As environmental, social and governance (ESG) considerations become more prominent in portfolios, institutional investors are asking more questions of their investment managers. We spoke with a few of our research analysts to help highlight some of the top issues that deserve attention when evaluating portfolio teams.
Several themes surfaced in this discussion. First, we believe equity and fixed-income analysts need to get up close and personal with companies to fully assess the ESG issues that these companies face. Second, ESG standards are rapidly evolving, which require analysts to understand how future changes could affect the business environment. And third, it takes a broad perspective across regions and sectors to fully grasp how a company stacks up against its global peers on ESG criteria.
When it comes to ESG assessments, data and ratings alone don’t tell the full story. Independent fieldwork is the key to developing a complete picture of corporate behavior. That’s why institutional investors need to ensure that portfolio managers are engaging with corporate management teams, visiting individual facilities, speaking with the rank and file, and fully understanding the ecosystem a firm operates in.
Looking Beyond the Data
As the effort to assess ESG issues grows, reporting requirements have grown as well—and so have the number of services that collect and model data to score or rate issuers. We use third-party ESG services, too, though even as they continue to refine their modeling and ingest more data, these tools are still imperfect. Data often tell less than the entire story—and sometimes they even tell an incorrect one.
We’ve seen a case in which a firm received a best-in-class rating for executive compensation because the CEO’s reported salary was quite low. But when we took a closer look, the source data revealed that the CEO had actually started his job very late in the year, so the salary number was abnormally low and communicated an incomplete picture of company governance.
For this reason, it’s not enough to simply tick the boxes by reviewing published ESG reports on a company and seeing that it has received a BBB or a BB rating. Investors need to ensure that a manager has deep enough resources to apply in-depth, fundamental analysis to verify the pieces of the puzzle, assemble them and ask: “Is this rating right or wrong…and why?”
We asked this question about a Chinese firm with a poor environmental score. Our analyst visited most of its sites and saw an environmentally conscious company with some of the country’s newest equipment. As we engaged with the management team, we discovered that the company’s sustainability data were submitted in Chinese and was being lost in translation. During our dialogue, we suggested that the information be sent in English, in order to shed light on the company’s true environmental position and to support a more accurate published rating.
As the demand for ESG information grows, there are inevitably disparities in the amount and quality of data provided. A huge, multinational firm can deploy a large team to generate a 50-page annual sustainability report. A small local firm, on the other hand, simply can’t match that effort—even if its ESG profile is no worse than that of its much larger counterpart.
In the emerging debt markets, where many companies are private, data transparency can be materially weaker than that of public companies, and coverage by third-party ESG data providers often doesn’t exist. That puts a premium on understanding the company and its governance structure.
Another information issue for fixed-income investors is the risk of “greenwashing”, where information is packaged to make a security seem much more environmentally friendly than it actually is. Green bonds, are typically self-labeled, meaning any issuer can label their bond as being environmentally friendly. But it’s up to the buyer to verify whether the projects being funded are really as green as depicted. For example, investors in a Massachusetts university’s green bond in 2015 probably didn’t expect the proceeds to be used to build a parking lot. In some cases, consultants certify environmentally questionable issues as green when, for example, a small amount of the proceeds will be used to install lightbulbs with only marginally better environmental profiles. Institutions that invest in green funds that don’t delve deeply enough into the project details could end up with decidedly un-green bonds.
Even if high-level numbers are accurate, it doesn’t change the fact that many aspects of a company’s ESG practices are highly nuanced. A ratings system, no matter how robust or granular it is, simply can’t accurately capture the full reality of how a company operates, and the data often paint a backward-looking picture of company behavior and performance. The world of ESG analysis doesn’t always lend itself to a homogeneous rating system. Informed human judgment and comprehensive analysis that assesses information in context is really the only way to fully gauge these issues.
ESG Doesn’t Stand Still—It’s a Moving Target
It’s true that you need to start with the basics when assessing a firm’s ESG profile. Has the company violated any rules? Is it falling short of, meeting or exceeding prevailing requirements? But ESG metrics are static, while ESG standards will always be evolving—making it a moving target. What’s accepted practice today may be considered unacceptable tomorrow: rules, regulations and popular opinion continue to evolve.
An analyst’s role is to understand how ESG standards are evolving and—in some cases—whether today’s acceptable or tolerated behavior creates risk down the road. A subprime credit provider, for instance, could be charging extremely high lending rates, while still being fully compliant legally. However, it’s likely this behavior will increasingly be viewed as socially harmful, which could create a growing backlash that hurts the firm’s business and its investors.
With companies that are more advanced in ESG practices, the question is: What measures or initiatives are they taking that can help society, and how might this action translate into better business prospects? ESG metrics and models may show good scores today for a Latin American microlender, but they don’t really answer this question. To find the answer, we looked firsthand at the company’s business model, which includes educational programs for both employees and clients, most of whom are lower on the economic pyramid. Building these strong bonds is not only good for society as a whole; it has resulted in a more sustainable business that’s not as exposed to its peers’ boom/bust cycles.
