ESG Ratings: A Simple Answer to A Complex Question?

ESG Ratings - third party "scores" on public (and some private) companies - are one of the foundational elements of current ESG analysis. However, per SEC Commissioner Hester M. Pierce, in a speech in June 2019:

There is, for example, a growing group of self-identified ESG experts that produce ESG ratings. ESG scorers come in many varieties, but it is a lucrative business for the successful ones. The business is a good one because the nature of ESG is so amorphous and the demand for metrics is so strong. ESG is broad enough to mean just about anything to anyone. The ambiguity and breadth of ESG allows ESG experts great latitude to impose their own judgments, which may be rooted in nothing at all other than their own preferences. Not surprisingly then, there are many different scorecards and standards out there, each of which embodies the maker’s judgments about any issues it chooses to classify as ESG. The analysis can appear arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason. Putting aside the analysis that produces the final score, some ESG scores are grounded in inaccurate information.” 

Yikes.

And yes, Commissioner Pierce was appointed by President Trump. But does she have a point?

Commissioner Pierce makes a range of arguments, including:

• Do companies respond to ESG surveys? "Some scorecard producers attempt to get information from the companies directly by submitting surveys to companies, the responses to which are then used to rate the ESG risk of the companies surveyed. A senior counsel from a major insurance company reported her experience at a recent Investor Advisory Committee meeting at the SEC. Her company received approximately 55 survey and data verification requests from ESG rating organizations in the last year. By her company’s estimate, it took 30 employees and 44.8 work days to respond to just one of these surveys. While this is just one company’s experience with one survey, one could expect that some surveys will go unanswered because of lack of corporate resources."
• A policy, or a practice? "Because many companies post sustainability reports, producers of ESG ratings can draw from these reports without directly contacting the company. ESG scoring is often arbitrary because these reports are read and analyzed by machines. Illustrating this arbitrariness, Sarah Teslik, a consultant on ESG issues, recommends that companies “go look at the list of things they grade on and then disclose the way they talk. You may be doing something just right, but you called it a practice; you didn’t call it a policy. And you only get credit if you call it a policy."
• Superficial research? "The errors in one ESG rater’s assessment of Barrick Gold Corporation were apparently so severe that the company aired its grievances publicly. The company, in its words, called out the rater’s “latest ESG Report, which we believe continues to be based on superficial research; inconsistent analysis based on a methodology that is not transparent; and a largely retrospective and controversy-based view of ESG performance. What results is a distorted and misleading assessment of Barrick’s ESG performance.” Barrick then went on to provide several examples of allegedly erroneous or conflicting statements in the rating report, including a claim that it operated a mine that it did not operate." (See Barrick website - Response to MSCI ESG Rating Report).
• Tesla is "worse" than ICE auto makers: "Even if the rating is not wrong on its own terms, the different ratings available can vary so widely, and provide such bizarre results that it is difficult to see how they can effectively guide investment decisions. For example, last year the electric car company Tesla received some lower environmental ratings than many traditional auto makers. This was not because of any substantive conclusion that there was non-green activity on Tesla’s part, but simply because its disclosures were not viewed by the rating companies to be sufficiently robust. For someone interested in gaining a perspective on actual environmental impact, rather than on the company’s willingness to fill out paperwork just so, the environmental rating would have been sorely misleading."

Hmm. And criticism of ESG ratings does not come only from the political end of the ESG spectrum. In academia, Sakis Kotsantonis and George Serafeim dig into these issues in “Four Things No One Will Tell You About ESG Data”:

In abstract:

1. "The sheer variety, and inconsistency, of the data and measures, and of how companies report them. Listing more than 20 different ways companies report their employee health and safety data, the authors show how such inconsistencies lead to significantly different results when looking at the same group of companies."
2. "‘Benchmarking,’ or how data providers define companies' peer groups, can be crucial in determining the performance ranking of a company. The lack of transparency among data providers about peer group components and observed ranges for ESG metrics creates market‐wide inconsistencies and undermines their reliability."
3. "The differences in the imputation methods used by ESG researchers and analysts to deal with vast ‘data gaps’ that span ranges of companies and time periods for different ESG metrics can cause large ‘disagreements’ among the providers, with different gap‐filling approaches leading to big discrepancies."
4. "The disagreements among ESG data providers are not only large, but actually increase with the quantity of publicly available information. Citing a recent study showing that companies that provide more ESG disclosure tend to have more variation in their ESG ratings, the authors interpret this finding as clear evidence of the need for ‘a clearer understanding of what different ESG metrics might tell us and how they might best be institutionalized for assessing corporate performance.’"

What does this mean for institutional investors?

Castle Hall does not provide ratings on underlying investments, be they the stocks or bonds of publicly traded companies, or private investments in the portfolio companies held by PE partnerships.

We do, however, focus on the investment process of asset managers: while a manager may talk a good marketing story, do they actually comprehensively integrate ESG criteria into each step of the investment decision making process - or is it marketing fluff and potentially greenwashing? Running a strategy which has added a few screens based on a quick subscription to a single ESG data provider would certainly seem to run close to the latter.

When allocating to third party asset managers purporting to follow an ESG strategy, asset owners cannot simply "tick the box" if a manager declares that it has engaged an ESG service provider to "rate" underlying investments. It is essential to ensure managers recognize any shortfalls or potential shortcomings in their vendor’s research. Is the manager actually cognizant of the limitations of their service provider’s methodology? Are they conducting any in-house ESG research to complement their service provider’s? At what stage of the investment process is the manager using this research - initial screening, or final stock selection?

These are questions institutional investors, outsourcing the investment process to external managers, can usefully ask when evaluating a manager's investment strategy.

There is, unfortunately, rarely a simple answer to a complex question.