If there’s one company that should be a slam dunk to rate based on environmental, social, and governance factors, it should be cigarette maker Philip Morris. But as it turns out, there’s a lot of disagreement among the major firms that provide ESG ratings.
“If you think about Philip Morris when it comes to ESG, obviously most people would think it’s very negative, and MSCI’s rating is negative,” said Michael Chen, director of portfolio management at Boston-based PanAgora Asset Management.
In actuality, it’s a bit more complicated, Chen added. “Remember ESG is made up of E, S and G,” he said. “From an E perspective, smoke is polluting, so that’s negative, and the S is negative because smoking causes lung cancer and harms people’s health. But Philip Morris has a pretty good governance structure, so Sustainalytics actually has them as neutral. It’s just different preferences at the end of the day.”
PanAgora, which has a three-year track record for its quantitative global sustainable equity strategy, collects most of its own ESG data, Chen said. When the firm does buy data from third parties, it collects the underlying information in its raw format, in order to avoid any pre-bottled scores. For one thing, PanAgora doesn’t want to invest in ideas that are offered up to everybody, which reduces the potential for profits. According to Chen, this is because the firm believes ESG factors also lead to alpha, or excess returns.
Stewart Investors, which has one of the longest track records in the sustainable investing category, likewise doesn’t use ratings from outside vendors to make investment decisions, according to Mohan Gundu, an analyst with the firm’s sustainable funds group. The firm does, however, use services such as ISS and RepRisk to monitor companies it owns.
According to Gundu, the challenge for raters is how to even begin assessing some companies from an ESG perspective. “Seven million people are killed by tobacco,” he said. “So how do you start? Or fizzy drinks companies. If you are a fizzy drinks company and you have fantastic operating statistics, you might try to make plastic bottles more recyclable, but at the heart of it is, ‘What are the health implications? Does the company need to exist?”
Stewart recently published a paper arguing that ESG ratings can end up hurting efforts by sustainable investors to engage with companies and get them to make meaningful changes. The paper raised the example of recent empty statements from British American Tobacco on sustainable agriculture for rural communities and empowerment.
“We are concerned that highly standardized ESG reports promote a box-ticking analysis of ESG credentials or worse yet, an excuse for inaction,” the letter stated. “That these ESG scores are then often used to construct indexes used by passive funds is a further concern. This is because it can encourage the gaming of ESG reporting without the scrutiny and encouragement provided by engagement from active managers.”
Recently, Kroll Bond Rating Agency has started providing ESG evaluations for bonds. But the ratings agency is staying away from offering simple scores. Instead, it’s asking how management is responding to the rise in ESG sensitivity, whether it’s capital providers, customers, regulators, or policymakers.
“We’re at the very beginning of our journey with ESG,” said Jim Nadler, CEO of KBRA. “But we really believe that investors can’t be expected to get their mind around anything that’s not fully transparent and fully understandable.”
According to Nadler, “investors don’t want ratings agencies or companies to make value judgements, like gun companies are bad. They want us to say this gun company is rated BB.” The concern from a credit rating standpoint, he said, is that over the next decade, more mass shootings could be tied to gun manufacturers.
“If that happens, it could have a real impact on the pricing of bonds and ratings,” he said. “That’s me giving you the facts on what could be a potential issue if you invest in a gun manufacturer.”