Elon Musk thinks ESG ratings make no sense.
As an ESG analyst, I tend to agree with Elon that third-party ESG ratings are not particularly reliable. Not only is the ESG landscape extremely vast and difficult to summarise in a single data point – from alignment with the Paris agreement to ethical supply chain and everything in between, ESG ratings provided by third-party data providers fail to capture whether a company is making a positive or negative impact on the world, among some other important factors that we measure at eInvest, such as a company’s willingness to engage on ESG issues.
For Elon, his reluctance towards ratings likely comes from the fact that the way third data providers score ESG is often overweight reduction of negative impacts while neglecting the positive impacts. For the eInvest Better Future Fund (Managed Fund) (ASX: IMPQ), we employ our own proprietary ESGE scoring system that serves as a solution to these challenges.
So, why can’t we use the off-the-shelf ESG ratings?
- Coverage of the IMPQ investible universe is typically low for third-party data providers, given we play in the small and mid-cap ASX listed space;
- There is notable variance in a company’s scores across the third-party data providers, which means there are inconsistencies in how ESG is weighted, and which metrics are used. As a result, the data is not reliable. The discrepancies across the providers are rooted in the fact that there is no widely accepted definition as to what constitutes each of the categories – different ESG characteristics mean different things to the data providers; and
- despite the challenges of using third party ratings, these ratings are frequently used by investors because unfortunately there is not a lot of agreement out there on how to measure ESG.
What does the eInvest Better Future Fund use instead? We create our own.
In the IMPQ portfolio, we use an internal ESGE scoring system – ESGE standing for Environment, Social, Governance and Engagement. Environment, Social and Governance each weighed 20%, while Engagement has the highest weighting of 40%.
A key benefit to doing our analysis in-house is that we can use any data we collect from analyst engagements with management teams and boards to assess the company’s willingness to engage on ESG issues and progress their ESG practices. For example, via a face-to-face conversation, we can assess a company’s progress on disclosing their Scope 1 and 2 emissions via face-to-face conversations – important information that is not captured in third party scores.
In 2021, following writing to IMPQ holdings that did not have at least 30% women on the board, we saw 10 portfolio companies appoint female Non-Executive Directors to the board – such as Janison Education and City Chic Collective. This increased board gender diversity following our consistent engagement with these companies would improve their G (governance) and E (engagement) scores.
Overall, we believe a solution to overcome the challenges associated with third-party scores is to account for both positive and negative impacts, and score company engagement as the key indicator of the company’s ESG performance. It shows where they are at, where they are headed and how authentic their approach to ESG & Sustainability is.
So, what are some signs of good company engagement?
- Transparent and detailed disclosure of ESG information in annual reports, sustainability reports, results presentations, or any other publicly available documents;
- Management and the board can address specific ESG questions when asked and are aware of all applicable ESG related laws such as the Modern Slavery Act; and
- prompt responses to analyst communications regarding AGM proposals or material ESG related concerns
To be clear, ESG scores are not bad, they certainly provide a helpful analysis of ESG credentials, but it is important to also look at the ESG integration component for a company and analyse how the company is integrating ESG into their business model and any positive making as a result. We believe company engagement is the most effective way to assess this.
Disclaimer: Please note that these are the views of the author Maddie Huynh , Associate Investment Analyst at eInvest, and is not financial advice. Past performance is not a reliable indicator of future performance.