Beyond ratings: Why it’s important to do your ESG homework
VISUALISING environmental, social and governance (ESG) issues holistically can reveal attractive opportunities in sectors that appear “ESG unfriendly” on conventional measures. This empowers investors and asset owners to help companies decarbonise in a practical and sensible manner, while minimising negative social and environmental impact.
The number of ESG rating providers has increased significantly with the rising focus on sustainability. Third-party ESG ratings provide valuable inputs into investment frameworks, influencing portfolio outcomes. However, the variance between ESG ratings from different providers is much higher when compared to credit ratings, and this is true across sectors.
Research analysed by the CFA Institute shows that the correlation of ESG ratings across the major providers range from 0.14 to 0.65, which means that the ratings are only moderately correlated at best. On the other hand, the correlation of credit ratings from different rating agencies is much higher, at around 0.8.
The lower correlation between the ESG ratings across providers partly results from different methodologies, which assign different materiality weights to multiple ESG factors and the varying ways that raw data from different “E”, “S” and “G” dimensions are put together to form a score.
It is challenging to achieve consistent ESG ratings given the multi-faceted nature of ESG analysis and the different methodologies that exist. Without standardised guidance for ESG data, there are many ways to interpret the same factors that ESG ratings providers use to interpret and make comparisons in their analyses. How different providers define peer groups and address data gaps also affect the ratings.
By contrast, credit ratings are more rigidly defined risk assessments that focus on assessing an issuer’s probability of default. In assessing default probabilities, the metrics and leverage ratios used as well as the data needed to calculate these ratios are more standardised. Hence, credit rating outcomes tend to be more aligned.
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Visualising issues holistically
We view ESG ratings more as “indicators” or informative analyses on the exposure of a company or sector to ESG risk and opportunity, rather than the final word on how companies score on ESG factors. Therefore, we treat third-party ESG ratings as another data source that we can leverage to perform our own ESG analysis.
Eastspring’s ESG scoring and integration tool leverages ESG data from external ESG rating sources but combines the data components using a proprietary framework. The framework makes use of our internal ESG materiality matrix, which references the industry’s best-in-class sources such as the Sustainability Accounting Standards Board, the Task Force on Climate-related Financial Disclosures and the International Capital Market Association, but also includes additional context which increases relevancy to our investment universe. This adds a quantitative element and complements the bond team’s ESG framework, which considers both an issuer’s ESG risk exposure and its preparedness to address those risks. We see portfolio construction as a layering process where we first consider the client’s needs, the client’s and our Responsible Investment policies, after which we layer the bond team’s credit analysis with further ESG assessment.
This approach has allowed us to consider opportunities in sectors that may appear “ESG unfriendly” on conventional measures or based on third-party ESG ratings. For example, a balanced assessment prevents us from automatically excluding companies that are involved in or derive more than a certain percentage turnover from coal. A blind blanket exclusion can be contentious, especially in Asia, given that our coal plants are relatively young and coal phase-out presents a practical financial challenge. Also, coal forms a key part of the energy baseload in Asia and emerging markets and strict exclusion would introduce other, perhaps social, challenges.
Our approach empowers us to look at companies’ holistic climate transition efforts and how they are tilting their business models to address the impact of climate change.
One of Eastspring’s key responsible investment principles is that we prefer engagement to divestments, and divestments are a last resort. We believe that investors and asset owners need to help companies decarbonise in a practical and sensible manner that also minimises negative social and environmental impact. The importance of a just transition is also in line with the Monetary Authority of Singapore’s (MAS) efforts to help financial institutions in Singapore strike a balance between reducing financed emissions while financing credible decarbonisation.
Greater convergence
Various efforts are in place to help improve the quality, reliability and comparability of ESG ratings. In Japan, the Financial Services Agency (FSA) finalised a new code of conduct for ESG ratings and data providers in December 2022. The MAS has also recently launched a public consultation on an industry code of conduct for providers of ESG ratings and data products. The call for similar regulation is gathering pace in Australia as the scale of ESG investment increases.
We are optimistic that the quality and consistency of ESG data and ratings will improve, and the different approaches will eventually converge. Therefore, the correlation of the ESG ratings across different third-party providers should rise over time. Having better quality and more standardised ESG data is helpful for active investors like us in our ESG assessment.
Joanne Khew is director and ESG specialist, and Rong Ren Goh is fixed income portfolio manager at Eastspring Investments
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