13 Oct We Are The Watchdogs
“Notre maison brûle, et nous regardons ailleurs. Nous ne pourrons pas dire que nous ne savions pas”
(Our house is burning, and we choose to look away. We will not be able to say that we did not know)
These words were pronounced by the late French President Jacques Chirac in 2002 during the 4th Earth Summit in Johannesburg. Chirac was warning of the inaction of leaders, and all world citizens, as ecological crises threaten our planet. As investors, we are also concerned by Chirac’s call to action. For us, the era of the “profits-are-everything investor” are over. We believe that all readers need to assume the role of the “investor-global citizen”. It is no longer admissible to look away while continuing to finance companies that are not good stewards of our planet, that propagate health epidemics, or engage in dubious ethical practices.
The progress made in compiling and rating companies on an array of non-financial criteria means, as Chirac said, that we can’t say that we don’t know what we are investing in. Environmental, Social, and Governance (ESG) ratings are becoming the preeminent source of information to judge a company’s non-financial risk. We presented the arguments in favor of ESG last week in “These Companies Will Boost Your Portfolio Performance”.
In this article, we make two calls for action. In the first section, we exhort each investor to become aware of the ESG standards, to perform the due diligence on potential companies for investment, and finally invest savings as responsible investor-global citizens. In the second section, we call to action all securities regulators, company executives, and ratings agencies to work together towards improving and developing a transparent, uniform, and comprehensive ESG rankings classification for non-financial company data comparable to the credit ratings provided by Moody’s and Standard & Poor’s.
Who Let The Dogs Out?
In the world of politics, the media serves as a watchdog. The media reports on the actions, and scandals, of politicians. Election-minded politicians don’t like to get caught with their pants down (no jibe at President Clinton) and therefore mind their P’s and Q’s.
In the corporate world, the actions of C-suite executives are watched by their boards of directors and activist investors. Each person acts in his/her best interest. Company directors are no exception and this is why remuneration packages tied to executives pay with company financial performance. Until recently, company directors have had no incentive to consider the impact of their business on ecosystems, human rights abuses, environmental supply chain management, etc. And why should managers have cared if no one was watching and if “going the extra mile” represented a cost for the company which, in turn, took off from the bottom line.
Even today, if left unchecked, many managers of corporations would run their companies with little interest in being good stewards of the environment or promoting enlightened social values. Most of the ESG norms are beyond the scope of government regulation, which is not an efficient way to promote socially responsible management and has no role in many corporate governance issues. Even environmental matters are hard to mandate and enforce through government environmental regulators, such as the U.S. Environmental Protection Agency (EPA) which has little bite.
Who is best suited to be the watchdog, overseeing the actions of corporate managers in the 21st century? We, the collective body of investor-global citizens, need to be the watchdog. Yes, the primary objective of the investor-global citizen in allocating savings to a company is to increase his/her personal wealth. But at the same time, by aiding in the financing of a corporation, the investor-global citizen is voting with his/her investment dollars in favor of the values incarnated by the company. The investor-global citizen realizes that these two objectives are not incompatible. This is not a choice between earning a high return by investing in a dirty gas pipeline company like Cheniere Energy (LNG) or rather settling for low returns by investing in an environmentally-friendly company like Waste Management (WM) running a recycling service. On the contrary, we would expect that environmentally-friendly companies will see a more sustained longer-term demand for their shares from the rising class of investor-global citizens.
Some readers may still be unsure of the superior long-term potential of ESG-focused companies. Even if you are not convinced of the virtues of sustainable investing, concentrating your portfolio holdings in ESG-focused companies might nonetheless still make sense. Think of it as a Pascal’s wager in investing. If the attributes of ESG-focused management indeed support relative long-term outperformance, investors will enjoy superior long-term portfolio returns into their retirement. If ESG proves not to have a long-term influence on firm value, investor portfolio returns will be little different than if a non-ESG portfolio was chosen. Even in the latter scenario, the investor will still enjoy the intangible benefit of knowing that his/her investment dollars/euros were used to support environmentally and socially responsible companies.
Let’s Get It Together
Readers would agree that it would be extremely advantageous to have standardized, complete ESG ratings to support investor due diligence in making investment decisions and proactively managing potential financial risks. Currently, the ESG ratings system needs improvement in order to fulfill its purpose of being a reliable source of investor due diligence. Voluntary ESG reporting by firm management, the need for mandatory, audited Company Sustainability Reports (CSRs), and inconsistencies between rating agency methodologies are all areas that need addressing.
Unlike SEC-required quarterly financial filings, there is currently no obligation for firm mangers to supply data on resource use, environmental initiatives, fair competition policies, employee satisfaction, consumer complaints, or any ESG criteria. Companies provide as much information as their public relations officers choose. The problem with self-reported and unaudited sustainability reports is that they invariably present companies in the best possible light, and rarely alert investors of negative issues. A report from the consulting firm Deloitte found that, after examining over 4,000 sustainability reports, the auditors discovered a significant number of data omissions, unsubstantiated claims, and inaccurate figures. Given that disclosures are unaudited, unlike financial statements used for investment analysis, there is a large incentive for companies to pander to ESG rating methodologies.
