Sustainable investment options have proliferated in recent years, but not all are created equal. ESG scores do not tell the full story; a deep fundamental analysis of a company or a portfolio manager's investment processes is therefore essential.
Sustainability is increasingly a key consideration for investors. Sustainable investment assets grew to $35.3 trillion globally in 2020.1 In fact, nearly $1 of every $3 is now managed sustainably according to the Global Sustainable Investment Alliance. Eager to benefit from investors’ growing appetite, investment managers have developed large numbers of products billed as "sustainable" "socially responsible" or "ESG" among other descriptors. Given the plethora of options, it is essential to analyze the integrity of every such investment’s sustainability claims, as not all are created equal.
Regulatory scrutiny has helped to raise awareness of "greenwashing" whereby companies and investment managers overstate their environmental or other sustainability credentials to make their offerings more attractive to consumers and investors. Many investors and regulators are thus now on high alert for misleading marketing, and with good reason. After the announcement of the EU’s Sustainable Finance Disclosure Regulation (SFDR), managed assets labeled as sustainable declined by $2 trillion, likely because managers worried about their strategies’ ability to withstand scrutiny.
The danger of ESG scores in isolation
Selecting credible sustainable strategies thus requires a thoughtful approach. While headline environmental, social and governance (ESG) scores or carbon emission data can be a good place to begin an evaluation, an investment manager’s entire process is necessary to draw conclusions. Our research seeks to gain an understanding across the universe of sustainable strategies to help clients align sustainable investments with their purpose.
Alongside growth in assets under management aligned to sustainable principles, numerous companies providing ESG scoring frameworks have emerged. They range from well-known and established generalists to those focused on niches such as greenhouse gas emissions. At a conservative estimate, there are now over 100 ESG data and ratings providers in existence.
Interestingly, the correlation among different providers’ ratings is estimated to be quite low, at less than 50%. There are numerous reasons for this. For example, data providers can attach very different weights to certain issues, such as employee turnover or greenhouse gas emissions. Others may hold past controversies against companies for much longer.
As such, it is not uncommon for the same firm to score very differently for ESG characteristics according to which data provider is used. By contrast, bond ratings from S&P, Moody’s and Fitch – used by the market as reliable indicators of credit risk – are highly correlated at over 90%. So, it is it clear that ESG ratings are subjective and should not be used in isolation or in the same definitive manner as bond ratings.
As experienced users of ESG data, Citi develops insights that we incorporate into our overall investment analysis. We feel that deeper awareness of ESG-related risks and potential opportunities in relation to our investments can make us better investors. Understanding the context of the ESG data points for each company is crucial. On its own, a score does not tell the whole story.
Understanding the process is key
An ESG score may also fail to capture recent relevant changes to a company’s strategy. For example, how much a company reveals about its sustainability practices can have a greater bearing on its score than the actual quality of those practices. Large and better resourced corporations may be able to devote more time to ESG reporting than smaller rivals. They may be rewarded for this fuller disclosure with better ratings, even if their sustainability credentials are inferior to those of firms with less capacity for thorough reporting.
For example, a clothing retailer may have robust human rights policies and procedures for its supply chain that result in an attractive ESG score. However, if the retailer is expanding so rapidly and is ill-equipped to implement its procedures adequately, it could be susceptible to future supply chain issues. It is this deeper understanding of a business that unlocks forward-looking and unique insights, which can be applied for the various sustainability investing approaches.
It is also important to note that a sustainable investment strategy of good quality might nevertheless have a low ESG score. For example, this could occur in the case of a strategy that targets companies that are poised to improve their sustainability practices and actively engages with those companies’ management teams to encourage positive change. Such a strategy would be an ideal fit for an investor seeking to support improvements in sustainability. However, relying on its ESG score in isolation and not taking into account the investment process would have erroneously removed the strategy as a potentially suitable option.
Another common example would be an energy transition strategy, involving companies that are seeking to move away from fossil fuels and towards renewable energy. If such a strategy’s carbon footprint were higher than that of a broad equity index, an investor might infer that the investment manager was greenwashing the strategy’s credentials.
However, a deeper analysis of the manager’s investment process may reveal a thorough strategy that invests in innovative energy and utility companies that are essential to a successful energy transition. While energy and utilities have a higher reported carbon footprint than most other sectors, the energy transition cannot occur without innovative companies from these areas.
Likewise, technology companies may have lower reported emissions. However, this alone would not make them appropriate for inclusion in a fund marketed as enabling an energy transition. In fact, if a fund marketed as a climate strategy fund was overly reliant on low emitters in sectors with little influence on climate-related matters, it may be that the manager is greenwashing by attempting to manipulate the fund’s score higher. A deeper look into the manager’s process is thus essential to make an informed investment decision.
At Citi, we seek to understand each client’s sustainability objectives, whether complete avoidance of certain industries or seeking out companies that are actively improving their sustainability characteristics. That understanding coupled with our analysis of sustainable investment processes allows us to help clients who seek to create a portfolio that reflects their own worldview in addition to their investment objectives and risk tolerance.