May 2016

RESPONSIBLE INVESTMENT: Through the ESG looking glass

Through the looking glassYou wouldn’t expect an oil company’s ESG rating to be higher than a green energy provider’s. Or would you? Fiona Rintoul finds the ESG ratings market that MSCI and Morningstar recently entered can be a bit topsy-turvy. In March this year, both Morningstar and MSCI launched fund ratings that score funds on environmental, social and governance (ESG) factors. It wasn’t the first time someone had tried to rate funds according to their ESG attributes, but because of Morningstar and MSCI’s reach, the industry sat up and took notice.  Both companies set out to rate about 20,000 funds globally. The aim, said Steven Smit,  head of sustainability at Morningstar, is to “provide investors with an ESG lens they can use to evaluate funds” – a worrying notion for some in the industry.  “Portfolio managers will be concerned,” said Enrique Pardo, global head of investment research at the mutual fund platform Allfunds Bank. “You will see asset management businesses want their portfolio managers to be top-rated in ESG.”  It’s easy to say that you’re paying attention to ESG criteria, harder actually to do it. The bright light of ESG ratings may shine on some funds and find them wanting.  FundQuest Advisor (FQA), BNP Paribas Investment Partners’ fund selector business, ascribes a proprietary ESG rating to all recommended funds – sometimes with surprising results.  “As a result of the application of our methodology, a fund marketed as an SRI [socially responsible investment] fund will not necessarily obtain a high ESG rating as the ranking also depends on the firm’s rating,” says Stéphane Pouchoulin, FQA’s chief executive.  This raises the thorny question of how ESG ratings should be calculated and whether they do in fact guide investors towards the most sustainable funds. The FQA evaluation is based on an annual proprietary questionnaire, complemented by on-site visits and face-to-face meetings.  At the company level, FQA evaluates ESG ownership, framework and implementation, including commitment to SRI initiatives, voting policy, normative or sectoral exclusions and resources. At the fund level, it evaluates active ESG ownership and implementation, including implementation of SRI policy, integration of ESG criteria, transparency and quality of financial and extra-financial reporting. “We believe that key criteria for ESG evaluation at both the fund and management company level are an independent assessment and evaluation, including extra-financial criteria, and a clear and consistent rating which can help track changes in the behaviour of the fund and management company over time,” says Pouchoulin.  By contrast, neither MSCI nor Morningstar rate the investment firm from which a fund comes.  MSCI’s Fund ESG Quality Score aggregates issuer-level ESG scores to provide an analysis of the overall ESG quality of a fund’s underlying holdings. The Morningstar Portfolio ESG Score is an asset-weighted average of normalised company-level ESG scores from Sustainalytics. BIG ADVANTAGE
This can skew the date in a couple of ways. One issue is that the company ESG ratings from which MSCI and Morningstar’s fund ESG ratings derive are partly based on operational factors. “It’s driven by how well companies disclose around environmental aspects,” says Lisa Beauvilain, head of sustainability and ESG at Impax Asset Management. “That really favours larger companies.”  In fact, she says, you could get a situation where a European oil company scores better than a mid-cap US company in the renewable energy sector. A fund invested in the oil company might then get a better ESG rating than a fund invested in the US renewable energy company. Or an interesting solution provider, in which a fund with a strong ESG focus might invest, potentially could not be rated at all.  “Many of the solution providers we are excited about are not covered,” says Beauvilain. “None of our renewable energy companies are covered by Sustainalytics. Where companies are not covered, you get certain skews.”  Ryan Smith, head of corporate governance and SRI at Kames Capital, echoes these concerns. “The standard model for good corporate governance that most rating agencies apply doesn’t fit with family-owned companies, but family-owned companies are often the best-performing because they have a lot of skin in the game,” he says. And overall, he sees too much emphasis on ‘how’ rather than ‘what’. “We’ve found that a lot of rating agencies focus on how a company does something rather than what it does. I make tobacco. I make it really efficiently. I score well. But I make tobacco.” ESG fund ratings based on the underlying ESG company ratings are also skewed in terms of geography. “They tend not to cover emerging markets,” says Smith. “You end up with a regional bias and a size bias.”  Indeed, according to Impax, the funds that are focused on, or that are overweight in European companies, are much more likely to score better than other funds. That’s because ESG disclosures are much more developed in Europe than in the USA or Asia.  MOMENTUM
