Be aware of bias in ESG ratings: Prudential
Investors should be fully aware of the complicated biases behind an ESG score to properly measure ESG risks and avoid greenwashing, warned Prudential.
“[Third-party] ESG ratings are quite useful in a general sense to gauge how well a company is doing on ESG. But we do tell our investment managers to do your own research as well,” said Liza Jansen, head of responsible investment at Prudential.
“Although they're quite useful and I do understand why a lot of investors want to use them, there are some biases in the data which you have to be very much aware of,” she told AsianInvestor.
Prudential runs life insurance businesses in many emerging markets in Asia and Africa, and it carefully utilises both third-party ESG data and an internal measurement framework to identify ESG risks.
Jansen thinks not everyone, especially investors of smaller scale, understands what an ESG rating means.
“The ESG rating often focuses on how a company operates instead of what the company does. They could try to operate more sustainably, but it doesn't mean that the product that you're eventually making is sustainable in itself,” she noted.
For example, tobacco companies in general have high ESG ratings, because they do well in sustainability in areas such as the manufacturing process or employee benefits. But the product is still unhealthy.
LOST IN TRANSLATION
ESG risks are highly correlated with the sector, and they are calculated very differently in different sectors. So, if one starts to compare the ESG ratings of companies from different sectors, the objective is often lost in translation, Jansen said.
Currently in the market, major index providers all have their own ESG scoring and rating system, providing different solutions to investors.
ESG scores do not provide an objective view of a company’s ethical position or its products and services. A single ESG score cannot capture the complexity of the wide range of non-financial ESG issues, noted Elena Philipova, director for sustainable finance at Refinitiv.
“It is much harder to expect companies to be able to report on the social impact of their products and services in an objective and measurable way. However, this approach can lead to counter-intuitive outcomes unless the focus of ESG data is clearly understood. Consider the example of Tesla scoring relatively poorly on ESG criteria,” Philipova told AsianInvestor.
To enable investors to choose the scores that align with their needs — net zero transition, for example — Philipova suggests using index providers’ designated data set, or the Transition Pathway Initiative (TPI) Management Quality score, rather than defaulting to the ESG score, which is a lot broader in nature, she said.
TPI is a global, asset owner-led initiative that provides benchmarks to assess corporate climate action.
NOT ALL’S FAIR
ESG ratings are also highly correlated with the GDP of the country in which a company operates, as well as the size of the company itself. That is, developed countries and large companies tend to have more resources, not just to ensure their operations are sustainable, but also for reporting: major companies produce the best sustainability reports, and that reporting behaviour will be rewarded and reflected as relatively high ESG scores.
This doesn’t necessarily mean the company does better than others at ESG. If others don’t report on ESG, their scores will be lower despite doing better, Prudential’s Jansen pointed out.
In that case, if an investor has any ESG rating overlay, especially for a global strategy, usually what they end up doing is allocating funds from emerging markets to developed markets, and from small companies to large companies, she said.
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“This is how ESG ratings work. It's not necessarily bad, it's just that if you use ESG ratings, be very aware of what you're doing and be very aware of those biases,” Jansen said. “That's why we ask our fund managers, especially when it's an active strategy, to do fundamental research, and use the research that the data provider has done for you, because they collect an enormous amount of data and information.”
She noted that Prudential actively checks on these factors and remedies for them in a way that aligns with its decarbonisation targets.
In practice, one of the best ways to avoid those biases is to take a best-in-class approach within sectors — that is, to compare companies in the same sector of similar size, for example, Jansen said.
From an economic perspective, this will avoid divestment from an entire sector, such as the energy sector, which is still essential to economic development.
“I think you should always take a best-in-class-within-the-sector approach, instead of just a blanket approach without looking at the impacts of your allocation on different sectors, countries, or size, among other factors,” Jansen said.
For ESG data that is not available from a third party, Prudential relies on its own assessment, especially for investments and markets that are not covered by external providers. Vietnam, a market that Prudential operates in but is not covered by any ESG providers, is one such case.
The British life insurer tries to set some standardisation within the company, on issues such as what frameworks to follow, and what factors are important for its ESG agenda.
For example, on sector-driven ESG risks, such as the carbon emissions of companies from energy sectors, Prudential aligns with the Sustainability Accounting Standards Board (SASB), which has standardised ESG metrics and risks that are important by sector.
Prudential also does ESG reporting following SASB’s recommendations for the insurance sector. It’s voluntary for companies in most emerging markets that Prudential operates in, but it is often mandatory in Europe.