By Shelburne, Vermont Financial Advisor Josh Kruk
January 19, 2022
We try to be as objective as possible in everything we do. The choice of carbon intensity and fossil fuel reserves as our two environmental metrics is one example.
The methodology for calculating a company’s carbon intensity and fossil fuel reserve ownership is fairly easy to understand. And the results of those calculations are less subject to individual interpretation than many other ESG concepts.
It’s also the reason we do not rely on third-party ESG ratings or scores. You may have seen these scores attached to a company or an investment fund. They attempt to distill a complex environmental, social and governance profile into a single letter or number rating (e.g., “A” rated, or 3 stars out of 5). This sounds convenient on the surface, but investors may not truly appreciate how those ratings are derived.
Ratings are impacted by which ESG criteria the third-party provider chooses to include (fairly subjective), how those criteria are weighted in the provider’s model (more subjective), and how the provider interprets data in arriving at the score (very subjective). Methodologies often vary significantly across providers, which could lead to markedly different conclusions about a single company or fund. By extension, relying solely on ratings could cause investors to unknowingly purchase a fund that is misaligned with their priorities.
Some ESG managers use external ratings as an input in determining which companies to include or exclude in their funds. Investors who see an ESG label on those funds may mistakenly assume that certain types of companies have been excluded when they actually have not. According to Bloomberg, MSCI, the largest provider of ESG data, upgraded the ESG ratings of 155 companies in the S&P 500 between January 2020 and June 2021. However, a reduction in carbon emissions was cited as a driving factor in only one of those upgrade decisions. And because MSCI compares companies within industries rather than across industries, fossil fuel companies can receive relatively high scores as long as they are deemed “less bad” than their peer group.
We are not picking on MSCI. In fact, MSCI data is an input to our process. We just prefer not to leave it up to them or anyone else to interpret that data for us. As tempting as it may be to take a shortcut by using a single rating or score, or to purchase a fund simply because it is sold with an ESG label, there still is no substitute for spending the time to really understand the underlying holdings.