Another problem with ESG fund ratings based on ESG analysis of the underlying companies in a portfolio is that the companies that are doing best at ESG right now might not be the best ones to invest in.  “Momentum is more telling,” says Ryan Smith, head of corporate governance and SRI at Kames Capital. “The best investments are companies that are improving their ESG performance, because ESG improvement is usually a sign of overall improvement.”  Smaller rating agencies, such as Kendal-based 3D Investing and As You Sow, an NGO based in Oakland, California, may provide more nuanced data, though the data’s applications are usually less wide. 3D Fund Analyst enables investors to compare 152 ethical funds on criteria such as ethical suitability, social impact and SRI capability. The results are interesting, for sure, but only cover those 152 UK-based funds.  As You Sow, which has as its mission “to promote environmental and social corporate responsibility through shareholder advocacy, coalition-building and innovative legal strategies”, provides tools for investors to assess funds with specific goals in mind.  Fossil Free Funds is one such tool. It allows investors to look up mutual funds and see how much of the fund’s assets are invested in fossil fuel stocks. Giving investors that information has provided something of a catalyst for change, and 16 funds now qualify compared with 11 initially. There is a version of the tool in the UK, and As You Sow is building tools for Germany, France and Denmark. “We’d like to cover all of Europe,” says Andrew Behar, chief executive of As You Sow.  Behar’s company had to dig deep to get the data for Fossil Free Funds and he emphasises the importance of “getting into the nuances”. However, like Impax’s Beauvilain and Kames Capital’s Smith, he welcomes the new initiatives from Morningstar and MSCI, even if the data is not yet perfect.  “It’s all great,” he says. “It’s finally getting to be mainstream.”  IMPROVING THE RATINGS
For its part, Impax has put forward some suggestions as to how ESG fund ratings could be improved. These include considering qualitative aspects, such as engagement, and incorporating what the company calls “intentionality”. This basically means making explicit reference to the fund’s intention. Is the fund’s intention to invest in environmental solution providers, or simply in companies with better processes across all sectors? “Funds just investing in companies with high ESG scores have an entirely different focus than funds investing in companies providing positive environmental benefits,” the company says.   It’s hard to argue with that – or with Smith’s assertion that there is no one-size-fits-all approach to ESG. The fundamental aim is to make these funds transparent to investors, so that they know what they are buying and whether it fits with their objectives.  “Market participants have expectations that differ according to their preferences and ESG ratings give them a turnkey solution enabling them to determine the extent to which they want to give their investments an ESG focus,” says FQA’s Pouchoulin. The new ratings may not be perfect, and may in some cases engender confusion, but they are a start. “Standards will emerge,” says Behar, who notes that Bloomberg has been collecting ESG data for years and “sucks up” every report his organisation produces.  Such aggregators of data may lead the way in the future, perhaps supplemented by standardising initiatives from the regulator.  “Regulators have a natural role to play in the establishment of ESG standards, as a consistent approach would enable better comparisons between products, benefiting investor protection and risk reduction,” says Pouchoulin. “Fund selectors also have a crucial role to play in this regard.” Certainly, as the sustainable investment sector grows and ESG principles become more mainstream among standard funds, clarity is essential. ESG investors must feel assured that they are getting what they signed up for if the sector is to thrive – and confidence in the wider industry is to be maintained. “If you don’t have transparency in the ethical ESG fund sector, you can’t expect it anywhere,” says Smith. ©2016 funds europe

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