“ESG rating – an arduous endeavour. Why ESG metrics still fail to provide a (single) source of truth”

The expression money talks is particularly relevant for ESG. The confirmation about ESG being a solid value driver made ESG turn to center stage. Yet, although ESG is highly regarded and discussed, it remains difficult to establish what it corresponds to exactly within each company. When assessing companies and their competitors, ESG considerations are often pushed to the curb for multiple reasons. The expertise to analyze this information is more than often not available or available data is insufficient. ESG related information has therefore been very difficult to analyze and the question of ESG ratings becomes all the more thorny. We found two recent examples to illustrate why a unified ESG rating is becoming inevitable.

No audits, no frameworks and a correlation that is far worse than what we are used to from other financial metrics

To start with: when it comes to ESG and ESG ratings, nothing is audited. Companies take their initiative to assess the current status of ESG within the company, meaning that they conduct their own health check. Taking this a step further, this becomes problematic because ESG is seen as a revenue driver. Therefore, a company could potentially be inclined to view its ESG advancement highly, even if it is misleading. Olivia Sibony, CEO of the ethical investment platform SeedTribe underlines that “the system is fundamentally flawed. By allowing companies to self-certify, they can hone in on one or two aspects that might look good on paper but don’t, for example, consider the end-to-end life cycle of a product or service”. In turn, such a system does not allow for the world to have a clear view on the status of ESG in a company.

Given that no solid framework really exists for ESG ratings, it is difficult to figure out which company is more ESG friendly than another. For example, oil companies are usually considered as having a clear negative impact on the environment, and are often condemned by environmentalists, yet auto companies and namely electric car companies are seen as more eco-friendly. However, under certain ESG standards, it has occurred that Exxon Mobil and Tesla have been awarded the same rating by a specific rating agency. For others, Tesla has been at the top of the most well rated ESG companies and for others at the very bottom. Although it seems rather counterintuitive to have such disparities and see that an electric car company compares to an oil company in terms of rating, it does exist, and this is only the starting point of ESG related issues.

When comparing different rating agencies, a company can have a completely and drastically different rating. If this brings anything to light, it is mainly the fact that there exists no standard whatsoever to evaluate ESG. Rating agencies such as S&P, Moody’s and Fitch usually produce and deliver financial ratings that are highly correlated (around 99%). However, for ESG, it is far from being the case. They are not correlated more than 61% at best. These results were based on a dataset of 5 ESG raters, and correlations have been studied between more than 863 companies. This demonstrates the extent to which nothing is harmonized and ESG ratings remain largely subjective. As of now, corporates need to start understanding the information that they need to be making public in order to make the ESG rating more reflective of the status of ESG within their own company.

Each rating agency for ESG can be and is driven by a specific preoccupation or a rating bias. This can for example be carbon footprint or equality between the sexes. This particular preoccupation drives the rating agency to rate companies mainly through that lens. It therefore makes it all the more difficult to compare and contrast ESG ratings of different rating agencies. Mona Shah, director at Stonehage Fleming Investment Management, a London-based multifamily office, develops on the fact that she has noticed conflicting ratings when building a sustainable investment portfolio. According to her, “ESG

analysis, by its very definition, is subjective. Different providers will inevitably have different ways of classifying whether they think social concerns are more important or whether they are driven by carbon footprint, for example.”

The EU taxonomy, Bloomberg’s launch of an ESG rating system and two major ESG rating agencies joining forces provide light at the end of the tunnel

ESG ratings not correlating well with each other is often a source of confusion for investors. This difficulty has been duly noted and this is why attempts at harmonization and frameworks are being made. The aim is to create a more consistent, transparent ESG rating methodology. By 2022, the European Union aims to introduce and enforce a new taxonomy implementing disclosure requirements for index providers of sustainability labels. On the European level, it would certainly bring about more transparency. It will introduce new disclosure requirements and will in turn lead the industry toward higher quality standards. Nevertheless, although the European Union is at the avant garde, other regions in the world are still far behind. The systems of rating providers can only improve significantly, if companies on a worldwide scale need to report sustainability data. The US for example is not very reactive, especially since the Securities and Exchange Commission (SEC) does not require disclosure of ESG data. Bloomberg, the largest media company in the world, has decided to put in place and launch its proprietary ESG rating system. The company spots an opportunity to provide transparent and complete scoring methodologies thanks to their access to the underlying dataset. Initially, it will start by elaborating ratings for about 252 oil and gas companies and broaden the composition for more than 4300 companies in the future. It may not be an astronomical figure, but it is certainly a start. Given all the databases that they own, and all the information they have access to, Bloomberg will certainly be able to succeed in its initiative.

On the smaller level, 2 ESG rating giants are joining forces in order to lighten the load for companies which suffer from sustainability reporting fatigue. The increasing demand for ESG data has made it imperative for them to set aside their differences, bury the hatchet and start working together.

These efforts don’t make up for the lack of homogeneity within the ESG ratings framework, but they certainly aim to provide more transparency and clarity in relation to this subject which is certainly a step forward.

