March 2018

INSIDE VIEW: The limitations of ESG

Wind_farmResponsible investment is a priority for the funds industry, but techniques to measure ESG principles are in their infancy, says Vivek Jamwal of Stradegi Investment Management Consulting. Commitment to environmental, social and governance (ESG) investing has grown tenfold over the past ten years. More than 1,600 asset owners and asset managers managing more than $70 trillion have signed up to the United Nations-supported Principles for Responsible Investment. However, the ESG ecosystem is still young, and asset owners and asset managers need to understand the limitations of the existing investment process. Some of the challenges are as follows:
     •  Not all ESG factors are easily quantifiable, and such factors may not directly translate into earnings growth or enhanced performance for the firm.
     •  Current corporate sustainability disclosures are heavily skewed towards process and procedures and not towards actual performance. It is estimated that 70% of ESG data points measure whether a company has a relevant policy in place, but having a policy in place does not measure the level of commitment towards implementing that policy. A good check from an investment perspective is to pair policy disclosures with actual performance. For example, if a company declares that it adheres to an energy-efficiency policy, but its total energy use, as a proportion of revenue, goes up over time, that could be a red flag. Either the company is not adhering to its policy or it is changing its business model to higher energy intensity lines of business.
     •  Applying the same set of factors to companies in different geographies and industries with varying business practices can be challenging. Companies have varying business models and some outsource large portions of their value chains, whereas others prefer to go for the vertical integration route.
     •  Different regions have varying challenges with regards to data quality that need to be considered, especially emerging markets. For example, in 2011 only 20% of companies in the S&P 500 index declared their sustainability metrics. That has risen to over 80%, however the same cannot be said about Asia, where the level of sustainability disclosures is still very low and varies markedly across countries. There are variations within regions, too. Chinese corporate governance practices vary markedly compared with Taiwanese ones. Metrics need to be normalised across countries and sectors or else one is comparing apples and oranges.
     •  ESG datasets are disclosure-based, binary and unverified. ESG datasets are basically an extension of accounting datasets that companies provide, and we have seen numerous cases where companies have misreported accounting information to their investors. Investors must consider that some of the datasets may be incorrect, because these numbers have not been audited. Investors can think about adding signals from big data to triangulate company disclosures. One strategy may be to scan high-frequency news datasets for companies that engage in child labour. This data point can be checked against a company’s disclosures on child labour.
     •  The ratings companies follow different methodologies in arriving at ESG scores. A correlation score of 0.32 across these companies (implying that ratings have a weak correlation) shows how little the agencies agree on how to measure ESG factors. For bond ratings, where the primary objective is to estimate the probability of default, the correlation among ratings firms is as high as 0.9.
     •  ESG research can be backward-looking and may fail to capture anticipated changes. There needs to be constant dialogue to keep up with companies and capture how they are changing their sustainability practices. Objectives
Asset owners and managers should spend a lot of time on understanding the objectives of implementing ESG in their investment process. What are their goals and what are the corresponding ESG metrics to be tracked to ensure they are meeting their goals? There are two major objectives that drive inclusion of ESG into the investment process. The first is to maximise returns, which is a common objective for everyone. The second objective is sustainability, and here the goals vary across firms. In some cases, asset owners may want to promote a specific cause, such as companies involved in renewable or ‘clean’ energy. In other cases, investors may want to avoid companies in the tobacco, gambling or defence industries. These goals will differ markedly, and hence there should be a process of customising the ESG framework to suit an investor’s beliefs. Again, the goals of asset owners and asset managers will vary. Asset owner goals can vary from creating broad-based ESG mandates to creating mandates that target a very specific objective. Asset managers, on the other hand, will use ESG to improve the outcomes of the investment management research process if there is no specific ESG mandate, or follow the specific ESG goals that asset owners have mandated. After the goals have been clearly defined, the next step is to create a structured approach for ESG integration, by recognising the current challenges in the ecosystem and creating a process to mitigate those challenges. There is no one-size-fits-all solution. We work with asset managers with a five-step process for ESG integration: collect, customise, normalise, look forward and integrate and help them build their own approach to ESG adoption. Asset managers need to customise the ESG factors to suit their beliefs, and try to evaluate companies based on their custom ESG scorecard. This ESG scorecard needs to account for differences across countries, sectors and business models. You may need to create multiple sets of these scorecards to account for business practice deviations. Integrating these results into your research process should be done after validating that the approach stands the test of time, by applying it to historical datasets. Vivek Jamwal is practice head (risk and research) at Stradegi Investment Management Consulting ©2018 funds global asia

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