What about companies that are behind the curve on ESG but working to get better? Based on surface-level scores, some investors might turn away. That happened with an Eastern European mining company that received a poor environmental rating because of pollution from outdated equipment. Our ground-level look revealed a concerted effort to upgrade to more environmentally-friendly equipment. Two years later, the company’s improvements were acknowledged and its rating was raised. The security rallied, as we’d expect based on our research into the relationship between upgrades and outperformance.
Management Teams Can Make or Break ESG Efforts
We’ve found that corporate governance often has a holistic element: If management is good at running its business, it also tends to be effective at managing local relations, whether it’s dealing with labor or the community, and thoughtful in managing its environmental footprint. Issues are acknowledged, plans articulated and execution is effective. The reverse is often true, too. Some firms are reactive or in denial, even when they face real issues that cost the company and its shareholders money.
We can see the contrast between effective and ineffective governance in the case of two pulp and paper companies. We engaged with management to understand the corporate strategy and whether the organization was aligned behind it. At the senior-management level, both firms echoed similar strategy pillars: a focus on matching supply and demand, evaluating managers based on profits, and a strong culture of sharing best practices.
But the stories diverged when we visited with individual facility managers. At the first firm, managers clearly articulated the corporate strategy, the roles their mills played in it and how they shared best practices with other managers. At the second firm, mill managers were disengaged from strategy, understanding their compensation to be tied to metrics like defect rate, volume and waste. In their view, each mill was so different that it didn’t make sense for them to learn from each other. Today, one firm is bankrupt and the other performing reasonably well. It’s not hard to figure out which is which.
Peer firms can provide an important cross-check on corporate management teams, too. Companies in the same industry aren’t shy about sharing information on their competitors, which can help us identify a potential issue and provide the rationale to start appraising the economic benefit or cost. This information is much harder to get if an analyst doesn’t have a strong network of industry connections.
It Takes More Than One Perspective to Complete the ESG Puzzle
Many ESG issues are highly sector specific—financial-services companies and manufacturers, for instance, face substantially different issues. But region and country play a role, too, as do distinctions between developed markets (DM) and emerging markets (EM). It usually takes multiple lenses for analysts to assemble the pieces of the puzzle.
A global perspective that looks across markets can provide a broader frame of reference for evaluating companies’ local operations. In the US, there are essentially two large mining companies—not much of a basis for comparison when they have assets all over the world in very different local contexts. Some analysts might presume that a firm’s local mining operations in Peru are risky. But a global perspective on mining combined with local expertise led our analysts to conclude the opposite.
Distinctions between DM and EM with respect to ESG have to be considered, too. When evaluating EM companies, some analysts may tend to apply DM views and assumptions on proper governance to firms that exist in very different ecosystems. This inclination can color an analyst’s assessment of a company and potentially lead to an incomplete conclusion.
In developed markets, for example, it’s usually assumed that a firm with broad, diffuse shareholder ownership is in a better governance state than a firm with a controlling shareholder that has influence over minority shareholders. However, when the local power structure is very different, a strong stakeholder might be a powerful voice that stands up for the company’s interests when challenges arise.
A longtime family-controlled bank that views the business as a long-term investment may avoid taking on excessive risk, resulting in a consistently high return on equity. On the other hand, a bank with more diffuse ownership could focus too much on generating a higher short-term stock price, which could lead to less beneficial decisions for the business in the long run. It’s important not to prejudge the effectiveness of governance structure.
Equity and fixed-income perspectives may differ slightly when analyzing ESG. Both equity and fixed-income investors are keen to focus on the potential downside risk from ESG exposure. However, equity portfolios may also apply their analysis to the upside potential of an ESG issue, for example, evaluating how a technology company may benefit by expanding into high-growth renewable energy markets.
When it comes to governance, the differences may be more pronounced. Both equity and fixed-income investors are concerned with reputation and governance principles of management teams. Yet fixed-income investments are often made to companies that are privately owned, which are often less transparent, so investors might have trouble getting good information. In addition, corporate management teams may endorse policies that are friendlier to either shareholders or bondholders—especially in buyout situations—which would lead to differing views on governance by equity or fixed-income investors.
The Big Picture
These insights reinforce that it’s a very difficult proposition for an investment manager to sit in a major financial center and make ESG judgments on companies with far-flung operations in diverse ecosystems while leaning too heavily on third-party quantitative tools, data and research. This concern seems to be reflected in many ESG questions we get from institutional investors.
To effectively assess a company’s ESG profile and trend, asset managers need sufficient analyst coverage and the ability to get down to the ground level and do the fundamental homework. Broad assumptions about industries, countries and risks can lead to suboptimal conclusions, improperly understood risks or missed opportunities. It’s critical to fully understand the ecosystem, maintain an open dialogue with management, visit local assets, and meet with the rank and file.
In our view, that’s really the only effective way to understand each piece of the ESG puzzle and how the pieces fit together for each company.
AB analysts Michelle Dunstan, Vivian Lubrano and Patrick O’Connell provided the insights and perspectives reflected in this report.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.