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ESG: The next subprime?

Written by Ultumus | 12 February 2021

This article is written in response to the fact that a number of European ETF issuers are planning either to convert their existing funds to ESG or launch new funds using ESG as a criteria. See the latest announcements from DWS and UBS:This reminds me of the trading joke:

“I have just had to fire Joe, for using the F word”

“But all traders swear”

“No, you misunderstand he was interested in the Fundamentals”

ESG seems to have captured that zeitgeist moment, where people are interested in purely the flag rather than the information behind it.

Disclaimer before I continue, I actually believe strongly that companies should be reporting in annual reports on environmental, social and governance, however my bug bear is with overarching perception that an ESG rating is a way of capturing this information.

Let’s first look at what is captured by the ESG headings:

Category Description
Environmental Environmental is meant to be a measure of a companies’ green credentials, including carbon neutrality, utilisation of natural resources, Paris alignment, water usage and pollution
Social Social is meant to be a measure of how a company treats its employees / clients and suppliers. This encompasses aspects such as labour relations, workforce diversity and social benefit
Governance Governance is a measure of the companies’ ethical stance, including aspects such as shareholder rights, code of conduct, tax strategy and whistle blower protection

For a breakdown on what some of these key terms mean, check out this blog post to find out more.

The first thing to note is that some of these aspects are hard to define in empirical evidence, if they are in fact referenced at all in the organisations profile. Additionally, there is not currently any real consistency in how these are measured / reported across countries. Until there is consistency in how ESG are reported / required within company reports the data behind these is subject to significant inference /sector perception.

Do we also have an inherent size basis? as it is only companies of a certain size that will be able to structure their reports in order they rank correctly for ESG, meaning companies that are smaller with less financial muscle but far more environmentally or socially responsible are ignored?

I would also question the rationale for “lumping” these aspects together into one number / rating, surely we should be measuring / encouraging companies to improve their ranking in the specific E / S and G rather than providing them a overall figure?  If index providers supplied an S&P 500 E, S&P 500 S and a S&P 500 G, I am sure we would see a push for companies to be included in all three but untill that stage, they have their rating averaged across three different categories, via a proprietary model using an undefined dataset.

ESG data is open to interpretation as with various models used to rank the various companies, with the ESG criteria being rated in very different approaches by different companies that are allegedly using the same inputs. For instance MSCI rates Tesla as A.

Whereas Sustainanalytics rates it as:

And Refinitiv / Reuters / LSE ( what are they known as this week?) I will give credit here at least Refinitiv portal does break down the respective scores

So for one company we have a rating of A, 31.1 and 56, I would suggest that this is slightly open to interpretation.

To continue this for Royal Dutch Shell ( another company that ESG seems to struggle with)

Refinitiv has it ranked number 1 out of comparable companies

Sustainanlytics has it ranked 53rd out of 280 comparable companies:

And MSCI has it as average:

Thus we have a badly defined dirty data set, that is open to interpretation, viewed in different manners by different organisations. Unfortunately on top of this we have ETF / index providers averaging these results and interpolating an average score. The below is a snippet from iShares product screener

Thus we have a rating that is open to interpretation creating pooled products from which there is interpreted an average rating. Does this approach remind anybody of anything? The sooner the regulators define a definition of ESG and require reporting to a defined standard in company reports the better. Till then anybody buying into ESG has to realise they have to do their own research as per their criteria, or appreciate they are merely virtue signalling or green washing.

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