Introduction
Investors are increasingly taking steps to understand and monitor how ESG (environmental, social and governance) issues are being managed in their portfolios.
We see several drivers for this including:
- Materiality – numerous examples show investee companies can materially impair their market valuation if ESG controversies emerge, e.g. BP, Rio Tinto, AMP.
- Regulation – there has also been increasing expectation from financial regulators around how investors manage ESG factors. This includes recent scrutiny by ASIC of companies and superannuation funds regarding potential misrepresentation of ESG credentials, usually referred to as ‘greenwashing’. Further to this, Australian regulation of sustainability disclosures will become standardised with the advent of mandatory climate-related financial disclosures, to be phased in from 1 January 2025.
- Stakeholders – beneficiaries, customers, employees, media, and the wider community are increasingly recognising the role institutional investors have in addressing real world social and environmental issues such as climate change and human rights, so are looking for ESG information demonstrating progress in these areas.
As a result, we have seen meaningful growth in the production and distribution of ESG data and analytics for the investment industry. The types and use-cases of ESG data and analytics vary but include carbon emissions, diversity metrics, modern slavery risks, UN Sustainable Development Goals (SDGs) alignment, and of course, a wide range of ESG ratings.
Significantly, there has been increased investor adoption of commercial ESG ratings databases and platforms sold by a plethora of third-party vendors, the largest of whom have become household names and have built substantial businesses in this area (like MSCI and Sustainalytics). These ESG ratings databases are mostly designed to cover a vast number of securities or issuers that themselves publicly report ESG-related metrics.
However, they also include variables and scoring methodologies that are proprietary to the vendor and are therefore at least partly subjective. The resultant lack of uniformity across vendor methodologies and outcomes is considered an ongoing challenge for investors and has at times been used by ESG sceptics to challenge the materiality of ESG considerations within an investment context. Nonetheless, an increasing proportion of investors now regularly incorporate such ESG analytics into their decision-making processes.
For many institutional investors however, their day-today investment activities focus on asset managers who run portfolios on their behalf. Frontier has included ESG considerations in its assessment and monitoring of managers for many years now. This is formalised in our ESG rating of products which is a standing element of our overall manager rating process. This helps provide clients with a conviction based and comparable ESG score for all rated products. Over time, we have enhanced our ESG assessment approach in line with our deepening experience, in response to industry developments, and to meet client needs.
This rating process is important as it empowers clients to compare how effectively competing managers integrate ESG considerations into their investment processes (and therefore enhance measurable investment outcomes). Ultimately, this assists our clients in manager selection processes.
So, now we have ESG ratings at both a security level and at an asset manager level.
At first glance, it may seem intuitive to expect there is commonality in the outcomes of these different ratings approaches. This expected ‘commonality’ suggests a product with a favourable ESG rating from Frontier would and should also receive a favourable scoring from a third-party vendor. But is this expectation reasonable, or is it problematic?
The purpose of this paper is to generate useful insights for clients by comparing the methodologies and outcomes of Frontier’s ESG ratings process and those of a third-party ESG scoring system (in this case, MSCI) via a brief case study. We illustrate that a simple causal relationship between these ratings will not always be apparent and offer some explanations why this might be so. Importantly, we highlight that these different ESG rating types serve different purposes and consideration of both, in the right context, can provide investors with complementary tools in evaluating and addressing ESG issues.
The final word
This analysis aims to highlight the importance for all clients to understand the two approaches to deriving ESG ratings are based on different methodologies and serve different objectives.
We strongly suggest they can be seen as quite complementary to each other, and this is of course why we offer clients easy access to both.
We maintain the view that the wholistic process Frontier undertakes to evaluate and monitor products on ESG is useful for product selection, subject to broader portfolio considerations. But having access to a third party ESG rating and reporting tool such as MSCI’s can also be very useful, for example, in testing and querying the manager’s responsible investment activities over time. It can also provide some oversight as to whether there are any undesirable exposures being adopted by the manager. And this oversight can be extended to the total sector configuration to examine what degree of overlap or offsetting there is in relation to ESG exposures as specified by certain factors or metrics.
So, what can we take away from the brief exploration of these results and the resultant considerations?
- A wholistic and rigorous rating process is essential for selecting and monitoring products with a view to ESG integration.
- Investors should consider the broader investment objectives of the product when assessing the ESG credentials of the manager and monitoring ESG exposures at various points in time.
- This rating process can be complemented by ESG (and carbon) reporting which is built from bottom-up exposures, provided by a credible data platform. The reporting results can be readily compared across products and provide guidance on total portfolio exposures. ESG reporting can provide useful information to stakeholders and can also provide some assurance toward regulatory requirements (such as the forthcoming Australian Sustainability Reporting Standards disclosures).
Ultimately, the information and analysis available regarding ESG considerations should enable a focus on those elements that are decision useful for a particular investor. The specific elements pertinent here will depend on the representations at the product and total fund level, while these in turn will be linked to the expectation of stakeholders, primarily beneficiaries/members.
Learn more
Frontier will continue to analyse ESG data as part of our manager research efforts so clients can expect their portfolios evolve in line with industry developments and expectations.
We have focussed our analysis in this paper on broader ESG ratings. While our comments also cover climate change at a high level, given that issue is a key pillar in our selection and evaluation of products, we will also extend this analysis to focus on climate change consideration in the future. That is, we will illustrate some results with a comparison of our own climate change assessments (part of the broader ESG scorecard) with carbon/climate reporting from a commercial ESG database in a future paper.
We hope you found this paper insightful. If you have any questions or would like to discuss Frontier’s ESG assessment approach, along with other third-party ESG rating providers, please don’t hesitate to reach out to your consultant or the Responsible Investment Team.
