OECD Works on Sorting Through the ESG Ratings Systems

OECD Works on Sorting Through the ESG Ratings Systems

A report from the Organization for Economic Cooperation and Development critiques “current market practices” in connection with Environmental, Social, and Governance investing. It says that the bewildering ratings, investment terminology, and individual metrics, “present a fragmented and inconsistent view of ESG risks and performances.”

On the bright side, the OECD also says that ESG ratings are “potentially useful in driving the disclosure of valuable information on how companies are managed and operated in reference to long-term value creation.”

The report, then, is an effort to help the emerging ESG ecosystem through its growing pains, and it is directed in the first instance both to the issuers and the investors who disclose and use information within that ecosystem.

Performance and Classification

One common question about ESG investing—does it over-perform? Does one “do well by doing good” as the saying goes. OECD’s reply: “[There is] little differentiation in the performance of funds with higher scoring and lower scoring ESG securities; the wide range of performance of funds across both categories indicates that a host of other factors, including particular investment strategies and their implementation, drive results.” So … no.

Does it follow that, aside from one’s moral convictions imparted from outside business considerations, there is no good reason to concern one’s self with ESG scores? No. But the reason is not an expectation of over-performance. The OECD says that under certain circumstances ESG can improve risk management.

The OECD sets out a broader “investment spectrum” and discusses ESG’s place within it. The spectrum ranges from “pure financial investment,” pursued solely to maximize shareholder/debtholder value and extends all the way to its antithesis, in essence philanthropy. We may think of philanthropy as place (1) on the spectrum, and pure financial investment (what one might call Friedmanite investing) at place (5). This leaves three intermediary possibilities: (2), social investing, where the focus is on social/environmental results but there is also some concern for financial return; (3) impact investing, where the investment is “with intent to have a measurable environmental and/or social return,” and (4) ESG investing proper, which seeks to enhance long-term financial value by use of ESG metrics.

The report reviews the evidence that this position (4) is growing in acceptance. Last year, a BNP survey of institutional investors and asset managers found that over half of the respondents said they are working to integrate ESG metrics. A survey by Bank of America said that growth in ESG smart beta policies has outpaced the growth of many other types of strategies. Many market participants “expect that ESG investing through funds and ETFs [will] grow to several trillion [dollars] within several years.”

Ratings and Indexes

In the course of that expected growth, it would be good to have reliable ratings and indexes.

Some of the ratings are developed through highly quantitative methodologies, using and weighing various metrics, with their subcategory metrics on the basis of other quantities. For instance, within the category of environmental scoring alone, Bloomberg considers carbon emissions, climate change effects, pollution, waste disposal, renewable energy, and resource depletion.

Some of those who do the rating are Bloomberg, Thomson Reuters, MSCI, and Vigeo Eiris.

The ratings involve a lot of decisions: what data to include or exclude, weighting, materiality, and the proper consideration of missing data. OECD regards the issue of materiality as crucial in terms of aligning the differing systems and getting a good analytical grip on the industry.  At present (without alignment), “If investors are using and relying on different service providers, the score inputs that shape securities selection “ could be driven by the idiosyncrasies of one provider vis-a-vis the other, rather than being driven by investment objectives and risk tolerance.

It certainly seems plausible that the impact of climate change on corporate valuation is material.  As the report says, there is a “growing body of research on the risks from climate change highlight channels by which they can affect economies, business, and financial sectors. These include the impact of physical risks from climate change related to storms, floods, fires, and negative spillover effects, such as to supply chains or financial markets.” Looking at it from the point of view of individual issuers, some industries are very exposed to “stranded assets:” as fossil fuels demands decline, and others are more exposed to the physical risks mentioned above.

The OECD report was the work of Riccardo Boffo and Robert Patalano.

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