The past 18 months have seen an acceleration of the Environment Social and Governance (ESG) agenda, and this is a positive development. However, this has created a dichotomy: investors clamour for "good" ESG assets and are keen to shun "poor" ones, says Andrew Probert of Duff & Phelps.

A low rating, or more accurately, "score" from the point of view of ESG, will likely affect an asset's market price. But as investors are aware, they can often achieve a better return from an asset that generates higher-than-expected returns over time or by buying it at a lower price. So, do assets that may be considered "bad" from an ESG viewpoint offer meaningful opportunities for investors?

That would depend on whether we are able to accurately identify a "bad" ESG asset that has the potential to outperform expectations, which can often prove to be a challenging task.

Does that sound too good to be true?

In reality, the assumptions about what constitutes a strong asset within the context of ESG are often flawed, while the data that many investors often rely on to make important decisions may not be fit for purpose. There are three key reasons why investors should consider being sceptical about the data they are currently being offered.

The first is methodology, as the scoring systems themselves can often prove problematic. Methodology is considered the "secret sauce" of any ratings provider. The research must stand up to scrutiny if it is to make it past the first hurdle. But in the case of ESG, there is often a lack of transparency as to how ratings are calculated.

Questions about the underlying data can be stifled because ratings are a proprietary service and therefore commercially sensitive. Further, if investors can look under the bonnet at these approaches, some will be likely to be found as backward—rather than forward-looking. They also often favour companies with large amounts of resources which can be dedicated to the collation of required data, a major hurdle in the widespread adoption of voluntary ESG disclosure, upon which many ESG ratings are based.

Second is the apparent lack of standardisation. Data that is disclosed is often not being captured in a standardised format. This is perhaps not so surprising, as there is a lack of uniform rules as to how any ESG risk or component be assessed and quantified.

In our recent survey, we found that market participants were utilising fourteen different combinations of the six major ESG frameworks and standards. Ratings providers go further by collating their own data sets. This non-standard data can often be a choice of whether a particular policy is in place or whether the respondent has answered the question at all.

This can fundamentally skew an assessment as to whether an asset is considered good or bad and deviates from the more holistic views offered by combined frameworks like the World Economic Forum's Measuring Stakeholder Capitalism.

Lastly, firms should consider issues like arbitrage and bad faith. Some companies will sometimes challenge the system by disclosing when others cannot. Others will arbitrage the methodology. If they do not receive the rating they desire, they may look at alternative providers. Therefore, a system that claims to identify and quantify the ESG characteristics of assets could be considered fundamentally flawed.

A rating by any other name

Part of the challenge is the data available for agencies to analyse. Many rely on publicly available data, while others often use data directly sourced from companies, which is not subject to any form of mandatory attestation. Those given a low score—or none—may not be bad at all. They may just not have dedicated—or perhaps even found—the necessary resource to disclose information to the agencies.

Putting forward detailed disclosures is not considered a simple task and involves a wide variety of internal and external stakeholders. Many organisations may overlook this due to a heavy time and monetary commitment.

Investors should also be conscious of what an ESG "rating" really is. After all, a credit rating is typically based on science. ESG ratings are more an art than a science. They may offer an appealing picture of an asset, but diligence and accuracy are fundamental considerations, and investment decisions should be grounded in strong data and not necessarily abstract representations.

Referring to these assessments as rating systems lends them a degree of credibility that can be challenged. In time, ESG ratings will be considered an essential tool in an investor's risk arsenal, but only when accurate and meaningful data is delivered, which may take some time to come to fruition.

Making the right decision

Investors are encouraged to do their homework, and not rely solely on answers produced by the algorithms. Instead, they should take a deeper dive behind the curtain, to look at process and procedure. In short, investors should consider a deeper interrogation and scrutiny of the data themselves.

Context is also key to the decision-making process. Many of the views offered by incumbent agencies could be considered somewhat short term. Do they capture the trajectory that the business is currently on from an ESG perspective? That's to say, how has the business improved over time, what are its stated intentions and how well has it delivered on those promises in the past?

Alignment with an investor's attitude and outlook for the future, attitude to risk and the organisation's ESG objectives are all crucial considerations.

Trust, but verify

Many of these ratings are often only updated on an annualised basis. While investors may appreciate the "hygiene factor" of having an ESG rating on their asset, it's important to remember that it can be considered a snapshot of a single moment in time, just like an MOT on a car.
While it is mandatory for a motorist to submit their car for a test, it only proves their vehicle was roadworthy when the inspector passed it. They would be remiss to rely on that assessment any time in the future.

Herein lies an opportunity. For the investor that can identify events or actions that will likely improve, or worsen, a business' ESG rating ahead of its next submission, they can get ahead of the game. So, a standardised approach with regular updates and independent attestation will go some way to providing credibility to ESG ratings.

However, investors should still rely on their own research, trusting that their intuition and that of their trusted advisers to produce the best outcome and returns over time.

By Andrew Probert, managing director, Transaction Advisory Services, Duff & Phelps, A Kroll Business