Why ESG ratings are good but additional scrutiny is better

There is far more scrutiny on a company’s environmental, social and governance (ESG) credentials today that at any time in history. Given the potential brand damage from falling short on contentious issues, regulatory censure from poorly designed policies issues and the sheer flow of money into sustainable funds, companies simply cannot afford to ignore ESG considerations.

Many companies have long factored ESG issues into their business models, even though they haven’t explicitly reported their inputs, processes and workforce relations in the depth demanded today. Some management teams have even told us that until recently, they positively avoided going into too much detail on projects, fearing it would reduce their competitive advantage, or because their own customers demanded anonymity.

The growth in the power of ESG rating agencies, whose opinion can categorise a company as having “good” or “bad” ESG practices, has made it more important for companies to publicise their ESG credentials. Done well, adoption of ESG standards can be a win for all stakeholders. But unfortunately, the data that a company needs to present isn’t always obvious and the scoring system still leaves much to be desired.

The rise of ratings

In much the same way that credit rating agencies analyse a company’s financial reports, ESG rating agencies use data from a company’s activities to assign an ESG score to a company’s activities.

There are a multitude of ESG data points – more than 100 in many cases – on which companies are increasingly expected to report. But there are no hard and fast rules, and often it may be as much qualitative as quantitative, making it easy for a company to omit some crucial data when there is no established template.

The output of the ratings process is to condense down the data points to three scores for the main pillars: environmental, social and governance. These three scores are regularly combined into a single score. A one size fits all approach. This becomes a hugely important issue for those funds or investors that can only invest in companies with a minimum score. Providing incomplete ESG data, the wrong statistics or omitting data altogether, can go a long way to producing a low ESG score. The danger is that a company is unfairly punished for lack of disclosure.

BP and Shell both publish annual sustainability reports, each exceeding 100 pages, requiring huge amounts of data and human resource to produce. In relative terms, the need to publish ever more data points penalises smaller, less well-resourced companies that lack the financial muscle to employ an army of ESG specialists to collect, collate and publicise their sustainability credentials. At the other end of the spectrum we see smaller companies that are expected to implement expensive employee engagement surveys despite having less than 20 employees, all working in the same building.

An unintended consequence of this need for an ever greater number of ESG data points may be that sustainable investments end up concentrated in larger, better resourced companies, putting smaller companies at a competitive disadvantage in attracting investor flows and raising their equity cost of capital as a result.

Applying common sense

Another apparent flaw in the scoring and ranking of companies on ESG practices is related to data point interpretation: What is the ESG score supposedly telling me? Possibly the two biggest issues of today are carbon emissions and use of water. Water is an increasingly scarce resource in many parts of the world, and companies are trying to increase the efficiency with which they extract and use it. However, the calculation of water intensity is not always straightforward.

A widespread method for measuring a company’s water intensity is the volume of water used per unit of revenue. The more water a company uses per unit of revenue the higher the intensity level. Companies are regularly ranked on their water intensity level and with it the implication that the higher the intensity, the worse the company is on this measure. Right? Well, it may not be.

Companies with the highest water intensity tend to be those, whose primary activity is providing clean water, like Severn Trent for example. Severn Trent cleans and supplies two billion litres of drinking water per day to 4.3 million customers.¹ The average household is charged just £1 per day for its water, under a strictly administered regulatory regime. So, while Severn Trent’s water intensity is high, I do not believe it is bad thing – in fact it is a good thing.

Similarly, carbon intensity is often measured with the same calculation method as water intensity: the amount of greenhouse gas produced relative to a company’s revenue. This means that if a company was to raise its prices by 10% (and assuming the price rises stick), then its carbon intensity has nominally declined by 9% – yet the company is still producing the same absolute amount of carbon.

A more appropriate measure could be to look at a company’s baseline water consumption or carbon emissions and track their improvement or degradation over time. Also, to measure the water and carbon output relative to peers and best practice, which aims to penalise less efficient producers (that isn’t captured when analysing output relative to revenues).

What these examples show is that while ESG ratings have focused management and investor’s minds on ESG issues, used in isolation they can be a blunt tool. These ratings (just like buy or sell stock recommendations or credit ratings) still need to be accompanied by thorough research before making an investment decision.

The good news is that increased scrutiny on ESG is having tangible benefits, especially in improving the environmental sustainability of listed companies. Corporates are measuring their output of carbon and putting in place schemes to reduce their environmental footprints over time. This is undoubtedly good news.

The fund management community has a big role to play in shaping future ESG policy. To that end, we need to ensure our analysis and methodology are fit for purpose.

Like cashflows and balance sheets, investors need to dig into the detail behind the ESG scores rather than take them at face value. A company’s ESG score, whether good or bad, should be the starting point for further analysis and, if need be, engagement with company management.

All stocks mentioned are for illustrative purposes only and should not be considered as advice or a recommendation for an investment strategy. All company information can be found on their websites and is accurate as at December 2021.