SEC-mandated and independently audited Company Sustainability Reports would be a huge step in the right direction. Most companies are already compiling much of what could become ESG-mandated information; the additional costs to file an audited report would be minimal. Mandating the disclosure of complete ESG data would remedy another limitation with the current voluntary reporting system. Experts in ESG ratings have observed that the more information a firm discloses, the better their ESG rating, even if the company’s business practices are worse than those of another firm which did not file complete ESG reports and hence receives a lower ESG score.
Yet another issue to remedy on the regulatory side is disclosure requirements across regions which vary significantly. Unlike the SEC in the U.S., the AMF (Autorité des Marchés Financières) offers “recommendations” to French-based companies on what ESG data they should report. ESG standards are much more followed by European companies, where two-thirds of European fund managers have mandates to invest client money respecting ESG norms. The greater focus on ESG in Europe has resulted in a geographical bias towards higher ESG scores for European companies. A flagrant example of this geographical bias is the case of BMW (OTCPK:BMWYY) (in Germany) versus Tesla (NASDAQ:TSLA) (in California).
BMW has a high rating despite a slew of controversies, including anti-competitive practices, illegal marketing practices, business ethics violations relating to intellectual property, employee and human rights violations along their supply chain, and even animal rights violations. Tesla, meanwhile, is the world leader in technology to reduce carbon emissions from automobiles. Go figure.
Coordinated ESG disclosure requirements across countries and regions would reduce this geographical bias in ESG scores.
We are not calling on companies to be regulated by governments to assure adherence to ESG norms. Far from it. We believe in a free-market capitalist system. If a company chooses not to use renewable energy or to employ child labour in third world countries, we believe the MARKET needs to punish the company management. Meaning that informed investors should refuse to finance companies not playing by the rules of decency. All regulators need to do is assure a universal standard to define what does and does not constitute ESG, then require that companies file this non-financial data along with the current mandatory financial filings.
The final step in the ESG process that needs improving is the ratings of the agencies themselves. Unlike Moody’s, Standard & Poor’s, and Fitch’s credit ratings for a company, which are almost identical across the three agencies, we observe huge inconsistencies between ESG rating agencies. The big ESG ratings agencies today are MSCI, Sustainalytics, RepRisk, and Institutional Share Services. Data giants Thomson Reuters and Bloomberg have also gotten into the act, compiling their own ESG scores. The unfortunate news is that individual company ratings are not at all comparable across agencies due to a lack of uniformity of rating scales, criteria, and objectives. What might look to be an ESG-focus company based on Thomson Reuters’ rankings may turn out to be a company to avoid using Sustainalytics’ ratings. This is not tenable.
An absurd example of these inconsistencies that we came across involves Bank of America (BAC).
These three agencies offer the whole gamut of ESG scores from bad to mediocre to great. All three agencies factored in many of the same issues facing BofA into their ratings. However, the final scores are dramatically different due to inconsistencies in how the ratings providers interpreted these issues. On one hand, there is an inherent subjectivity employed by ratings agencies when selecting relevant ESG issues to consider. On the other hand, each rating agency has a customized scoring method which evaluates different non-financial metrics and frequently disagree about the component weightings of ESG.
Our hope here is for ESG ratings agencies to become more transparent on how the various environmental, social, and governance criteria impact their scores. Agencies are losing credibility with their current scoring systems. Even the treatment of information not provided by the company affects agencies’ ratings differently. Imagine if Standard & Poor’s gave Goldman Sachs (GS) a AAA rating and Moody’s gave Goldman a Ba3 rating!
A final limitation of ESG ratings that agencies need to address is the lack of company-specific factors. Companies that operate within the same industry see their different criteria weights and factors applied the same. Moreover, in an effort to standardize disclosures and metrics by industry, a company’s ESG score may be more influenced by its participation in an industry group rather than company-specific factors. Does it make sense to evaluate two Industrial firms, such as Boeing (NYSE:BA) and Waste Management Inc., which generates a significant portion of its revenue through recycling services, identically, without considering company-specific risks? Animal testing, for example, would be a very company-specific factor, which may be very relevant for Estee Lauder (NYSE:EL) but not at all relevant for Goldman Sachs.
In sum we, as investors, need consistent grades from the ESG ratings agencies to be able to make informed decisions vis-à-vis our ESG values as well as non-financial risks companies are undertaking. And on the side of companies, the variable geometry of ESG scores across ratings agencies do not leave managers with consistent benchmarks necessary to drive improvement.
Investor-global citizens need to step up to the plate and vote with their investment dollars/euros in favor of companies running sustainable businesses and choke off financing for companies depredating our planet. Regulators and companies need to assure that complete ESG disclosures are made available to the investing public. And finally, given that investments will be increasingly based on a company’s ESG rating, the ratings agencies that assign these ratings need to recognize the vital impact of their work on investment strategies. Currently, there is no uniform criteria used by the largest and most influential ratings agencies. We encourage readers to voice their opinions on social media platforms in favor of the call to action we have laid out above.
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