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How can the buy-side be sure of the ESG ratings of their investments?


Buy-side firms can’t be sure about the ESG ratings of their investments. At least that is what most of them will say. A few weeks ago, #DisruptionBanking wrote to several of the largest asset managers. Only one of them came back with an answer, RBC BlueBay Asset Management shared a credible example of the potential ESG rating of one of their investments.

The firm in question is described as “an energy management company that leads the industry by revenue contribution from clean energy.” The description continues with ambitious targets to achieve net-zero within the company’s supply chain by 2050.

That’s not all that RBC have mentioned. There are many more investee companies that are continuing with their ESG activities according to the author. The question remains though. How can these activities be translated into investment ratings? Even the RBC European Equity team had problems explaining this within their story. They explained how “there are complications for asset owners…, with varying methodologies to calculate net-zero targets.”

They are not the only ones on the buy-side having difficulties with calculating carbon offset, ESG ratings or net-zero targets amongst their investments. The other asset management firms didn’t even respond to our request to disclose how they rate the exposure of their investments.

Radovan Vojtko, Founder and CEO of Quantpedia offered some insight to the problem.   

Radovan and his team at Quantpedia regularly analyze strategies that portfolio managers use. Many of these strategies are implemented by companies across the world in their search for Alpha.

Are there any accurate ESG ratings to rely on?

Radovan shared how it was a normal thing for large pension funds or sovereign wealth funds to ask leading asset managers to ensure that their investments adhered to ESG standards. The problem with the current marketplace is “How do I know that what I’m investing in is going to meet these requirements?” Radovan asked.

“We have a huge global market that we can invest in. But there’s no standard.”

One doesn’t need to be reminded about how asset managers like State Street Global Advisors vowed to turn up the heat on ESG standards in early 2020. Back then they sent a letter telling companies that they would vote accordingly should there be any ‘laggards’ not meeting ESG standards amongst the companies they invest in. Lots of companies. Many of whom have tried to replicate business plans like the one listed at the beginning of this story. Some haven’t been able to.

Flicking through some of the recent decisions made by Moody’s on their site, there is mention of an ESG rating score. Fitch Ratings also have an ESG Relevance Score:

Yet today there is no real industry standard. And some government decisions are also making the ESG waters murkier. Decisions to increase fossil-fuel reliance, influenced by the war in Ukraine.

And whilst it might be easy to downgrade the UK for allowing investment into the North Sea whilst giving countries like Denmark a high ESG rating. The same doesn’t apply to companies in the UK or Denmark. That’s without even considering placing an ESG rating on their national currencies, points out Radovan.  

Can ESG succeed where the Dodd-Frank Act failed?

There have been some attempts at addressing how banks and financial institutions operate. Most notably the Dodd-Frank Act came into place in 2010 in response to the global financial crisis. Michael Barr, who was one of the designers of the Dodd-Frank Act, was recently nominated by President Biden to serve as the Federal Reserve’s top banking regulator. The Democrats traditionally like regulation. Surely, we can expect the U.S. Government to be showing a desire to look at ESG ratings?

The White House did issue a very strong Executive Order on Climate-Related Financial Risk in May of 2021. The Roadmap to build a climate-resilient economy that the White House issued last October was also clear. However, in a recent story it was reported that Biden considers Congress to be lagging on ESG. At the same time both Congress and the US Senate have had diverging opinions on climate matters from within their ranks. In fact, some Republicans are pushing back against the financial sector’s embrace of ESG metrics in credit analysis and investment decisions.

Ultimately ESG is also far more complicated than Dodd-Frank, Radovan explained. In fact, if Dodd-Frank hasn’t yet actually been fully implemented, then what hope for any type of ESG legislation any time soon? Radovan asked.

ESG compliance is one consideration, the other consideration is the huge returns still available in markets today. ESG compliant banks will have to give up generating revenues on carbon-heavy companies. Companies that are currently helping to meet the demand in the wake of Russia turning off gas supply to countries like Germany.

Can investors turn a blind eye to the opportunities out there? Will their desire to help nature over-ride their instinct to make returns? Probably not any time soon.

There is a lot of politics around the ESG space. There will always be confusion between countries and states about what ESG stands for. This confusion will lead to differences in how countries approach ESG.

