Sustainability, or environmental, social and governance (ESG) considerations are an integral part of the investment decision making process at Milford, just as they are for most asset management firms. There are however different approaches to measuring ESG considerations. At Milford we believe in undertaking our own fundamental analysis of each company within our investment portfolios. A common alternative globally is to use ESG ratings compiled by an external rating agency.
Sustainability Made Simple
A company’s ESG rating is typically calculated as a weighted average of different scores across various ESG factors. The benefit of this approach is that it provides a high-level indication of a company’s ESG credentials. This simplicity allows companies to be easily compared and analysed for suitability in ESG funds or indices. The score can also be used in conjunction with alternative ESG approaches to form a more detailed analysis.
Despite this simplicity, there are numerous drawbacks to using an ESG rating.
Devil in the Detail
A key disadvantage of a ratings-based approach to assessing sustainability is the lack of consistency across the various rating agencies, such as MSCI, S&P Global and Sustainalytics. Each agency uses different methodologies and weightings for the numerous ESG factors employed which can lead to vastly different scores for the same company.
Research indicates a clear lack of correlation between ESG ratings. A recent MIT research paper noted that the correlation of ESG scores among six key rating agencies was on average 0.61 (1.00 representing a perfect correlation and 0 no correlation). This compares to the correlation between credit rating agencies scores of 0.99.
Source: Corporate Citizenship
Most ESG scores also include a sector neutrality aspect which means that companies are scored across all factors, diluting those more important to an individual company. This means companies with significant environmental or social impacts, such as fossil fuels, can generate a good overall score due to strong performance across a range of other factors.
Rubbish In, Rubbish Out
Another criticism of rating agencies is one that can be aimed at all ESG analysis, and that is the constraints of the data available. For the most part, the agencies collect the information via company reports and surveys. It is vast amount of data that takes time to collate and is easy to manipulate.
In addition, rating agencies can only measure the data available, hence a large company that provides a lot of ESG information can be rated more highly than a small company with better ESG credentials but less comprehensive reporting. Some small companies are missed completely. This drives a clear bias towards large firms who have the resources to deploy into the development and reporting of ESG policy and disclosure, despite not necessarily making a positive impact on the environment or society.
Art not Science?
Sustainability considerations are often as qualitative as they are quantitative, and ESG analysis requires a level of interpretation, context and subjectivity. Key questions we consider are:
- How do we rate the different factors to reflect what is important?
- How do we balance an outstanding performance in one area of ESG when it is offset by an average score across other factors?
- Is it ok to be the best ESG performer in a high impact industry or should the score reflect the absolute impact, regardless of relative performance?
While there is often no clear answer, we try to focus on what is important. This, in our view, is a company’s sustainability intentions across the biggest issues they are facing, and their delivery against those intentions. A strong governance structure, well-designed remuneration to focus attention on the key outcomes and care of its people are also vital for a good company.
For investors trying to understand a company’s sustainability credentials, we think looking at an external ESG score alone is broadly ineffective and potentially misleading.
When Tesla was removed from the S&P 500 ESG Index earlier this month following a downgrade of its ESG score, Elon Musk tweeted “ESG is a scam”.
ESG is not a scam, but the black box nature of ESG ratings with ambiguous methodologies, lack of consistency and a large level of subjective interpretation mean ESG scores should, as a minimum, be used in conjunction with further company level analysis to fully understand each company’s sustainability performance.