Is ESG investing delivering to plan?

Published in FM Report – by Terry Devitt

Over the last decade and more ESG (Environmental, Social and Governance) has grown to become the standout topic in the mainstream investment world. Despite this, as an adviser I am still waiting for my first client to walk in the door and independently raise the topic of ESG with me. Perhaps we are still a little behind the curve here in Ireland. That said there is no avoiding it. This year alone the world has seen a whole series of extreme weather events and the growth in awareness around the E part of ESG has certainly grown hugely, helped by such events. The S (equality of opportunity and reward regardless of gender, race, social status) and G (running our companies and institutions properly and fairly taking account of all stakeholders) maybe not so much. There are of course good reasons for this bias. While all of the issues embedded in ESG are unquestionably important, it’s the climate which has taken centre stage and become urgent. If the world reaches a point mid century where large areas of the world have become uninhabitable, Social and Governance issues will almost certainly recede very much in importance.

And of course the regulators have become involved, in turn driven by growing concerns amongst politicians that action needs to be taken on all fronts. All financial service providers including banks, fund managers and advisers now face a plethora of regulations around ESG as they go about their business and engage with clients and customers. But are we getting it right?

At present, within the EU we have the SFDR system, a classification system for funds based on ESG criteria, and in all honesty it is not fit for purpose. We have been given three fund categories, Articles 6, 8 and 9, with 6 applied to the least ESG friendly funds, 9 to the most friendly and 8 to those funds who lean towards ESG but who don’t quite match up to the highest standards. In practice, however, very few funds want to be rated 6 unless they have no other option (oil funds, commodity funds etc) and a large number of funds currently rated Article 6 have ambitions to move to Article 8 in time. The hurdle Article 9 is too high so few can achieve it – so what happens in practice is that the vast majority of funds aim to be in the middle category or Article 8. We then end up with a vast array of funds, all categorised as Article 8 and no further differentiation. This is clearly of questionable value to the ultimate investor.

The end game must be to regulate at either the company or the rating agency level and to do so with the aim of achieving consistency and with a proper focus on what ESG goals are all about. I would be extremely surprised if we are still dealing with a three tier SFDR system two years from now. In this context, it is interesting to note that consultations between the EU Commission and the financial services industry have already gotten underway with a view to carrying out a complete overhaul of the SFDR system by 2024.

It really is very difficult to see how a revised system, if it is to be meaningful can avoid involving the rating agencies, either formally or informally. At present there are upwards of a dozen rating agencies operating in the marketplace, each with their own approaches and methodologies, the most high profile of which are probably MSCI and Sustainalytics (owned by Morningstar). Comparisons are often made with the credit rating agencies (S&P, Moodys etc). However the degree of correlation among the credit rating agencies is more than 90% while the degree of correlation among the ESG rating agencies is less than 50%. In other words a given company is less the 50% likely to get the same ESG score from two different agencies. This is completely understandable given the huge range of variables which could potentially be measured and included and the weight which could be attributed to the chosen variables in arriving at the final score. This low level of consistency raises very serious questions about the usefulness of ESG ratings in general.

Another facet which has become apparent is that there is quite a direct correlation between the size of a company and the likelihood of that company getting a positive ESG score (see chart below). One suspects that the reason for this is directly related to the capacity of larger companies to devote greater resources to their ESG status and to producing the full range of data required by the rating agencies. It does not mean however, that larger companies are doing better at ESG than smaller companies and very often the opposite may well be true but this will not be captured by the current methodologies.

A final area of concern relates to passive investing in ESG. The availability of scoring systems from the rating agencies has allowed a massive expansion of passive ESG investing in recent years and the number of ESG ETFs has proliferated hugely. Bloomberg reported recently that just 5% of passive funds were delivering on their ESG targets and regulators, such as the FCA in the UK, have discovered in their investigations that the vast majority of passive ESG funds simply don’t stand up to scrutiny. The response to these findings, as mentioned above, will inevitably be increased regulation.

As an advisory firm charged with the job of making fund recommendations to clients, our chosen policy is to avoid passive ESG funds altogether. And in selecting actively managed funds, we strongly favour managers who go well beyond the systems and output of the rating agencies and who apply their own proprietary filters to select their ultimate investments.

So, in summary, there is clearly a lot to do if we are to create a proper framework for ESG investing, one that will greatly improve both the transparency and consistency from companies and rating agencies, allowing investors to make decisions which promote the most desirable outcomes.

Author: Terry Devitt, Head of Investments at Harvest Financial Services first published in the FM Report.