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Are your ESG investments ‘sustainable grade’?

Quality concept
Olivier Le Moal

At the end of 2020, an estimated $38 trillion in assets under management carried the ESG label, an increase of more than 24 percent from 2018. Looking into the future, ESG assets are on track to grow globally to more than $53 trillion by 2025.

This substantial increase is the result of two forces: One is the growth in legitimate responsible issues of securities and loans and demand by responsible investors, but another is the irresponsible or careless labeling of activities as legitimate — essentially abusing the ESG label.

One simple indicator may illustrate the impact of the labeling problem: A revision in Europe tightening the rules for the use of the ESG label dropped the value of ESG investment by $2 trillion between 2018 and 2020, even after accounting for the increase due to new issues.

Regulators concerned with the ESG labeling issue on the investment side are led by the European Union (Regulatory Technical standards that include rather comprehensive disclosures responsibilities of asset managers) and the Financial Conduct Authority (FCA) of the United Kingdom (with its recent letter to asset managers). The U.S. Securities and Exchange Commission’s interest is very recent, as a result of the change in its leadership. The SEC has not yet produced any guidelines or regulations, although it is expected to start with the narrower issue of climate change.

What is the ESG problem? Is everything ESG?

We can summarize the problem with these questions:

  1. What is E, what is S, what is G, what is ESG?
  2. How much contribution (goodness) should each bring?
  3. What tradeoffs should be accepted within each component of E, S, G and across the components (no firm will be expected to be good on all of them)?
  4. Do damaging effects (badness) count as negative contributions to ESG? 

Securities market regulators can only contribute to addressing the first issues, definition, disclosure and transparency about the accepted components of ESG. But they cannot really address the other three: how much is good enough, tradeoffs and valuations of negative contributions. It is outside their scope.

Raters can help, but the current methodologies of most of them assume a specific model about sustainability and its indicators, and the relative weights assigned to each. They do not consider either the quality of the contribution nor account for negative contributions. If a firm has been involved in bribery, for example, it will get a low score on G but not a negative score.

A few examples illustrate the four problems of ESG mentioned above and the need for change.

One is that of the sustainability-linked bond issued in June by JBS, the largest meat processor in the world. The "link" is a promised reduction of about 30 percent for its Scope 1 and Scope 2 emissions. There is no commitment related to its Scope 3 (in the case of JBS, livestock and land use change), which account for over 90 percent of the company total emissions.

The problem of questionable ESG labeling is real and can have a significant negative impact in the form of greenwashing, as well as on lost opportunities to do good.

JBS has paid billions of dollars of fines in Brazil and the United States after admitting to bribing three former Brazilian presidents and 1,850 other politicians, as well as insider trading. It has been accused of contributing and enabling the deforestation of the Amazon and other areas in the world (it has pledged to reduce its contribution), and is one of the largest contributors to water pollution in the U.S. It pleaded guilty of bribery in the purchase of Pilgrim Pride in the U.S. and to price fixing in the pork and chicken market. Bad G, bad S, bad E, a tiny E.

Should JBS be included in an ESG portfolio? It was rated as No. 118 out of 256 (top 50 percent) in the food and beverage industry by ISS ESG (issuer of the bond’s second opinion).

As another example, Phillip Morris, whose motto is "Delivering a smoke-free future," sells 700 billion cigarettes a year and is rated "best in class" in the Dow Jones Sustainability Index North America. Are responsible farming (E) or good employee benefits (S) or board diversity (G) enough to compensate for the damage caused by its product and qualify it as a high-rating ESG investment?  Granted, some ESG portfolios exclude tobacco as part of their negative exclusion policy but some include it, as is obvious from best-in-class rating by the Dow Jones index. 

On a less dramatic level — but with a large impact on the ESG universe and equally illustrative — is the case of technology companies such as Alphabet, Amazon and Facebook, which tend to be among the largest holdings for ESG funds. Amazon and Alphabet are the largest buyers of renewable energy, which would give them a high score on the E. But all three have been accused of exercising their monopoly power (bad G). And Amazon has been accused of deplorable labor (bad S) predatory pricing and violation of privacy laws in Europe (bad G).

Investment grade: Credit risk and sustainability risk

To look for a possible solution to better ESG classification, it is illustrative to compare the case of credit risk and credit ratings with the sustainability risks and ratings.

