Sustainability in credit: Why ESG scores don’t tell the whole story

ESG ratings are a helpful baseline to assess companies, but views on their ESG risks and opportunities can be honed – and sometimes corrected – through deeper research, trend analysis and meetings with company executives.

Sustainability in credit: Why ESG scores don’t tell the whole story

Michael Erard is an author, journalist and linguist who for five years worked as a metaphor designer at the FrameWorks Institute, a Washington, DC think-tank. On one occasion, he needed to create an image for a city department in charge of multiple health programmes, many aimed at supporting vulnerable demographics.

“The right metaphor must speak to inclusion and community, and suggest some benefit, such as health or opportunity, that’s more widely shared. I tried ‘bridge’ and ‘platform’, but ultimately went with ‘key ring’: the department holds the keys for unlocking health,” he explained in a 2015 essay.1

Performance and ESG can be viewed as a set of keys hung on the same key ring, both helping to unlock value

For a long time, investors assumed they had to choose between environmental, social and governance (ESG) considerations and performance, as if opening one door shut the other. In fact, just like the health programmes Erard wrote about, performance and ESG can be viewed as a set of keys hung on the same key ring, both helping to unlock value.

As the body of supporting evidence has grown, investors have begun to review their assumptions. “The market is starting to view ESG performance as positively correlated with financial performance, and to think about ESG as an enhancer of investment returns rather than something requiring a trade-off,” says Richard Butters, ESG analyst at Aviva Investors.

ESG ratings: Infuriatingly inconsistent

However, not all ESG metrics are created equal. Some are top-level summary ratings, such as those provided by MSCI or Sustainalytics, while others are topic specific. For instance, much of the information in the reports published by CDP focuses on companies’ environmental and greenhouse gas emissions programmes.

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. 

Different agencies look at different metrics or apply different weights to subjects they think are material for the sector and for specific companies

“To give an example, some of the major 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,” says Demi Angelaki, global liquidity portfolio manager at Aviva Investors.

ESG ratings have a role to play, but investors must choose the right measures and remember the limitations of existing scores.

Data quality has a long way to go

Compared to traditional financial reporting, the level of ESG disclosure is not as deep, nor is it consistent between companies within a peer group.

“If you were to build a table with all the ESG metrics you want to track for a particular industry, and you linked that to the most recent financial statement period, in some cases only 20 to 30 per cent of those metrics would populate – regional differences also emerge due to local reporting requirements,” explains Butters.

The quality and availability of ESG data are improving

However, the quality and availability of data are at least improving, either thanks to regulation or simply due to improved awareness about the issue. Butters says that, where sustainability reports used to be a marketing exercise with precious little detail, companies now include metrics, targets, clear descriptions of progress and KPIs.2

Where ESG reporting has further to go is on developing a baseline sustainability accounting standard, not only for asset owners and asset managers, but also companies themselves. If the latter do not disclose ESG data, asset owners will not be able to accurately report on the ESG profile of their holdings.3 Encouragingly, many of the ESG reporting standards are beginning to converge, which should provide greater clarity for reporting companies and their investors.4

“It is very much down to what companies are willing to disclose, and there are regional discrepancies. If everyone disclosed to European standards, we would be in great shape,” says Alessandro Rovelli, senior credit research analyst at Aviva Investors.

Nevertheless, ESG ratings are helpful as a baseline when analysing a new company’s sustainability credentials, for credit research, and to allow comparisons between products in client reporting.

A good starting point

“It would be impossible for clients to reconcile each investment manager’s proprietary process and understand how that would feed into their own internal analysis. To facilitate that consistency across asset managers, ESG ratings provided by agencies will continue to be important,” says Butters.

Using an external score consistently also helps research teams develop a deeper understanding of the methodology and its limitations, giving them a certain level of comfort.

“We have our own internal quantitative ESG score, called Elements, which embeds several values, indicators that are both sector and company specific, and which integrates ESG factors. Once we have the Elements score, the first thing I look at as a credit analyst is the company’s MSCI report, which provides more colour at the company level so I can see if there are any specific ESG issues. From there, I can drill down further,” explains Rovelli.

