Grace Le, co-manager of the Artemis Corporate Bond Fund, looks at the pros and cons of ESG ratings for fixed income. Can one size fit all? Can companies ‘game’ the system? And what is really being measured?
A growing number of people are looking at how we can contribute to addressing the world’s environmental and societal challenges. So it is of little surprise that there is increased scrutiny on how and where capital is deployed. Investors who are naïve enough to ignore these developments do so at their own peril. A company, even one that is financially sound, can perform poorly if investors decide that they no longer want to be associated with a particular industry and are no longer willing to lend to it. Funding costs will be impacted, which in turn will affect financial cashflows. A prime example of this can be seen in the tobacco industry. Despite sound financial results, tobacco bonds have persistently underperformed the broader market in recent years. A smaller buyer base has pushed prices lower.
Taking the measure of measurements
But how does one measure environmental, social and governance issues? How do you measure the unquantifiable? Enter ESG ratings. ESG ratings assign a letter rating or a numerical value to a company, essentially denoting whether it is a ‘good ESG company’ or a ‘bad’ one. We applaud these agencies’ efforts to simplify investors’ lives by providing a quick assessment of a company’s ESG practices. But the subjective nature of ESG factors and these rating agencies’ desire to have a scalable methodology means that a single, condensed rating falls short of expectations.
Disclosing what investors want to hear?
ESG ratings providers use consistent, transparent methodologies which enable a scalable model across multiple geographies, asset classes and in turn index construction. Unfortunately, this requires that most ESG ratings agencies rely to a significant extent on companies to self-disclose. This is an approach that has traditionally favoured large companies in developed markets. These tend to have well-established investor relations functions and the time and resource to craft a broad and upbeat ESG narrative.
Walking the talk or ticking the box?
Let’s look at how governance scores work at one of the most prominent ESG ratings agencies, for example. The governance score is a combination of themes which you would typically expect such as compensation disclosures or board independence. However, there is also an emphasis on whether companies have various explicit written policies, whether they conduct employee surveys or even whether specific training programs have been developed. A company could even be marked down for not being a signatory to a particular framework. Having a specific policy around the ‘scope of support and degree for programs and certifications’ for employees is better than not having one. But the combined ESG weighting for such policies is out of proportion.
ESG ratings agencies’ efforts to have a scalable, transparent and consistent methodology have somewhat reduced part of the governance weighting to a tick box exercise. Larger companies which can afford the time and resource to write up policy documents fare better than their smaller counterparts. It’s worth highlighting that the crux is on whether an actual policy exists or not, and not on whether the company has actually adhered to the policy!