, ranging up to 1,000 metrics. This creates issues by itself, requiring the ratings firms to make subjective judgments on which are the most material factors and what weighting should be applied to each (in their opinion). This subjectivity underpins why correlation is poor and why the same company might be rated very differently by two ESG rating firms, making ultimate comparison for an investor difficult.
Too many metrics spoil the planet
The cautionary tale is that an investor who invests in a company with a high ESG score assuming their investment is now aligned with reducing carbon emissions, may be unaware that the methodology used to score that company might not even measure commitment to Net Zero. The example of McDonalds, taken from a Bloomberg Business Week article, illustrates this.
In 2019 McDonald’s supply chain generated 50 million tons of emissions, an increase of about 7% in four years. Yet MSCI awarded the firm a ratings upgrade, citing the company’s environmental practices. This was implemented after dropping carbon emissions as a factor in the rating; the rationale given was that MSCI determined that climate change neither posed a risk nor offered opportunities to the company’s profits. Convenient.
ESG ratings are certainly a useful addition to the investment decision-making toolkit, but investors should question any siren call from the E of ESG. A firm may score highly on the S and G but not on the E; this high ESG score could be used to divert attention from the fact that behind the scenes a company is lobbying against climate legislation that would negatively impact profits. Equally, companies must guard against complacency just because they have scored well on ESG metrics. Investors are now looking deeper than the headline scores and being ‘best-of-breed’ on a relative basis will count for little if real progress, on an absolute basis, is limited.
A wave of regulation has led to too much focus on metrics (how do we measure and report), rather than on performance (are we reducing emissions). One can draw the analogy of a marathon runner spending most of his training time searching for which fitness tracker they are going to wear on race day to measure their pace, rather than putting in the regular training to ensure they complete the race.
Unless global emissions are reduced significantly over the next few decades, everything else of a social or governance nature becomes, frankly, irrelevant. If simultaneous droughts result in the global food distribution network breaking down, it is unlikely that we will care how diverse the Board of a company is. Focusing on ESG ratings without understanding their parameters and limitations may lead to much-needed capital not flowing to where it is most needed for the transition to a low carbon economy. The absurd result in the long-term could be that humanity faces a terrible, yet still strangely compliant, mass level extinction.
So some final advice if reducing emissions is what matters to you. When considering whether to invest in a company with a high ESG rating, remember Ronald Reagan’s dictum about nuclear disarmament negotiations with the Soviets: ‘trust, but verify.’