A problem of incoherent ESG standards – did ESG stocks really outperform their non- ESG counterparts during the pandemic?

As we can see, creating a single source of truth on ESG rating remains a challenging task and there are some pertinent illustrations for how badly we need a generally accepted and standardized reporting framework. The following recent developments have shown that the broader economy is still at the beginning of understanding how sustainable thinking can be implemented properly into financial markets. The most prominent logical fallacy might have emerged from the COVID-19 pandemic and the general belief that an ESG label had immunized stocks from the broader stock market slump. A prominent research paper recently published by a team of researchers from NYU Stern School of Business, Tilburg University and University of Waterloo suggests that environmental, social, and governance (“ESG”) scores might have been falsely touted as indicators of share price resilience during the COVID-19 humanitarian crisis. In their paper, Demers, Hendriske, Joos and Lev present robust evidence that, once a firm’s industry affiliation and accounting- and market-based measures of risk have been properly controlled for, ESG scores offer no positive explanatory power for returns during COVID-19. More specifically, they undertook extensive analyses to investigate the underlying root- causes for financial resilience during the COVID crisis, concluding that celebrations of ESG as an important resilience factor in times of crisis were, at best, premature. In essence, they unveiled that ESG had been insignificant in fully specified return regressions for the first quarter of 2020, and it had been negatively associated with returns during the market’s “recovery” period in the second quarter of 2020. This antithetic claim comes as a surprise to the wider investment community. Instead of ESG performance and corporate sustainability in general, more indirect measures such as industry affiliation,

market-based measures of risk, accounting-based variables capturing the firm’s financial flexibility (liquidity and leverage) and investments in internally-developed intangible assets could be root-caused as the underlying reasons for the COVID return models. ESG did not meaningfully add to the combined accounting and market models’ performance. Their research definitely raises the question whether the logical fallacy might come as a result of a still largely ineffective, logically deceiving and unsophisticated ESG rating methodology.

How the omnipresence of FAANG stocks in sustainable portfolios might be misleading ESG investors – are we whitewashing high-yield tech stocks?

The fact that ESG ratings as a whole are still uninformative and potentially insignificant might be epitomized by the large volume of technology-laden funds branded “ESG”. While the majority of them might do very well on E and S, their business models raise growing concerns when it comes to G. Especially the US tech giants find themselves at the centre of controversies over data privacy, questionable labour practices and monopolistic behaviour. This might be an obvious and quite striking example that ESG metrics do not yet rate the single E-,S- and G-components adequately. Google has announced in September that it is now fully carbon-neutral. Yet, during the big tech antitrust hearing in July in front of the US Congress, Google CEO Sundar Pichai had to justify himself over allegations of weak corporate governance practices. US Congress chairman David Cicilline gave the following opening statement at the hearing on “Online Platforms and Market Power: Examining the Dominance of Amazon, Apple, Facebook, and Google”:

“Many of the practices used by these companies have harmful economic effects. They discourage entrepreneurship, destroy jobs, hike costs, and degrade quality. Simply put: They have too much power.”

Given the antitrust issues of big tech and the fact that funds with high performing ESG metrics have been found to have large technology holdings, particularly from Microsoft, Apple, Amazon, Facebook, Netflix and Alphabet, these funds branded as sustainable are under fire. We have outlined the force at play earlier in this article: ownership of tech stocks that have soared in recent years — and especially during the COVID crisis. In 2020, 8 of the 10 best performing large-cap US funds that incorporated ESG metrics as a key part of their selection process had either Apple, Amazon or Microsoft as their biggest holding, according to Morningstar data. On average, 17% of those 10 funds’ portfolios are in so-called FAANG stocks.

Lauren Peacock, a campaign manager at ShareAction, said there was a risk that “tech is becoming the new oil and gas — investors don’t want to rock the boat when the returns are so good”. So, are we running the risk that shortcomings in meaningful and representative ESG metrics are exploited for whitewashing high yield big tech stocks?

Authors: Oumaima Sadouk, Lukas Rombach

Sources:

Why ESG ratings need an overhaul:

https://www.raconteur.net/finance/responsible-investment-2020/esg-ratings-overhaul

Conflicting ESG ratings are confusing investors:

https://www.bloomberg.com/news/articles/2019-12-11/conflicting-esg-ratings-are-confusing- sustainable-investors

Bloomberg launches ESG ratings:

https://www.financialstandard.com.au/news/bloomberg-launches-esg-ratings-170629134

Bloomberg launches proprietary ESG scores:

https://www.prnewswire.com/news- releases/bloomberg-launches-proprietary-esg-scores-301109999.html

FT.com: ESG reporting powerhouses bury the hatchet: https://www.ft.com/content/675216be- d751-46c6-8b49-2fc4c923bb36

ESG did not immunize stocks against COVID-19 Market Crash:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3675920

Funds branded ‘ESG’ are laden with technology stocks: https://www.ft.com/content/ea295d51-d5c2-4916-8c63-017c352ea577

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