Living in the past

Marte Borhaug, global head of sustainable outcomes at Aviva Investors, believes taking controversy scores at face value is a dangerous shortcut. It could also become an issue for sustainable funds, as the market may lose credibility if some funds are tainted because of poorly researched investments.

“There is a high risk of clients discovering companies they didn’t expect to be there in the first place. There could be a big gap between perception and portfolio reality,” she says.

First and foremost, the lack of consistency in approach by the companies providing controversy scores is stark. Which begs the question: how can investors tell which is ‘right’ and which is not?

For example, only seven companies are flagged for controversies in both datasets of two of the biggest ratings providers, MSCI and ISS (including Shell and phosphate rock miner OCP). This is because their scoring methodologies measure different things, so names often appear on one list but not the other.

Figure 1: Overlap between MSCI and ISS controversy scores

Although every approach, from MSCI to ISS, has its merits, the differences make it more important for investors to develop the resources and expertise to complement data providers’ analyses and bring a different perspective.

Part of the issue is that the scores do not account for hidden controversies. Instead, they typically reflect headline-making issues, while ignoring lower-profile violations that have not yet been picked up externally.

Moreover, the scores do not always account for steps taken by companies to improve and remediate issues in a timely manner, which are crucial to assessing a company’s future performance. For example, the legacy of the 2015 ‘Dieselgate’ scandal that rocked German car giant Volkswagen lives on today; the company still has a zero MSCI controversy score despite having made significant organisational changes to fix the issues uncovered.

The WBA’s Neale explains why. “We are talking about some companies with operations in 100 countries and supply chains in 150 countries; you are never going to be able to get to the whole truth of that, so you have to take an awful lot on trust,” he says.

Quantifying harm and comparing events such as deaths, illnesses or sexual harassment is a complex area in itself. “You don’t want to be the people that sit there and say: ‘300 cases of sexual harassment are equivalent to four fatalities’. But quantifying impacts, controversies or responses to controversies is, in some way, necessary for creating rankings. If you’re going to be bold and step into that area, it helps to be transparent on what approach you’re using,” he says.

Furthermore, remedial action is often hard to measure and unlikely to be satisfactory to victims. 

Boeing and Airbus have low scores as measured by ESG Elements, [Aviva Investors’ in-house quantitative ESG score, which is based on several MSCI indicators alongside proprietary ones] – mainly due to past controversies. However, when qualitative analysis is added to the process, differences between the two companies are apparent.

The Airbus controversy stemmed from endemic bribery within its commercial aircraft business spanning more than ten years, but the company has since taken significant steps to mitigate against this happening again.

Meanwhile, Boeing’s controversy sprang from the tragic loss of life in two crashes of its 737 MAX aircraft, which uncovered safety issues and deep-rooted cultural problems. While the planes have now been re-certified, Malini Chauhan, ESG sector analyst at Aviva Investors, says cultural issues continue to pose a risk, both to investors and other stakeholders.

Boeing has not acknowledged the 737 MAX shortcomings stemmed from a company-wide issue, pinning them instead on two former employees.¹

The stark contrast between the two companies’ responses demonstrates the importance of remedial action to mitigate the risk of reoccurrence of incidents with tremendous negative social impact – and shows why investors need to look beyond scores to assess this for themselves at a qualitative level.

The correlation between share prices and controversies varies and seems dependent on many factors. However, the materiality of a controversy is dependent on the firm’s business model, making it doubly important to look beyond the score and into the nature of the controversy to assess its potential impact on valuation. For example, a failure linked to the core product of the company, such as an oil spill for an oil company, a medical defect for a pharmaceutical company or an engine failure for a car company – is likely to hit harder than a failure at the margin.

According to research by Bank of America Merrill Lynch², the impact of ESG controversies on share prices of companies in the S&P 500 is stark: 24 ESG controversies wiped $534 billion off the value of large US companies over a five-year period starting in 2014.

Figure 2: The impact of controversies on share prices

When it comes to companies’ impact on people and the planet, information from independent sources, such as research from civil society organisations, is essential. These organisations often operate on the ground, close to companies’ operations, and provide insight into current practices that may yet hit the headlines, providing more depth and granularity to data provider scores.

“We will look into what the data providers have told us, whether through talking to the company, desk-based research, or talking to NGOs on the ground, to verify their statements. Using company employees, whistle-blowers, and that kind of bottom-up information is hugely important,” says Borhaug.

Moreover, the information is not just a proxy indicative of future controversies; having the information at hand today can also allow investors push for change. “Using a broader range of information is part of the due diligence necessary to be a responsible investor,” says Borhaug.

Understanding a company’s controversy risk requires a combination of art and science. “In an ideal world, there would be sufficient quantitative data to easily aggregate and analyse, but that doesn’t always exist. Sometimes there is an element of intuition, and you just have to monitor the markets and look for warning signs,” notes Richard Butters, ESG analyst at Aviva Investors.

As well as negative media reports, Twitter sentiment, emerging themes on employee site Glassdoor or online petitions can be useful indicators. Yet to have an intuition in the first place, investors need to look at many other data points, and this is where controversy scores can have a role. “If there is a controversy, you tend to see it in a score. If there is a zero score, that would require due diligence,” says Butters.

Another key tool of influence and research comes through engagement. Face-to-face interaction can help investors gauge a firm in subtle ways desk-based research can never achieve. Investors need to understand not just the implications of controversies, but also the change undertaken by companies after they have been hit by a scandal. If the remedies taken and progress made are significant, it can be rewarding to invest in such a company before the slow-moving controversy score begins to reflect the improvement.

Predicting corporate controversies will never be a perfect science. There is no model, algorithm or complete dataset available to help magic up an answer. However, just as vulcanologists searching for eruption clues, investors can learn to better identify the tremors signalling insight from the ones that merely add to the informational noise.