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27 November 2020 Jennifer Hill

Turning limitations into positives

A lack of consistency across ESG ratings represents a challenge for investors – and an opportunity for active managers to add value.

Call it ethical, sustainable or the now familiar acronym ESG (environmental, social and governance) investing, it matters more than ever.

“People are increasingly upset about great unfairness in society, such as climate change and diversity. These things are really starting to rattle people’s cages,” said Darren Lloyd Thomas, managing director of Thomas and Thomas Financial Services in Wales, which has 60%  of assets under management in purely ethical portfolios, up from 47% a year ago.

ESG has become a big part of the investment world, but is it more substantial than a marketing gimmick? David Liddell, a director of online advisory investment service IpsoFacto Investor, concedes that it is easy to be cynical: 20 ESG funds were invested in Boohoo – one had the fast fashion e-tailer as its largest holding – when it emerged in July that it was paying garment factory workers in Leicester as little as £3.50 an hour.

However,  it is “quite plain” to Liddell that a robust investment process should now take account of ESG – and perhaps always should have. “A fundamental part of the investment process is assessing the future market environment for a firm’s products, the attitude  and  taste of consumers in society, and the ability of the company to govern and deliver on its plans – these should always have been pretty fundamental to assessing a company’s future cash flow,” he said.

“Of course, now we mean much more by ESG, for example the impact of the company on climate change, how good its working conditions are and diversity of the board.”

Some of these issues lend themselves to a numerical approach, with board diversity being one. Others are much more subjective.

Integrating a robust ESG approach into investment decision-making is also problematic. The CFA cites three problems: it is difficult to assign a monetary value to ESG issues and to integrate them into quantitative models; ESG-related disclosure by companies may be limited, unverified and non- standardised; and ESG issues tend to influence financial performance in the long term, whereas many investors have relatively short-term horizons.


Apples and pears

ESG is another set of data that allows investors to make better investment decisions. That is primarily  because ESG factors are now widely regarded as risk factors for investors.

Increasingly, fund managers are thinking of ESG in both positive and negative terms – using considerations to identify investment opportunities as well as avoiding pitfalls. Because many areas of ESG investing  are  subjective, it can be hard to compare like with like when trying to make comparisons.

“While using negative screening made it easier to score from an ESG perspective, this is becoming less valuable as many managers prefer to focus on best-in- class, themes and engagement, as opposed to simply excluding areas,” said Gavin Haynes, an investment consultant at Fairview Investing.

“There are an increasing number of ratings and index providers offering guidance, but the data sources and methodologies employed vary widely – comparing one to the other is like comparing apples with pears.”

Moreover, most ESG ratings systems are based on industry-relative assessments rather than absolute scoring frameworks, which detracts from their value to fund managers, like those employed by Alliance Trust, who take a company-focused, bottom-up approach.

That is chief among the reasons for an over-reliance on ESG scores being unhelpful at best and dangerous at worst. “The investment world has a big role to play in shaping the future of the planet for the benefit of all of us – none of us should be passive investors in that regard,” said James Carthew, head of research at QuotedData.

“But broad-brush ratings systems that attempt to inform investors on how ESG-friendly a company or  fund  is, are extremely subjective, often flawed and sometimes downright misleading. There is a danger that they encourage a box-ticking mentality, which offers the worst of all possible worlds.”

Thomas believes the shortcomings of ESG scoring could result in future investor litigation against advisers who recommend funds based on scores without considering how underlying holdings fit with a client’s values. “The whole issue with ESG scores, whether you’re using Morningstar or RSMR, is that they don’t immediately reflect the criteria that the ratings agency  has used. You have to see through the screening. As a light touch, it works. But it can be dangerous if you don’t do your homework properly.”

Even ratings providers accept their limitations. “It is true that there is a lack of consistency across ESG ratings,” said Hortense Bioy, director of sustainability research for Europe at global research provider Morningstar.

Each provider has its own methodology for assigning company-specific ratings. The differences in how ratings providers calculate ESG scores can result in the same company being ranked highly by one provider and poorly by another. And while most frameworks focus on material risk analysis, some prefer to focus on impact, which requires a different set of data.

Transparency is crucial. It is important that investors understand that a company’s ESG score may differ between ratings providers, because they may be measuring different things or when measuring the same thing have different views regarding which issues are most material or which elements of best practice should be considered, said Bioy.


