The problem with ESG scores

October 21, 2022 08:52
Photo: Reuters

Sustainable investing around the world is facing a wave of new regulation, seeking to improve transparency and standardise reporting requirements for sustainability funds.

This is true in Asia as well. In Hong Kong, the Security and Futures Commission and Hong Kong Exchanges and Clearing have signalled their support for a set of global standards being proposed by the International Sustainability Standards Board (ISSB) by year-end. After which they are expected to become mandatory for listed firms on the local bourse.

The intentions behind these regulations are laudable; to reduce greenwashing, help separate the wheat from the chaff, and reorient capital towards more sustainable companies. However, as with many regulations, there is a risk of unintended consequences. One of the key risks is that investors are increasingly turning to third-party environmental, social and governance (ESG) data providers to help them with their analysis, and more worryingly, to help them decide whether a company is sustainable or not.

Some ESG data can be useful in certain circumstances, but an over reliance on simplistic ESG scores can be a dangerous strategy, especially when using them to build investment portfolios. Relying too heavily on ESG scores is also unlikely to help reorient capital towards more sustainable companies.
Why, what is the problem?

Unfortunately, ESG data suffers from a multitude of flaws, and doesn’t focus on the areas that matter. One of the first challenges is that ESG scoring methodologies tend to focus on how well companies manage their internal processes, rather than the real-world impacts of their products and services. For example, British American Tobacco on its Malaysian-listed subsidiary website trumpets its sustainability credentials and long-standing presence on the Dow Jones Sustainability Indices, along with its drive to eliminate single use plastics. However, with global sales of over 600 billion cigarettes per year is it really a sustainable company?

Secondly, when looking at the scores themselves, there are often large variations between the scores and ratings from different ESG data providers. One company may be rated as best in class by one provider and worst in class by another. This is because each provider has its own methodology, with different areas of emphasis.

These issues are compounded by the fact there are gaps and a lack of consistency in the source data being collected from the companies being assessed. When ESG data providers cannot find the data they need, they use estimates, which sometimes result in strange outcomes.

Finally, there are inherent biases in the scores, with larger, developed market companies tending to score better than smaller companies, especially in emerging markets. Smaller companies often lack the resources needed to produce lengthy sustainability reports, and so are at risk of being penalised for their lack of data.

Some ESG data can be useful in certain circumstances, but an over reliance on simplistic ESG scores can be a dangerous strategy.

So how best to assess whether a company is sustainable or not?

A better approach would be to look at companies in the region that are well placed to contribute to, and benefit from, sustainable development. Companies that can help reduce people’s ecological footprint, or advance human development, or ideally both. These attributes are difficult to identify by relying solely on ESG scores. As William Cameron said in 1963: “Not everything that counts can be counted, and not everything that can be counted counts.”

As an investor, it’s best to do your own research, which is more qualitative in nature and based on a wide variety of information sources. From there it’s possible to take a broad and rounded approach to assessing the sustainability credentials of a company, by asking a variety of questions, such as:
How do the products and services contribute to sustainable development? Are they helping us solve difficult problems, meet vital needs, and do more with less? How does the management team think about sustainability and how do they act upon their beliefs?

None of these things can be easily captured in a single metric or ESG score. Instead, it’s preferable to use sensible judgement, and base one’s analysis on a broad base of both qualitative and quantitative evidence from the firms in question.

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Portfolio Manager at Stewart Investors