The Environment, Social, and Governance (ESG) criteria is the way forward. This standard is used to provide social credit ratings for companies, and see how they tackle ESG-related issues to become a more sustainable company. ESG is in high demand amongst investors, because they want to invest in places that align with their own values. International organisations have endorsed the use of ESG-related standards, including the United Nations (UN) via its Principles for Responsible Investment (PRI), an initiative to make sure investment companies incorporate ESG issues into their investment decisions. From 2006 to 2018, Assets under Management (AUM) has grown from 6.5 to 81.7 trillion dollars under the PRI initiative (Eccles & Klimenko, 2019), showcasing a growing interest in ESG principles amongst investors.
However, ESG is also important to investors for financial reasons. Companies that ignore ESG issues tend to lose money (meaning investors do too). The Bank of America estimates that up to $600 billion has been lost to ‘ESG controversies’ in the S&P 500 since 2013 (Reuters, 2020). On the other hand, the Bank of America reports that the highest performing ESG firms are outperforming the lowest performing firms by more than 40%, become high quality stocks, are less volatile, and have higher three year returns (Eccles & Klimenko, 2019).
ESG is thus very important: it makes sure companies are held accountable for their business, and for investors, they can put their money in a company that is profitable and that they are confident in. To that end, sustainability ratings are widely used, and there are various agencies, such as MSCI, Bloomberg, and Sustainalytics that do ESG ratings for companies.
The Edge Markets (2021): RHB has downgraded various plantation companies amidst growing ESG concerns.
A question you might be thinking of is that if ESG ratings exist for companies, why do people still make investments in companies that get caught up in ESG controversies, like Dieselgate 2015? There is an issue with the current rating system, and a tech alternative powered by Artificial Intelligence (AI) has entered the playing field. In this series of posts, we will look at how ESG is currently being benchmarked, its limitations, and how effective the new AI-powered benchmarking is.
TRADITIONAL RATING AGENCIES
Quick Disclaimer:
Before I continue with this post, I would like to note that various ideas noted down in this paper were primarily derived from the work of Arthur Hughes, Michael Urban, and Dariusz Wójcik from the School of Geography and the Environment at the University of Oxford (Hughes, Urban & Wójcik, 2021). My area of exploration on the topic was to compare the different approaches to ESG rating, and their paper is the first comparative study on the human-driven and AI approach to ESG benchmarking. There was one other informative paper related to ESG benchmarking (In, Rook, Monk & Rajagopal, 2019), but it was a general paper on possible alternative ESG data sources rather than a commentary analyzing how the human and AI based approaches work. In these series of posts, I have supplemented their work with some of my own research and commentary to enhance the discussion on how ESG affects investors.
What about them? How do they work?
Traditional rating agencies refer to the big players in ESG rating such as MSCI, Bloomberg, and Sustainalytics. In this post, I will be referring to them as Traditionalists. The analysis and final output benchmarking by Traditionalists is subject to the discretion of a human analyst. In terms of their modus operandi, Traditionalists identify key issues and apply weightings to them to use as criteria for a company’s ESG rating. Key issues refer to ESG-related issues that affect a company financially. Data used alongside the key issues and weightings come from corporate data, online data, and face-to-face contact (F2F) to come up with the final rating for a company.
What's wrong with what they’re currently doing?
For starters, Traditionalists take a rather questionable approach in coming up with ratings by relying heavily on company disclosure—it is estimated that 45% of benchmarking is based on disclosures. This becomes a problem if a company chooses to be less transparent about their ESG problems. Therefore, there is a justifiable concern regarding transparency of these data sources, particularly the integrity and reliability of this data.
There is actually a term for an extreme version of this problem known as greenwashing, where a company influences and misleads their ESG ratings, and is a major problem in the Traditionalist ESG rating system. Moreover, there is a lack of standardization in the selection of key issues and weightings: in the case of MSCI, weightings are decided for the entire year, and key issues are subject to change at the discretion of MSCI. Therefore, the methodology in determining the rating for one year may be different from another.
So how confident can an investor be in a Traditionalist rating? To add to the organizational subjectivity, Traditionalists rely heavily on the brainpower of a select few, often leaving analysts with the tall task of examining a long list of companies—MSCI, for instance, rates about 14,000 companies with a manpower of only 185, meaning that a single research analyst handles an average of almost 80 companies (Hughes, Urban & Wójcik, 2021).
This complication has led to major flaws in ESG ratings. Take Boohoo, for example, a major fashion retailer in the UK. They had been rated highly and included in various ESG funds, until they got caught up in a wage scandal for underpaying workers (Chatelin, 2020). On the other hand, an environmentally conscious but small company could be given a lower rating than they deserve due to limited company disclosure (Reuters, 2020).
From my own data sleuthing, Traditionalists continue to have shortcomings in their reporting. Looking at Top Glove, which has been removed from three ESG indexes amidst forced labor allegations, poor labor conditions, and a poor safety protocols that led to Covid-19 infecting 25% of its workforce (The Business Times, 2021; Nikkei Asia, 2021), Top Glove still has a medium ESG risk rating of 26.1 (scoring is on a scale of 0–40, with 0 being the worst and 40 being the best) and a Level 2 (moderate) controversy level (on a scale of 1–5, 1 being low and 5 being severe) (Sustainalytics, accessed Jul 2021). From a chronological perspective, the forced labor allegations happened in March 2021, and the poor labor conditions and Covid situation in June 2021. Sustainalytics last updated their rating in April 2021.
All in all, the Traditionalist approach, although viable for the most part for investment decisions, is riddled with significant amounts of subjectivity, is not necessarily reliable or up-to-date, and possibly suffers from a lack of transparency. A quote obtained during an interview with a research analyst conducted by Hughes, Urban & Wójcik (2021) best summarizes the limitations of the Traditionalist approach:
“With MSCI scores, there’s a lot more research that goes into them than I think people give them credit for. But it is somewhat arbitrary because they cover so many companies.”
By MUHAMMED Hazim, Segi Enam intern, 16 Aug 2021 | LinkedIn
Edited by Nadirah SHARIF