Let’s start off by making it clear that we are not accusing anyone of telling untruths. We have no doubt that the various parties involved are measuring as accurately as they are able to and are telling us what they genuinely believe. However, they do of course all have an agenda, and there are some glaring and unavoidable inconsistencies in what investors are presented with.
We will first turn the spotlight on five prominent ESG ratings assessors. A seminal paper[1] finds that the correlation between their pairwise ratings of companies averages 0.61 overall for a range of ESG metrics. By comparison the correlation of credit ratings is 0.99.
It gets worse. The aggregate correlations for the S and G component are 0.49 and 0.38 respectively. Given that these are intrinsically less easy to measure than physical attributes such as water usage or carbon emissions, it is not surprising that the aggregate for the E component is higher at 0.65. However, within that figure there is disturbing disagreement. The correlation for Green House Gas emissions is only 0.13 and that for water usage only 0.30. These are hardly numbers which inspire confidence for investors, whether index compilers or asset owners, to take serious decisions on.
Next we will look at some of the results in the indices. Here investors’ major focus is on carbon emissions, ie. the total emitted. However, index providers rank companies by carbon intensity, ie. the amount per unit of output. For example, Exxon is zero weighted in the MSCI Low Carbon Target index while other companies such as Schlumberger (oil services), Pembina (pipelines) or Prairiesky Royalty (leasing out oil fields) are overweighted many times because their businesses don’t directly emit carbon. From the index compiler’s perspective this improves the risk profile of their indices. But it is hard to argue that any of the other three companies are not responsible for carbon emissions nor that they will be unaffected by a switch to greener energy.
The problem of measuring ‘scope 3’ emissions, those caused by the user of the product, is also not yet solved. A petrol car user has very different emissions from the wearer of a pair of trainers and any measurement of how much he or she will emit is almost by definition a peer into the future.
Finally, there is the question of ‘big oil.’ A number of companies, including Repsol, Shell and BP, have made big stated commitments to reducing carbon emissions. For example, Repsol’s target is net zero by 2050. However, the International Energy Agency is on record that in 2019 the net % of ‘big oil’ capital expenditure devoted to non-core business was less than 1%. Those statements are not obviously compatible.
In practice the oilcos are again focusing on carbon intensity, which may or may not deliver a net reduction in emissions. For example, Total’s commitment only covers Europe or around one third of their business (and the least fast growing).
So what should investors do to make a difference and who should they believe? We are fully behind the direction of travel but have also concluded that the ESG data provided is not sufficiently reliable to base quantitative decision-making on. It is one thing for an active manager to estimate the sustainability risk of owning a company such as Sports Direct or Exxon, and perhaps to use a ratings agency as an input into their decision. It is very different to base overweights and underweights across a carbon-tilted index, which might be a significant part of an investor’s total portfolio, on this data.
If an investor wishes to reduce a portfolio's carbon profile in order to mitigate climate change risk, of the investment options available we would suggest that using a carbon tilting approach is not yet proven to be effective, and it may be better to choose to reduce exposure to oil. That may or may not turn out to be a good decision investment-wise - we won't know that for many years yet - but it is likely to lead to a better outcome in terms of climate emissions than the carbon tilters' approach of underweighting the oil extractors and overweighting oil services and similar companies.
How to deal more generally with ESG data is more difficult. In an ideal world there would be standards, as there are for auditing, but that is some way away. In the meantime we would make three suggestions which we consider will achieve a better outcome ultimately. We would contrast that with some of the more tick-box activities which are being forced on investment managers by well-meaning (or in some cases less so) parties today.
- Ratings assessors collaborate to agree definitions and metrics.
- Investors invest actively. Asset manager research analysts are better placed than ratings agencies to act as a conduit to assess sustainability and if necessary drive change.
- Investors actively look for strategies which provide solutions to the sustainability challenge rather than just incumbents who have seen the light and are changing.
We are indebted to several managers for pointing us in the direction of some of the data used here as well as some other interesting material. If you wish to know who they are or see some of the sources we have used behind this paper, please feel free to contact us.
[1] Berg, F., Kölbel, J.F. and Rigobon, R., 2019. Aggregate confusion: The divergence of ESG ratings. MIT Sloan Research Paper No. 5822-19.