Understanding the ESG risks and opportunities helps credit analysts form a holistic view of a company

ESG ratings do not always impact a credit rating directly, but understanding the ESG risks and opportunities helps credit analysts form a holistic view of a company. In some cases, this can be direct. For example, if a business has a much higher exposure to carbon than industry peers and a carbon tax is announced, the impact on its earnings and balance sheet over time can be assessed quite precisely.

Other ESG 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 simply managing brand damage to undergoing a full programme of policy, audit and practice reviews, entailing significant costs.

“Credit analysts focus more on cashflows and balance sheets, while MSCI reports and ESG team analyses focus on ESG criteria, particularly governance, which is a crucial element. This analysis is a major factor in our investment decisions. The ESG team also votes at company AGMs, so they are well placed to work with the portfolio managers to analyse and raise governance issues,” says Rovelli.

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 picks up not only a snapshot of the metrics, but also the first derivative of the trend, so it incorporates a rate-of-change perspective as well,” says Butters.

The credit analysts and portfolio managers can focus on other areas unless they see signs things are beginning to deteriorate

The trend view is helpful because, for a company with strong ESG credentials, the credit analysts and portfolio managers can focus on other areas unless they see signs things are beginning to deteriorate.

On the other hand, for poor ESG performers, an argument might be made to hold the security regardless, either because the valuation more than compensates for the ESG 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 as it manifests itself over time. In that case, you would be focusing more on the momentum than on the point-in-time characteristics,” notes Butters.

“I’ve also seen cases where I think companies are ‘gaming’ the system, focusing disclosure in areas that feature prominently in rating assessment methodologies – which we believe aren’t as material,” he adds. As he explains, meeting with the management team of a company provides critical qualitative insight, as it can give analysts a clearer sense of executives’ commitment and understanding of key ESG issues.

When asking company management about environmental practices and related compensation, for instance, Butters says: “If the response is a lot of hesitation and platitudes, that tells me there might be a lack of commitment. On the other hand, if they immediately come with a response that has conviction, talking about KPIs and how they feed into the compensation plan, I have a lot more confidence and can feed that into the analysis.”

Finding discrepancies

Probing the areas or firms where ESG views are different from one scoring system to another can also be a useful exercise. “Those differences are a catalyst for some of the more fruitful discussions we have,” notes Butters.

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 its governance, an assessment that was subsequently shared across the investment teams.

Meeting with company management can give you a sense of what is happening at a firm and what your concerns should be

“This happened not long before the scandal broke. It illustrates how meeting with company management can give you a sense of what is happening at a firm and what your concerns should be, beyond a pure metrics-based analysis,” says Butters.

For Rovelli, 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 almost impossible to predict even with regular management meetings, since it was a case of well-hidden fraud, what has happened since is interesting.

“When the scandal broke five years ago, its bonds were all over the place. I had been neutral on Volkswagen, and by the time the news broke it was too late to sell. We decided to hold our positions, believing there would eventually be a way out for the company,” explains Rovelli. “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 he found through continuous research and regular engagement, the company then underwent a significant transformation, from the strategy – whereby electric vehicles (EV) replaced diesel as a strategic drive – to company culture and the protection of whistle blowers.

“There are still some governance issues, but on the environmental side Volkswagen is the biggest investor in EV, coming second just behind Tesla in terms of production. We have been upgrading its credit and ESG scores for a couple of years in light of this,” adds Rovelli.

In contrast, while MSCI’s ESG rating for Volkswagen went from BBB before the scandal broke to CCC shortly afterwards, it remains there to this day despite the radical changes made at the company. This is driven by news flow, whereby MSCI notches Volkswagen’s ESG score down every time there is news of a fine or settlement – which continues to happen as some outstanding fines and legal opinions remain.

“We think this is unfair, as the MSCI ESG score should recognise the company’s transformation, its improving financials and ESG credentials, and the likelihood this ESG improvement is going to continue,” says Rovelli.

What are we trying to measure?

Assessing ESG credentials is also more complex than avoiding companies with poor scores, because much depends on investors’ objectives. 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.

Clients are increasingly demanding to see sustainability improvements in their portfolios

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 as well as financial performance.

“Usually, I think about them from an investment performance perspective, but for a strategy meant to be aligned with particular Sustainable Development Goals, for instance, an impact assessment of a company becomes the key point,” concludes Butters.

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