ESG - The momentum is there - now we need some standardised metrics to measure performance

Expert: Eric Borremans, Head of ESG, Pictet et Cie Asset Management 

State of play

• ESG is becoming more and more important in the market. ESG metrics are evolving in today’s market.
• Since there is no Global Investment Performance Standards (GIPS) equivalent in the market it is important to understand how these different metrics are compiled and used.

Headlines

• With the importance of ESG growing, it is important that metrics are standardized.
• There are many initiatives in the market and time will tell which ones will remain long term.
• Fundamentally, ESG is a toolbox that can be embedded in the construction of different portfolios. In doing so an Investment manager can choose to:
  • Do the ESG evaluation themselves
  • Rely on third party ratings or labels
  • Rely on the bigger players such as MSCI and Morningstar

• In cases 2 and 3, the Investment manager must be aware of how the biases of the ratings are made in the composition of their portfolios.
• For example, ISS will rate corporate governance of a company and compare it to others in the same market. i.e. a Japanese company to a Japanese company and may have a high Governance rating as a result. If this same company were compared globally, it may all of a sudden find itself in the bottom quartile.  It is very important to understand the methodology of how the ratings are made. 
• By using this data, an Investment manager can than decide to overweight well governed companies in a portfolio and underweight those which are less well governed and perhaps prone to controversy. In doing so, portfolio managers can declare percentages of portfolios 70pct green as per the metrics they have chosen to use.
• Some metrics are less subjective such as pct of revenue derived from activities such as coal, tobacco, oil and gas and arctic drilling.
• It is in the aggregation of ESG data that are skewed from the E, S and G biases of the provider. It is in the aggregation of the methodologies that take weighted averages of different aspects of a company where certain negative aspects are averaged out by beneficial ones.  If a company has labour problems but has board diversity as a counterweight, the company still has labour problems.  It is the metrics that highlight the weakest link of companies that are most transparent.
• Another metric can be how many companies that the firm follows does the firm visit? Here the number of companies is less important than the quality of the review and style the firm is using.
• One popular metric today is the SDG (Sustainable Development Goals) which reflects what a firm intends to do to get there. Although ambitious, it should not be forgotten that this is a system designed by countries for countries and therefore not a perfect fit into the private sector and has its limitations
• There are currently nine labels throughout Europe. Some reflect green strategies and some set standards to exclude those who fail ESG standards.
• There are also now factsheets done by MSCI and Morningstar that enable one to compare like to like portfolios. Be aware that by doing so, one is tacitly adhering to their ESG rating philosophy.
• As a result of these metrics being very differently calculated, there is very little correlation between ratings.
• On a positive note, the draft EU resolution that will be delivered in March 2021, is instituting 32 mandatory entity and portfolio metrics. Among other things, there is be a Carbon Footprint metric as well as if companies follow ILO standards. Because of the number of the metrics, the aggregation issue will remain for those wishing to reduce the different ESG metrics to a single number. 

Key themes 

• ESG versus Credit Agencies – will there be convergence? Perhaps good for it not to completely converge although it would be easier. Keeping the ESG ratings and their different methodologies does avoid groupthink.   Until there is a fully open data repository for companies where they report a common set of information, it would be best to keep these ratings separate.
• What is the overall role of the ESG analysis versus investment analysis? There is a fundamental issue when a company e. a tobacco company which makes products that kill, gets a high mark on ESG.  This is an issue that will continue to be debated.  If a company makes a hazardous good but then performs well in ESG terms it will always be difficult to reconcile.  Ultimately, it will be the client who will decide in cases such as these.  

It should be noted that there are cases where, for example,  a coal fuelled company can be rated as brown but with investor pressure can be motivated to make the appropriate investment to make the company green.