Do ESG Ratings simplify matters or make them worse? asks Ali Wilson, Techspert: Investment, The Verve Group
ESG remains the acronym on everyone’s lips and yet it seems that we still don’t truly know what it is, or even what it wants to be at the present time. Following on from my previous article for Professional Paraplanner, covering a few misunderstandings around the topic, I’d like to continue on that note with how the industry has tried to simplify things, but seemingly have just made things worse.
In an attempt to simplify ESG offerings, a number of firms have implemented ESG ratings, which rate an investment fund or portfolio based on their own assessment of the characteristics of the underlying investee companies. The question is “how reliable and consistent can they be for advisers wanting to incorporate an ESG proposition?” My answer is “not very reliable and consistent at all!” as you will see demonstrated below.
The following charts have been prepared by BDO USA LLP, an accounting firm in the US, and illustrate just how uncorrelated ESG ratings are between two globally recognised ratings agencies in S&P and Sustainalytics (Morningstar), in comparison to credit risk correlation as per S&P and Moody’s ratings. As you can see, S&P and Moody’s credit risk ratings show a strong correlation, meaning they award roughly similar ratings to the same companies. However, the ESG ratings have a low level of correlation, meaning a fund or portfolio awarded a high ESG rating from one firm may receive a low rating from another; which one do you trust?
Please note, the below is just looking at two ratings providers; with the ESG market still picking up rapidly, there are numerous other alternatives with many more likely to launch in the near future.
Visuals courtesy of BDO USA, LLP © 2021 BDO USA, LLP. All rights reserved.
As you can see, although the ratings in isolation might seem like a simple solution, the consistency just isn’t there at the moment meaning the value of ratings like these are currently very limited.
Hopefully the upcoming UK legislation regarding fund sustainability disclosures, following the Sustainability Disclosure Requirements (SDR) discussion paper, will help UK ratings agencies find some consistency; this should also extend across Europe with the UK’s legislation mapping directly to the EU equivalent (SFDR).
Currently, ESG funds make much more sense if you forget the green or ethical marketing going around at the moment, and think of them more as a sustainable investment solution in terms of returns, rather than trying to do anything explicitly positive or avoiding any particular sectors. By following more stringent standards, however, fund managers can at least show to the adviser (and the end client) that they are carrying out additional due diligence that can classify an investee company as carrying a significantly reduced risk of falling foul of any of the three ESG pillars.
To summarise, there is nothing wrong with the concept of ESG investing. It is my personal belief that funds should be managed in line with ‘ESG’ guidelines, but just as a matter of good practice and enhanced risk mitigation by the fund managers running money on behalf of their clients. However, the problem currently lies within the marketing of ESG as some sort of ‘green’ or ‘ethical’ way of investing when the reality is far from that, and not exactly helped by the inconsistencies within third-party ratings. I cannot help but think at some point down the line, we will be hearing drive-time radio ads from small-time lawyers wanting to claim on clients’ behalf after being mis-sold an ‘ethical’ investment because a fund house decided to slap some windfarm photos and their most favourable third-party ESG rating in the brochure, and the adviser has failed to look under the bonnet properly about what kind of companies make up the fund.
Moving forward, the upcoming FCA legislation should bring some much-needed clarity for everyone involved, be it fund houses, advisers and end clients; finally simplifying the ESG market in the way that has been attempted so far.
