Almost 100 new ESG-focused funds have been launched in Europe this year and the trend shows no sign of abating.
However, there remains no agreed definition of what environmental, social and governance (ESG) criteria are. An investment that one fund views as ethically sound could breach numerous standards of another.
“ESG is a relatively new field,” says Elena Philipova, global head of ESG proposition at Thomson Reuters. “There are a lot of inconsistencies.”
“Defining ESG is still very much an open debate,” says Chirag Patel, head of innovation and advisory solutions at State Street. “Different providers are seeking to establish a minimum ESG standard.”
Leading the way is the European Commission (EC), currently in the process of establishing a taxonomy on what constitutes a sustainable investment to provide investors with more clarity. The move could lead to the first global benchmark.
But Eoin Fahy, head of responsible investing at KBI Global Investors, says the EC faces an immense task.
“If the European Commission draws up a definition that is too broad then the whole thing is meaningless, and anyone can claim their fund is sustainable. But if the definition is too narrow then fund groups won’t try to create sustainable funds,” he says.
“The EC’s approach needs to be reasonably broad based then investors, particularly in the institutional space, can use their resources to figure out what is or is not a sustainable fund.”
NNIP head of equity specialties Jeroen Bos says the nub of the problem is that different kinds of ESG definitions mean different things to different asset managers.
“There needs to be a requirement for asset managers to integrate ESG [into their portfolios] in a serious way,” he says. “But to go further than that is difficult because you get into all sorts of discussions about how you measure and quantify data.”
According to Patel, there is a desire among asset managers, data providers and investors for a uniformity of data disclosure across companies. Because companies do not typically self-report, says Patel, investors end up having to rely on third-party assessments.
“Research suggests correlations can be as low as 30-40% between different providers scoring the same company,” Patel says.
“If you move towards a self-disclosure standard it will drive regulatory requirements. If such a regulatory effort were to happen, investors can rely on the companies to provide comparable information across the board just like financial information, such as annual or quarterly statements.”
Patel believes this will allow each ESG attribute to be measured in a comparable fashion, eliminating the possibility of subjective interpretation.
As the number of ESG funds increases so does the number of ESG rating systems, such as Morningstar Sustainability Ratings, MSCI ESG Research, Sustainalytics, Climetrics, ISS Environmental and the Social Equality Score.
However, such systems are widely viewed as having limitations, such as favouring large-cap firms with larger resources to meet ESG criteria requirements.
Expert Investor looked at Morningstar’s Sustainability Ratings for funds that describe themselves as sustainable and found 15 out of about 370 had been given a ‘low’ rating despite many receiving ‘A+’ scores from the United Nations Principles for Responsible Investment (UNPRI) (see table below).
According to Helena Viñes Fiestas, head of sustainability research and policy at BNP Paribas Asset Management, ESG ratings systems often fail to take into account issues such as transparency, lack of impact assessment and stewardship.
Larger-listed companies, for example, tend to be more compliant with transparency requirements than small and mid-caps, especially from emerging markets, but that does not necessarily mean the larger companies have better ESG practices overall.
“While ratings look at ESG practices, they don’t look at impact. When you look at the Morningstar ratings all of the thematic funds, whether it is social or environmental, tend to be really damaged by the methodology because the ratings don’t include the positive impact of the product,” she says.
For instance, a coal mining company could score highly despite an obviously negative environmental impact, while a small bicycle company could score negatively due to a low level of transparency.
“An environmentally sustainable economic growth model may be a global priority but indirectly [the rating systems’] message is that it is better to invest in a coal mining company than a bicycle company if the level of transparency from the former is higher than the latter,” Fiestas says.
On stewardship, she says ratings do not include activist investor action such as voting and putting pressure on companies to be more sustainable.
“The ratings are biased towards large companies in Europe and the US, and don’t take into account positive impact of activities, engagement and stewardship. The ratings systems are aware [of this problem] and that they need to improve.”
Bos adds that a lot of what managers were doing within their investment processes was lost if only ESG data was looked at.
The NNIP equity specialities head says engagement was very important to improve company behaviour but that it was not included in a lot of ratings methodologies.
“In terms of the companies we invest in we look at whether they actually have the intention to improve society and to treat their workers and the environment well,” he says. “But this ‘intentionality’ is not captured [by the ratings systems].”
“To us it’s really important because it indicates the company culture, its behaviour and governance.”
Fahy shares the view that ‘intentionality’ is important, adding that a utility company providing thousands of people with water in a developing country has an obviously positive social impact but might not get a high rating because of transparency issues or the lack of an independent chair.
“We don’t find ratings particularly helpful. We’re not dismissing the ESG ratings on individual companies but when you start using those to make an ESG rating in a portfolio, that’s when the ratings become skewed,” he said.
However, Fahy, Bos and Fiestas all agree ESG ratings still play a vital role in the investment process as they create more awareness about ESG.
In light of ESG ratings’ limitations, Philipova says it’s important to not blindly adhere to one rating. “Fund selectors need to cherry pick what they need to align with their objectives to fulfil their obligations and their ability, rather than match what they need in a label and apply it blindly,” she says.
“When you look underneath the hood you find that definitions are very different and not necessarily what you would expect from the name of the fund.”
She believes selectors should look out for the scope of the data in terms of disclosure and comparability.
“Let’s take one company that publishes emissions on its headquarters and another on all its global operations. If we look at the absolute number, the one that has partial disclosure is going to look better,” she says.
“But it’s not because this company manages its footprint more effectively, it’s just lacking transparency and the scope of the data can be global, regional or segmental.”
A better comparison would need consolidated data from across companies, Philipova argues, adding the data would be distorted without it. “With ESG, the information can be buried in the footnotes or not mentioned. The comparability of data improvement is very important to improve overall data disclosure,” she says.
Similarly, Patel feels it’s important to use multiple data sources as there’s no gold standard that offers visibility into characteristics across everything in a typical portfolio.
“Using a rendered agnostic approach where multiple best-in-class data providers are used for different parts of a portfolio is probably the best solution for selectors until we see a convergence in standards,” he says.
Patel says another challenge is the frequency of data on companies.
“This data from third-party providers is usually only updated on an annual or semi-annual basis.”
For Bos, selecting funds that hold companies on ESG behaviour is more important than holding companies that had the highest ESG scores if selectors want to improve their risk/return profile.
He says it is important to ask portfolio managers about their investment process and engagement efforts. “As part of the process, ratings are fine as long as you know what they represent,” says Bos.
According to Fahy, a red flag selectors should watch out for is if a fund manager is not a UNPRI signatory.
“The vast majority of credible asset managers are UNPRI signatories and I would ask questions if they weren’t. I would be asking investment managers for their PRI assessment and their results as they are not publicly published,” he says.
“If they don’t send the results their submissions are published by PRI. I would also be very suspicious of a fund that only mentioned ESG or SRI [socially responsible investing] in the ESG and SRI sections of their fund documents.”
Fahy adds that fund selectors should be asking questions surrounding proxy voting, engagement, ESG criteria incorporation, stock examples and governance to fund managers when looking for an ESG fund to invest in.
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