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Top-down approach to ESG creating flawed ratings

11 March 2021

A flawed approach to ESG ratings is leading to unsustainable companies receiving strong scores, Aegon Investment Management has warned.

Euan Ker, sustainable investment analyst, Aegon AM, believes ratings agencies are missing the “whole story” by taking a top-down approach.

Ker says: “Third-party ESG ratings are just inputs. They are not the whole story. ESG screens generally do not consider the sustainability of the company’s products or services, by focusing mostly on how a company operates, rather than what it does. The ratings can inadvertently attribute strong sustainability credentials to companies whose products may be fundamentally unsustainable.

“The sustainability of a company’s products or services is vital to its long-term strategic success. An unsustainable product such as coal is a huge strategic headache for any management team, just as a sustainable one should create a tailwind of opportunities.”

According to Ker, ESG screenings by ratings providers are restrictive in terms of coverage and screening tools, leading investors to a small field of the same choices.

Ker explains: “ESG screens lack truly global coverage. They are based on company disclosures which favours large cap, mature businesses and disadvantages small-cap, mid-cap and emerging market companies. Many peer strategies tend to invest solely in sustainability leaders, i.e. firms that already have high sustainability products and practices. However, sustainability leaders are generally well known and well researched, which means the prospect of uncovering mispriced stocks is more limited.”

Additionally, different ESG screening tools can deliver different results, with thousands of data points to choose from, says Ker.

Instead, Ker believes the focus should be upon materiality and a “bottom-up approach” to assessing ESG credentials.

Ker adds: “Bottom-up, rigorous analysis best captures the nuance of material product impact and ESG factors to valuing a company. Being different is an opportunity. The danger of simply using off-the-shelf ESG ratings is relying on a myriad of plain vanilla, ‘me-too’ type ESG products. Our focus on mid-cap sustainability ‘improvers’ creates a differentiated portfolio and allows us to allocate capital to companies that we believe are really making an impact.”

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