Data capture

The quality of an ESG scoring system depends to a large extent on the quality  of underlying data. ESG ratings and research providers use many data sources and regularly communicate with the companies they assess to ensure all relevant information has been captured and provide an opportunity for feedback. 

ESG risk ratings capture far more than what companies are disclosing. Sustainalytics (owned 40% by Morningstar and soon-to-be wholly owned) assesses more than 60,000 news sources daily for incidents ranging from oil spills to employee discrimination lawsuits.

“This incident research and subsequent controversy assessments play a large role in informing our overall view of company ESG risks and the degree to which policies and programmes are translating into on-the-ground practices,” said Bioy.

“A lack of disclosure on material ESG topics can intrinsically be a signal of weak company management and has been shown to be associated with a higher cost of capital.” 

Developments in technology, like blockchain and artificial intelligence, will facilitate the collection of data. That, in turn, will lead to new ESG scoring approaches and help fund managers to collect more data. A key area of focus for these new data sources is impact analysis – an area of growing interest for investors keen to make a positive difference with their investments as well as profits.

New frameworks for analyses are emerging all the time. In September, Morningstar unveiled its ‘ESG commitment level’ framework for assessing both individual funds and the asset management firms that run them.

Expressed on a four-tier scale running from best to worst –  leader,  advanced,  basic and low – the initiative aims to identify funds and asset managers that its analysts see as best-in-class in the context of ESG investing, while calling out those that are subpar in their approach. Morningstar will monitor strategies and fund managers for changes that could materially affect their ESG commitment levels.

Looking ahead, Bioy expects the harmonisation and standardisation of corporate ESG disclosure to make ESG ratings more robust. “At the moment, part of the data is estimated, which contributes to the lack of clarity and comparability,” she said.

While the lack of consistency across ESG ratings represents a challenge for investors, greater uniformity would not necessarily be beneficial, however.

“Diversity of views is a good thing,” said Bioy. “You wouldn’t expect stockbrokers to issue the same buy/sell recommendations, so why would you expect ESG ratings to send the same signals?”

Canaccord Genuity Wealth Management is of the same mindset. It expects to see greater distinction between ESG risks and opportunities and more sophisticated data capture, analysis and interpretation, but uniformity of ratings systems is  not on its wish list.

“Different agencies have different strengths and the divergence in scores between providers is healthy,” said Patrick Thomas, its head of ESG investing. “We see scores as a useful starting  point  to ask managers more targeted questions.”


Proprietary systems

Portfolio managers often compare data across providers to form their own opinions. In this respect, a lack of correlation among third-party ESG ratings presents an opportunity for active investors to add value for clients – particularly those investment firms with proprietary research capabilities.

Many asset managers have created their own proprietary scoring systems. These tend to use underlying ESG indicators provided by third-party rating agencies (instead of headline ESG ratings), giving greater scope for their own analysis.

Chris Welsford, managing director of Ayres Punchard Investment Management, has long said that ESG should be viewed as an analytical tool that enables fund managers to conduct thorough qualitative analysis on their investee companies. The Isle of Wight- based advice firm has offered clients socially responsible investment choices since Welsford founded it in 1995 with an inheritance from his late mother.

In running its Key to the Future model portfolio service, it takes as a starting point data analysis from Worthstone, which looks beyond ESG scores and considers other important factors such as social impact and transparency. The adviser then undertakes its own in-house research with reference to the United Nations’ 17 sustainable development goals.

“ESG is qualitative research and analysis and as such there  has  to be judgement and context built into the process,” said Welsford. “A fund manager who is running a thematic conventional energy fund will need to use ESG in a different way from one  that is running a clean energy fund. But both can benefit from using ESG to better understand risk and opportunity in their investee companies.”

For Canaccord Genuity, fund managers need to be able to distinguish between data (which on its own tells them nothing) and information (which does). ESG integration is a prerequisite for every active fund it owns.

“There are a handful of managers that get here by proxy through their style and sector preferences, but generally we expect to see processes that leverage internal proprietary ESG analysis,” said Thomas. “Not having this is like saying a fund manager needn’t bother reading an annual report. It’s simply an expectation.”

Fund managers often complement their proprietary data by engaging with companies to build on their insights.

“The more nuanced approach required in assessing companies from an ESG perspective, provides an opportunity for active managers to add value through engagement and helping drive change, which is not so easy for passives,” said Haynes.


