For a long time, investors assumed they had to choose between environmental, social & governance (ESG) considerations and performance, as if opening one door shut the other. In fact, performance and ESG can be viewed as a set of keys hung on the same key ring, both helping to unlock value. ESG is now widely considered as an enhancer of returns rather than something requiring a trade-off. 
However, not all ESG metrics are created equal. Some are top-level summary ratings, while others are topic-specific. Muddying the waters further, each ratings provider uses a different methodology, which results in a low correlation between ratings that supposedly measure the same thing. To give an example, some European banks are among the ESG leaders for Sustainalytics but rank as average by MSCI. Different agencies look at different metrics or apply different weights to subjects they think are material for the sector and for specific companies.
Data quality has a long way to go
Compared to traditional financial reporting, ESG disclosure is not as deep, nor is it consistent between companies. If you were to build a table with the ESG metrics you want to track for a particular industry, and you linked that to the most recent financial statement, in some cases only 20 to 30 per cent of those metrics would populate.
However, the quality and availability of data are improving, either thanks to regulation or improved awareness. Where sustainability reports used to offer little detail, companies now include metrics, targets, descriptions of progress and KPIs (key performance indicators).
ESG reporting has further to go on developing a baseline sustainability accounting standard. If companies do not disclose ESG data, asset owners will not be able to accurately report on the ESG profile of their holdings. Encouragingly, reporting standards are beginning to converge, which should provide greater clarity for reporting companies and investors.
A good starting point
Using an external score consistently also helps research teams develop a deeper understanding of the methodology and its limitations.
This has benefited our own quantitative ESG score, called Elements, which embeds several sector and company-specific indicators and integrates ESG factors. Once we have the Elements score, we look at the company’s MSCI report to see if there are any specific ESG issues. From there, we can drill down further.
ESG ratings do not always impact a credit rating directly, but understanding ESG risks and opportunities helps credit analysts form a holistic view of a company. For example, if a business has a higher exposure to carbon than peers and a carbon tax is announced, the impact on its earnings and balance sheet can be assessed quite precisely.
Other risks are much more qualitative and difficult to estimate. For instance, the effects of a controversy in a company’s supply chain can range from managing brand damage to undergoing a full programme of policy, audit and practice reviews, entailing significant costs.
Video versus snapshot
Another important aspect of the analysis is the ability to look at the momentum of a company’s ESG practices, in contrast with the backward-looking snapshots external scores provide.
When an ESG analyst does a full assessment of a company, they will assign a point-in-time opinion (positive, neutral or negative) and a trend opinion, whether it is improving, stable or deteriorating. In addition, our proprietary scoring system incorporates a rate-of-change perspective.
This means that for a company with strong ESG credentials, the credit analysts and portfolio managers can focus on other areas unless things begin to deteriorate. On the other hand, for poor ESG performers, an argument might be made to hold the security regardless, either because the valuation compensates for the risk – which is defensible in a non-SRI portfolio – or because there is a strong improving trend.
There are situations where you invest in a company because you are looking to ride the improvement over time. In that case, you would be focusing more on the momentum than point-in-time characteristics.
Meeting with the management team of a company provides critical qualitative insight. When asking management about environmental practices and related compensation, for instance, if the response is hesitation and platitudes, that indicates there might be a lack of commitment. On the other hand, if their response has conviction, talking about KPIs and how they feed into the compensation plan, we have a lot more confidence and can feed that into the analysis.
Finding discrepancies
Probing the areas or firms where ESG views differ between scoring systems can also be useful. Boohoo offers a striking example. Although Aviva Investors’ proprietary ESG score for the company was positive – demonstrating analysts can only get so far with a pure metrics-based analysis – it was more in the middle of the range versus industry peers than in MSCI’s ESG ratings, which had placed Boohoo at the higher end.
However, engagement with Boohoo’s management team highlighted significant concerns over governance, an assessment that was shared with the investment teams.
Volkswagen is a good illustration in the other direction. While the emissions scandal that engulfed the German auto giant in late 2015 would have been impossible to predict even with regular management meetings, since it was a well-hidden fraud, what has happened since is interesting.
When the scandal broke, its bonds were all over the place. We decided to hold our positions, believing there would eventually be a way out for the company. In fact, bond prices had recovered within three to six months, and within 12 months fines and settlements were mostly agreed, drawing a line under how much Volkswagen would have to pay.
As we found through research and engagement, the company underwent a significant transformation, from the strategy – whereby electric vehicles replaced diesel as a focus – to company culture.
What are we trying to measure?
Assessing ESG credentials is more complex than avoiding companies with poor scores. For active managers that take their stewardship and engagement responsibilities seriously, there is some rationale in having exposure to underperformers to use their influence to improve ESG practices.
In addition, mainstream portfolios have targets to beat their benchmark, which requires managers to be pragmatic and balance ESG risks with return opportunities. On the other hand, clients are increasingly demanding to see sustainability improvements in their portfolios.
Usually, we think about them from a performance perspective, but for a strategy meant to be aligned with particular Sustainable Development Goals, an impact assessment of a company becomes the key point.
Richard Butters is an ESG analyst at Aviva Investors. The views expressed above are his own and should not be taken as investment advice.