By Patrick Hubert, senior sustainable investment manager, Beyond Ratings and Aled Jones, director, SI product management, FTSE Russell
What explains a company’s ESG performance? As investors become increasingly convinced of the financial materiality of environmental, social and governance factors, they are integrating ESG scores and ratings into investment processes and stock selection. But what if the characteristics inherent in those scores mean that they tell only part of the story? What if they are unfairly penalizing some best-in-class companies, and elevating more run-of-the-mill ESG performers?
ESG practitioners have recognized for some time that ESG scoring approaches have a number of inherent biases. Large companies tend to get better scores than small-caps. Developed market companies outperform their emerging market peers. Some sectors systematically fare better than others.
The reasons for these biases are not difficult to find:
Large companies face greater scrutiny by investors and other stakeholders (e.g. regulators) than small ones. But they also have more resources to apply to reporting to and communicating with these stakeholders. Further, as the focus on ESG practices increases, large companies are able to formalize deeper and better ESG management processes and outcomes.
Governance expectations, corporate culture, and regulatory requirements relating to ESG tend to be stricter in richer countries than in poorer ones.
Some sectors are fundamentally more exposed to ESG issues, whether positively, in the case of clean energy or water utilities, for example, or negatively, such as oil and gas, prompting more proactive ESG management and disclosure.
But while the reasons for these biases may be intuitive, their relative contribution to ESG performance has hardly been quantified. To address this, we set out to examine how much these three factors, individually and combined, explain a company’s ESG score.
In doing so, we can offer investors an additional lens through which to examine ESG performance – by isolating:
- The "explained score" i.e. the component of the ESG score that is driven by the three "factors" already outlined (size, country, sector), and
- The "residual score" i.e. the remainder of the ESG score, that results from the company management’s own efforts
Using the FTSE Russell ESG scores database, which includes nearly 4,700 companies, we applied a rigorous, robust, and sophisticated statistical method to separate the two components. The method, a PLS (Partial-Least-Square) regression analysis, included analyzing the degree to which the three factors are independent or correlated (for more details, see our report here).
The analysis found that, on average, almost half (46%) of a company’s ESG score can be explained by its size, sector and country. To take the country bias as an example, much of the variance in ESG scores between companies in different countries disappears once the bias is removed (see chart below).
Source: Beyond Ratings, as of 24 June 2019. Past performance is no guarantee of future performance. Please see the end for important legal disclosures.
What does this mean for investors and issuers? The crucial insight is that these biases may—in ESG performance terms—flatter larger companies, in ESG-exposed sectors, in wealthier countries. Smaller companies in emerging markets and less exposed sectors may be unfairly excluded from ESG universes and over-looked for investment, despite "residual" ESG performance that is better than some of their peers.
This insight may have financial implications: it is possible that this superior "hidden" ESG performance could be predictive of financial outperformance.
Should investors always seek to account for these biases? That is debatable. Good ESG performance is a positive whether it is achieved with or without the tailwinds of strong regulation and peer-group best practice—ESG performance explained by size, country or sector is still part of overall ESG performance.
Indeed, it is likely to be impossible to create ESG framework that entirely avoids these biases, because any model based on ESG data has an implicit bias towards disclosure. Companies with lower disclosure will generally always perform worse than those with better disclosure.
To overcome this bias would require the introduction of universally accepted ESG disclosure frameworks, mirroring global accounting standards. Recent announcements that the key standard players such as GRI, SASB and CDP will work closely together is a step in the right direction that should be welcomed by all.
ESG data is important, not just because it is being used more widely than ever, but because it gives investors a broader perspective on risk and opportunity. It is another string to the investor’s bow. And we believe that demand for ESG data will continue to grow.
It is therefore essential that investors understand the constituents of corporate ESG performance and consider these characteristics as they deploy it in their decision-making. This will enable them to cast a more critical eye over some perceived leaders, and perhaps give greater credit to companies that perform well, despite the chips being stacked against them.
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