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Financial Industry Insights from Advisors Asset Management

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ESG Ratings Are a Mess, But Standardization is Not the Answer


Responsible investing (RI) has been around for a long time, with the issues and themes gaining ever more prominence in recent years. A sustainable revolution is now sweeping its way through society in terms of what we value and tolerate, impacting many sectors and companies. This now lies at the heart of the rise in RI and ESG (environmental, social and corporate governance) investing.

As it has moved higher on the agenda over the years, consumers, companies, and governments alike have developed a desire and appetite to do more for ESG. Yet with the growth of ESG and RI, the landscape has become more difficult to navigate.

One of the challenges we see investors beginning to face is that of ESG ratings agencies, which often struggle to deal with the inherent ambiguity, subjectivity, and differing beliefs found in the RI universe. ESG has already proven to be a subjective topic thanks to a lack of consistency in its definition across the industry. As a result, the very formulaic “one-size-fits-all” approach of ratings agencies is becoming an increasingly blunt instrument when faced with the complexity of ESG issues.

The lack of continuity in definitions or of consistent data produced by companies to analyze – when coupled with a lack of consistent methodology within agencies – often results in a counterintuitive output, with some agencies even having completely conflicting views on identical topics and issues.

Alongside the issue of a lack of consistency in methodology, we have the issue that agencies tend to focus on business practices as opposed to products. This can result in a scenario where businesses which one would logically assume is bad for the environment, receive higher scores thanks to their ability to leverage their credentials. For example, a tobacco company can score very highly thanks to having good practices when it comes to governance, diversity and inclusion, and a good sustainability report. But at the end of the day, they’re still a tobacco company. Conversely, there could be a biotech company that is working on a breakthrough cure to cancer, yet if they don’t produce a sustainability report or might not have ideal governance, they receive a poor ESG score. And therein lies the issue.

We are beginning to see consolidation occur across agencies, and this standardization can be a good move. However, not all data will be able to be standardized. While it’s easy to standardize quantifiable outputs, such as carbon emissions and water usage, governance related topics are more difficult to assess.

Across the industry, we are finding ratings being led by this quantitative approach, focusing on what the data is. Although the data collected by ratings agencies provides a great source of information, this approach often misses the bigger picture, and we should be very wary of their conclusions.

ESG is already a bit of grey area thanks to the great span of definitions across the industry, and as such this has pushed us into the need for rating agencies to be more qualitative in analysis of companies. We have seen rating agencies further afield, such as in Germany, take the approach to interview fund managers and companies to see what their philosophy is, what their process and beliefs are, and base the ratings on these findings. There is now a growing need for rating agencies to come in and understand what companies do and how they do it, using the evidence to provide a rating based on qualitative measures rather than aggregated details.

Due to the subjective nature of ESG, there will be ongoing grey areas and debates. Sustainability and governance are, and should continue to be, in our opinion, qualitative topics. As a result, we believe a rigorous, bottom-up approach is often better positioned to capture the nuance, products, and values of individual companies.

We believe removing the conformity and “off-the-shelf” nature of ESG ratings should allow for a more diverse range of companies to shine through as sustainable leaders and sustainable improvers. This may ultimately provide consumers, companies, and governments alike with the opportunity to invest in companies which they believe are truly making a difference.

 

CRN: 2021-0817-9397 R

The opinions and views of this commentary are that of Aegon Asset Management and are not necessarily that of Advisors Asset Management.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit http://www.aamlive.com/.


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