Grading on a Curve: How ESG Ratings Can Fall Short in Emerging Markets

Grading on a Curve: How ESG Ratings Can Fall Short in Emerging Markets

Grading on a Curve: How ESG Ratings Can Fall Short in Emerging Markets 1200 675 Blackpeak

2019 was a banner year in the remarkable rise of ESG investing. Morningstar reported that nearly 500 actively traded funds in the United States added ESG language to their prospectuses, up from 50 in 2018. According to one survey, some 70% of institutional investors in the United States, United Kingdom, and Canada now look at ESG principles when making investment decisions. Retail investors, too, bought up ESG-oriented ETFs in record numbers, and private markets are not far behind.

Yet, despite the massive demand, measuring actual ESG performance across companies, industries, and countries remains inconsistent. More data, we’re led to believe, is the solution. Companies such as MSCI, Sustainalytics, and RepRisk now offer bond-like ESG ratings for many publicly-listed and private companies. ESG ratings sound great in principle. What better way than a single, standardized score or letter grade to benchmark ESG performance? If ratings work for credit, why can’t they work for carbon?

Follow the Leaders?

Like any asset class, ESG-rated “winners” can be bundled and marketed to those that want to do good with their investment dollars. Active fund managers can use ESG ratings to screen for potential trades. Meanwhile, retail investors can now choose among the more than one thousand ESG-themed index funds on the market.

One such index is the MSCI Emerging Markets ESG Leaders Index (NYSE.EMSG), which is made up of 411 publicly traded companies based in emerging markets like mainland China, Southeast Asia, and Latin America, all of which allegedly outperform their peers on ESG issues.

Yet, if investors dug below the surface into the companies that make up the EMSG, certain issues are revealed – recurring bribery and embezzlement problems, OFAC sanctions, large regulatory fines, and suppression of local protests, just to name a few.

Criticisms of ESG ratings are nothing new. Studies have found that despite their quantitative and data-driven veneer, the models that produce such ratings are deeply subjective. In 2018, Tesla became the poster child for such caprice. That year, MSCI ranked the US electric carmaker near the top of the industry on overall ESG performance. Meanwhile, FTSE, a competing ESG rating agency looking at the same data, said that Tesla was the worst performer among global automakers based on its own ratings model. Wells Fargo has similarly been pulled in two directions. Needless to say, a company’s final ESG report card is heavily impacted by the values, weights, and assumptions behind the model.

 

Self-reporting and Grading on a Curve

In emerging markets, however, there is an even deeper concern with ESG ratings – the bias of voluntary self-disclosure. In the above Tesla example, the divergence in ESG ratings was caused by different model assumptions made about the same data set. In emerging markets, where ESG reporting is often not mandatory, the underlying data itself can often be misleading.

No matter how robust a ratings model is, data comparability remains a significant challenge to the reliability of ESG indices as long as companies choose how and what to report. Furthermore, when indices add curved grading to the mix – the method of assigning higher scores to marginally outperforming companies within the same industry – what results is an even more skewed picture about who the leading ESG practitioners actually are.

Returning to the MSCI Emerging Markets ESG Leaders Index, companies like the controversial state-owned Russian gas giant Rosneft (ROSN.MCX) and African cobalt miner China Molybendum (3993.HK) make the cut as ESG “leaders” on an index like the EMSG not because they have particularly clean track records but because they are graded on a curve.

Most ESG funds and indices are still loath to exclude companies engaged in fossil fuels, mining, and weapons manufacturers altogether. As a result, such companies need only be marginally better than their industry peers to be branded ESG “leaders.” More worryingly, when companies voluntarily self-report ESG performance (even if it is bad), they get “credit” in ratings models that many of their competitors do not.

To be clear, not all of these companies are gaming the system. ESG self-reporting should be encouraged, particularly in markets where regulators have been slow to adopt ESG disclosure requirements. According to the United Nations’ Sustainable Stock Exchanges Initiative, only 54 of the world’s 102 major stock exchanges have published ESG reporting guidance for their listed companies. The Global Reporting Initiative and other organizations also provide useful frameworks for companies that choose to self-disclose.

Yet, at the end of the day, data and information produced from voluntary ESG disclosures must be taken with a grain of salt. Larger companies tend to disclose more frequently, mainly because they have the resources and knowhow that SMEs do not. It is also important to note that even when ESG company data is self-reported (either voluntarily or due to regulation), such data is rarely independently audited.

ESG ratings are not useless. In proper context, they provide a valuable starting point for investors trying orient themselves in an ocean of unstructured data. Yet for investors who are serious about evaluating ESG risk, particularly in emerging markets, they must go deeper.

 

Going Deeper: Incorporating Standards with a Strong Materiality Focus

Not all investors will have the time and resources to conduct exhaustive ESG research into every investment decision they make. However, for private equity investors and “active” asset managers with concentrated portfolios, ESG risk research should be integrated into the pre-investment due diligence process.

During this process, investors must strive to understand a company’s ESG performance in the context of its actual business operations and strategic goals. Not all ESG-friendly business decisions are efficient capital allocations; investee companies should not be rewarded for them. This level of context often gets lost in ESG ratings. Most ratings agencies incorporate financial materiality in their assessments, but they are designed for breadth and comparibility, not company-level depth.

By incorporating standards with a strong materiality focus during the due diligence process and taking extra care with self-reported data, investors will have a much better chance of separating the true ESG leaders from the followers.

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