The decision to remove Tesla from the S&P 500 ESG Index earlier this year seems out of tune with the thinking of many. The world’s largest maker of electric cars is a crucial enabler of a shift away from fossil fuels, yet S&P Dow Jones Indices excluded Tesla from the benchmark index over, among other factors, the company’s labour rights record and lack of a low carbon strategy. Tesla board member Hiromichi Mizuno, a Japanese champion of sustainable investment, said that current ESG ratings give too much weight to negative impacts and not enough to positive. There may be some truth here, but it is also clear that a single, data-driven ESG index cannot be everything at once. At a minimum, there should be two distinct ratings: one to reflect a company’s positive impacts and another its negative externalities. Attempting to capture both in one score dilutes the informational value of the final rating: the positives and negatives inevitably cancel each other out, resulting in a rating that fails to represent either and can’t be relied upon to guide capital allocation decisions. One option is to focus the ESG (environmental, social and governance) rating on the negative externalities while using the United Nations sustainable development goals (SDG) framework to assess which business activities are critical to addressing challenges like climate change. Tesla, for example, would have a high SDG score because its revenue comes from selling electric vehicles and other green tech products, which are important in the push to reach net zero carbon emissions. If an investor’s goal is to allocate capital for climate solutions, then the SDG rating should be the driver. If the goal is to invest in companies that behave in an environmentally and socially responsible manner, then the ESG rating should dominate. In practice, the two could be used together. There are technical reasons current ESG ratings don’t fully capture a company’s level of sustainability. One reason is that ratings providers often combine varying environmental, social and governance scores into a headline rating. This approach works better the closer it gets to either end of ESG spectrum. For example, a very high ESG rating usually indicates that a company is performing well across all three pillars. For most companies that fall in the middle, however, the headline ESG rating could be misleading. A company with poor environmental practices could still be included if its environmental score is sufficiently smoothed out by an above-average performance in social and governance terms. This explains why fossil fuel companies with little interest in the energy transition may have an unexpectedly high ESG score, even as a company like Tesla falls down the rankings – and why investors need to pay close attention to ESG fund holdings. It also matters whether companies are scored on a relative or absolute basis. In this scenario, a company that performs poorly on ESG on an absolute basis could get a top rating because its peers are doing even worse. At a portfolio level, such an approach can be meaningless. A portfolio of best-in-class coal mining companies, for example, could appear to be doing better on ESG than one of average finance companies. A deeper type of company-specific analysis is required to get a complete picture. This is not always possible for ESG analysts who run quantitative models and apply qualitative overlays, as they might lack the knowledge required to make sense of the data in context. More suited to the task would be seasoned fundamentals analysts familiar with ESG methodologies, who meet companies regularly and can gain first-hand insights into their ESG practices.
Take, for example, emissions management. Let’s say petrochemical company All About the Money (AAM) sees its carbon intensity decline year on year while rival Love the Planet (LP) sees an increase. Current ratings are likely to rate AAM more favourably. But that could ignore facts on the ground. Perhaps, AAM doesn’t care about the environment and its overall carbon intensity only declined because its dirtiest plant was offline for much of the year. LP, meanwhile, increased its carbon intensity temporarily because its more carbon-intensive products accounting for a bigger share of its revenue last year. But it has been retrofitting production lines to improve emission efficiency and investing in negative emission technologies, meaning its carbon footprint will be smaller in the future. Without these additional insights, it would be impossible to assign either firm the correct rating. Over time, we expect to see further standardisation and more complementary use of different rating types, though qualitative insights will remain essential. Integrating ESG into the investment process isn’t so much a destination as a journey – one that gets better as more people undertake it.
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