Active enagement

In its article, ESG Scoring in an Imperfect World, Sustainable Growth Advisers (SGA), one of the nine managers of Alliance Trust, uses stocks examples to highlight why it prioritises its own proprietary research over third- party input when assessing ESG factors.

One such example is industrial gases company Linde, whose operations result in significant consumption of electricity and production of CO2. Two years ago, SGA started discussing the issue with the company’s chief sustainability officer. In the  past year, it has engaged with the chief executive and chief financial officer.

Through this, it gained a greater appreciation of Linde’s sustainability framework to improve productivity, and the ways in which the company’s gases can reduce emissions and energy consumption for its customers.

Following its due diligence, SGA assigned Linde a high score for environmental considerations in February 2019. By contrast, MSCI upgraded Linde’s ESG score from BBB to A just last June, based on its carbon mitigation strategy and efficiency programmes that SGA had already identified.

SGA is one of seven Alliance Trust managers that are signatories to the United Nations’ principles for responsible investment. It is a focus shared by Equity Ownership Services (EOS) at Federated Hermes, an external, independent ESG expert that Willis Towers Watson (WTW), investment manager of Alliance Trust and itself a signatory, has appointed to provide voting recommendations and undertake engagement activities on its behalf.

During the first 6 months of 2020, EOS at Federated Hermes has engaged with over 90 companies held by the Trust on 347 ESG issues and  objectives. These engagements are typically multi- year endeavours, but it has recorded progress on 22% of its objectives in this short period.

Advisers and the clients they represent have a part to play too. While few individual investors have the clout to make their views heard, investors in funds have the “strength in numbers” necessary to elicit change, said Carthew.

Ayres Punchard Investment Management takes any controversial issues back to fund managers for engagement. One area of focus has been the use of child labour in cobalt mining. This resulted in Microsoft making changes to its procurement procedures and supply chain scrutiny to address the use of unlawfully mined cobalt, which implicated the company in child slave labour.


Ahead of the curve

Some advisers are long-term proponents of Alliance Trust for more traditional reasons. Francis Klonowski, director of Leeds-based Klonowski & Co, has used the Trust for 25 years, increasingly so since it adopted its multi-manager approach in March 2017.

He likes the low-cost access it affords to a well-diversified global portfolio that emphasises best-in-class companies, and has an impressive 53-year track record of increasing dividends paid to shareholders. He points to ongoing charges of 0.62% compared to 1.5% for many open-ended multi-manager funds.

“The private investors I know were brought up in an age when a hot summer day was a miracle – not a cause for concern,” he said.

However, the Trust’s integration of ESG factors has gained plaudits from various quarters. “We like the approach taken by  Alliance Trust. Without  selling  itself  as an ESG fund, it is clearly taking the issue seriously,” said Liddell at IpsoFacto Investor.

Carthew at QuotedData said: “This is a move in the right direction and we applaud Alliance Trust’s efforts in this area.”

For Winterflood Securities analyst Annabel Herman, “Alliance Trust seems to be ahead of the curve” in sustainable investing.

In a broker note published in March,  she highlights WTW’s regard for ESG risks and opportunities as a core part of the research, selection and monitoring process. It places “emphasis on active engagement and stewardship at the stock-picker level”, while the appointment of Hermes EOS is a “positive step in leading engagement”, she said.

Data suggests the Trust’s  carbon  footprint is significantly lower than its  benchmark’s. It had a weighted average carbon intensity of 87.0 t CO2e/$M sales on 30 June 2020, compared to 163.3 t CO2e/$M sales for the MSCI All Country World Index.

The Trust also has lower exposure to companies owning fossil fuel reserves.

The Trust’s latest set of annual results contained more information on voting, engagement and carbon emissions than most of its peers and Winterflood “would not be surprised to see this level of reporting becoming increasingly familiar across the sector in the years ahead”, said Herman.

Haynes at Fairview Investing expects investment trust boards to increasingly scrutinise managers to ensure they are implementing ESG considerations.

“This is not a fad or a short-term theme, but a structural shift in the  way  money is invested,” he said. “ESG is increasingly becoming a part of mainstream investing across the globe and investors who ignore it will be left behind.”

Jennifer Hill is a freelance journalist. 

This article was originally published in our Autumn 2020 Quarterly Newsletter.

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