The challenge Asset Managers are facing with ESG

Governments and regulators around the world are scrambling to get an understanding of how to approach the topic of digital assets. There is huge uncertainty due to inflation. Tensions between Taiwan and China. In the meantime, there is not much more than the World Economic Forum and the COP-26 meetings to maintain global awareness for ESG topics, especially within government. Yes, some central banks are still pushing ESG policies in places like Singapore or Switzerland. And lots of financial institutions and consulting firms have beefed up their ESG talent as well. In the meantime one of the places that we are hearing about developments is at the IOSCO where the IFRS Monitoring Board recently met to discuss ‘draft standards’ that are being worked on.

It’s encouraging to see someone addressing the issue within the global banking community. However, Radovan is not optimistic about how soon we will have any type of working version. He pointed out that in the meantime we are still looking at asset managers around the world waiting for someone to tell them what the guidelines and best practices are. Waiting for them to be laid out for them. While they wait, one has to worry about what decisions will influence how they are going to invest today.

Asset managers need to have a balanced portfolio to best serve their customers. They can’t just all invest in RBC European Equity teams one green energy investee company. Besides, the investee might just have a good ESG outlook but a dismal financial strategy.

ESG Information about borrowers in the institutional market

There are other considerations for financial institutions. Namely the UN Principles for Responsible Investment (PRI) which offer some small clarity for financial institutions.

These principles are fine if you are just dealing with companies or straightforward investments. How individual companies interpret these principles and use them in their portfolio strategy is more of a concern.

Radovan assured us that when he uses ratings agencies like Moody’s to ensure a strategy is sound, there is little difference between the results he gets from the three leading providers of ratings data. But that is when he is using the main credit rating agencies to run a model. The situation is dramatically different when his team must use one of the many ESG ratings companies that are available on the market.

“You need to find out how the rating agency you are using are calculating the ESG rating. To avoid being accused of greenwashing you can’t just use one rating agency. You need to use many of them. Especially if you are trying to find an alpha in ESG.” Radovan explained. “You must combine the ratings from multiple agencies. You need to create a model on top of their models so you can somehow find your own rating from amongst all their ratings.”

Portfolio managers are under pressure to be compliant with ESG. They need to show that they are investing in the right companies. The challenge is when the performance numbers between individual rating agencies are so far apart. How can you be sure you are compliant with such varying results?

One of the companies who have developed popular ESG ratings is MSCI. But even their ratings have confused some users. One twitter user accused MSCI of awarding a “AA” rating to $ECV despite potential issues with supply chain labor standards within the company. Similar issues plague data providers like Morningstar or Refinitiv. Alongside them, Radovan assured us, there is also a whole host of startups offering what they think is sound ESG data. ESGDS, Novata, SustainLab, ESGAnalytics.AI, the list is compelling. Radovan believes that the industry will consolidate in the future as the market matures. Unfortunately, this may take some time. In the meantime, challenges for portfolio managers continue.

Currently the individual methodologies of companies offering data in the space are not correlated. For portfolio managers this causes a lot of problems as their models offer different performance depending on which company’s ratings are applied. Some of the divergences in performance can be startling.

Scandinavian ESG ratings

The current solutions offered might be confusing for the buy-side, but have a thought for the sell-side. Sell-side banks are also concerned about who they loan money to and what their clients ESG exposure is. Offering some hope is Nasdaq Europe.

Nasdaq Europe stands out as Scandinavian countries have led green initiatives globally for many years. The Nasdaq exchanges trade in Denmark, Sweden, Finland, and Norway; all of them have strong green credentials. In a recent press release Henrik Husman, President of Nasdaq Helsinki explained their stance in more detail:

ESG versions of our liquid benchmark indexes are a great addition to those investors looking to invest in a more sustainable way. Since the launch of OMX Stockholm 30 ESG index in 2018, it has grown into one of the most traded ESG indexes in Europe.”

Want to know more? Check out a recent post about how companies listed on the European Nasdaq exchanges are promoting their ESG credentials:

Nasdaq Helsinki is just one example of a leading financial institution becoming a leader in the ESG space. It’s good to see. But Radovan has a more important question. Radovan wants to know when a bank will become fully green. He suspects it may not be one of the household brands we see today, but he thinks the bank of tomorrow should be green. The Tesla of banking is missing. Somewhere the Elon Musk of green banking might already be reading this story. Hopefully the founder, be they a woman or a man, will be thinking of ways to develop a future unicorn for green banking.

Author: Andy Samu

#ESG #PortfolioManagers #BuySide #SellSide #ESGratings #Sustainability #Quantpedia #Risk

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