Many institutional investors require certain investment-grade levels to include securities in their portfolios. Perhaps there could be a similar requirement for responsible investors regarding sustainability risks. The assessment of credit risk is very well-developed, and the industry has some characteristics that are very conducive to consensus. When it comes to sustainability, the case is almost the opposite, but there are still some lessons can be learned.

 

 

Credit risk

Sustainability risk

Rating agencies

Three majors: S&P, Moody’s and Fitch

Hundreds

Definition of the risks

Well defined: risk of default

What is sustainability? Large variety of ill-defined risks, context-specific, industry-specific, firm-specific, dynamic

Estimation

Well-defined methodology, basically similar between the rating agencies.

Every rating agency has its own list of indicators, of estimation of variables, its own methodology for aggregating and weighing.

Consensus

Very similar ratings for most issuers, little dispersion. Relative consensus.

Widely different ratings for most issuers. Wide dispersion.

Investors

Very clear of their needs and wants

Confused as to what sustainability means, should be context-specific

 

Can the industry coalesce around one definition of sustainability and a few raters? Given the myriad aspects to be considered, their tradeoffs and the context in which they operate, this seems unlikely. There are hundreds of raters, thousands of indicators of aspects of sustainability and of sustainability indices (MSCI alone has over 1,500 ESG indices). The industry does not have any interest in consensus, it thrives on differentiation. It is competitive, not collaborative.

What can be done? Should we abandon the effort and give up? 

Sustainable grade: How good do you have to be?

It’s impossible to be perfect, to be good at everything. There must be tradeoffs when it comes to the the sustainability performance of firms. But the current situation in which this question is not asked cannot continue as it can be seen in the serious irresponsibility of some firms labeled as good "ESG" investments.

Is it possible to find some level of aggregate performance that can be considered an acceptable minimum? How much E or how much S or how much G does a security or a loan need to have?  What is the minimum needed to qualify?

Your company has antidiscrimination policies? Then it has a bit of S. Does it have a recycling program? Then it has a of bit E. Does it have over 30 percent of women on the board? Then it has a bit of G. But how much is enough? What constitutes and acceptable levels of each factor? How much can your company trade in good E practices for less than stellar policies when it comes to S or for G?

I propose the definition of a minimum aggregate level or ratings to be deemed a sustainable company and included in ESG portfolios: a sustainability grade, analogous to an investment grade in the case of credit risk.  

The proposal: To qualify to be included in a "sustainable grade" ESG portfolio, a security should have an average ESG rating, calculated over, say, 10 selected raters. It should receive a rating of no less than 7 over 10 (their ratings rescaled to 10), and no less than 5 over 10 in each component, E, S and G. Funds focused on one component would need a 7 on that focus.

Can the industry coalesce around 1 definition of sustainability and a few raters? Given the myriad aspects to be considered, their tradeoffs and the context in which they operate, this seems unlikely.

The raters would be selected after validations of the sustainability representativeness of their ratings by the organization managing the definition of sustainable grade. The actual thresholds chosen would also have to be validated to ensure that the securities selected as eligible provide a reasonable universe over which to build ESG funds.

This proposal would mitigate some problems mentioned above, and it would also avoid the current phenomenon in which an ESG fund can include highly rated securities (say Unilever) alongside low-rated ones (say Phillip Morris) and still achieve an overall favorable rating. 

The drawback of this proposal is that it may exclude some desirable securities from the point of view of returns (such as Amazon) but they could be included in "non sustainable grade" ESG portfolios, in the same way that not all investors are interested in investment grade securities.

Who will determine the threshold?

The model used to designate investment grade levels is not suitable for sustainable grade determinations, given the contrasting characteristics of the risks and the resulting wide dispersion of the ratings. The idea that the rating industry should participate is valid. But in this case, the raters themselves are not suitable to determine the grade threshold as they could have conflicts of interests, particularly because many of them would not be included in the determination of the threshold.

What’s more, regulators, as mentioned above, have a limited scope. An independent institution would be needed to select the raters by validating the representativeness of their ratings and establishing the thresholds. My recommendation would be the International Capital Markets Association, an association of financial institutions that has developed the widely accepted Green, Social, Sustainability and Sustainability-Linked Bond Principles.

The problem of questionable ESG labeling is real and can have a significant negative impact in the form of greenwashing, as well as on lost opportunities to do good. The practice cannot go unchecked. My proposal may be an imperfect solution, but it would gain time while better ones are found.

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