ESG ratings – a quick fix or a bodged job?

ESG ratings – a quick fix or a bodged job?

The dramatic growth in ESG and sustainable investing over the past few years is now well documented. What was once a sleepy backwater of the financial industry is now very much in the limelight.

Why this has changed so dramatically is not entirely clear. From our perspective as a dedicated sustainability-focused investment boutique, we think the primary driver has been the end client. Just as consumers switched to fairly-traded chocolate and free-range eggs in the 1990s and 2000s, so investors now demand portfolios that help drive positive change in the world around them, or at the very least avoid making things worse.

According to the 2Degrees Investing Initiative, 46% of retail investors who are interested in investing sustainably do so because they want to have a positive impact on the world. A further 19% want to avoid negative impacts with the remainder investing this way because they think it will enhance their returns

Asset managers – not backward in coming forward

Asset managers have been quick to respond to this shift in demand. According to Morgan Stanley, since the first quarter of 2021, Morningstar has added 3,450 sustainability funds to its database. Net inflows into ESG funds have been running at an annualized rate of c.24% over the past three years. This compares with just over 5% for the broader market.  Our own asset growth at WHEB has also been remarkable. The strategy had around A$800m invested in it in mid-March 2020. Just two years later it has over three times this amount at A$2.4bn. Over the same period, the amount invested in the Pengana WHEB Sustainable Impact Fund has grown over five-fold from A$49m to A$$269m.

It is perhaps inevitable that this spectacular market growth will stimulate product development that includes funds that only consider sustainability issues in a perfunctory way.  ESG ratings, often generated through algorithms or grounded on overly simplistic assumptions, have flooded the market, and provide a cheap and quick way to add ‘ESG’ to a fund label.

Flawed and unquestioning use of ESG ratings

That these ratings are often deeply flawed is now widely acknowledged. Our own experience bears this out as well. In recent months one rating agency estimated that 0% of the revenues of one of our portfolio companies would be considered eligible for the EU Taxonomy. This is because the company sits in a ‘power supply and electronics’ sub-sector. The company though is called SolarEdge for a reason; it gets effectively 100% of its revenues selling electronic components that make solar modules more efficient.

We also had to respond recently to a client who had been alerted by an ESG data provider to a major reputational risk facing another company that we own in the strategy. The company was reported to have had a spill of hydraulic fluid from a truck at a construction site in Connecticut. While the spill was of course wholly regrettable, it was small, caused no damage to the environment and had no ill-effects or even presented any risk to workers. The company employs 28,000 people in 350 offices across 40 countries and generated nearly €4bn in revenues last year.  It is absurd that this issue was flagged as a potential reputational issue for the company.

Fund managers have also been publicly harangued for unthinkingly adopting voting positions set out by their proxy agencies. In a recent opinion piece in the Financial Times, Michael Moritz, a partner at Sequoia Capital, labelled investors that fail to question proxy agency guidance as ‘lazy’. ‘It’s just easier to outsource these decisions to a third party’, he said.

Caveat emptor

We have a lot of sympathy with this perspective, not just when it comes to corporate governance, but on ratings that address the full spectrum of sustainability issues. The agenda is too complex and nuanced to be captured by a simplistic rating. It requires experience alongside deep research and scrutiny. The problem is this takes time and is expensive.

Asset managers that view sustainability merely as a marketing exercise want a quick and cheap solution to ‘tick the ESG box’. But not all asset managers see sustainability this way. For us, sustainability is about creating deep structural changes in the global economy that are already driving asset prices. Understanding these changes and factoring them into our assessment process is at the core of what we do. ESG ratings and the investment strategies that rely on them may turn out to be less of a quick fix, and more a botched job.

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Pengana Capital Group