Myths About the EU | #3: The ESG-Score of a Fund Shows How Sustainable an Investment Is | QNG

INSIGHT SERIES by Roland Kölsch, Quality Assurance Company for Sustainable investments (QNG), Germany

| New, exciting topics, which become increasingly complex in the course of a development, always mean that society has reached the point of wanting to convey simple messages again. As understandable and media-psychological as this is in a development process to bring a core message (again) to the people, it is all the more necessary to provide for enlightenment in case of a too strong simplification and especially in case of a prayer mill-like repetition of many media of too simplified and then also often wrong messages.

In connection with the current efforts of the EU on Sustainable Finance, for example, there are a number of misleading statements that I would like to discuss in the framework of the article series Myths about the EU.

| Myth #1: The EU defines sustainable investments (published on 21.08.2020)

| Myth #2: The planned EU Ecolabel will identify sustainable investments (published on 28.08.2020)

| Myth #3: The ESG-Score of a Fund Shows How Sustainable an Investment Is

Recently, quantitative evaluation systems for “measuring” the sustainability of investments have been shooting up like mushrooms. A simple, at first glance tempting method are portfolio ESG-scores.

What works well at company level, as these models that are developed and established by ESG rating agencies, are generally based on best-in-class approaches, is unfortunately only applicable to a very limited extent at product level.

In some cases it makes sense to aggregate individual KPIs, like for example for CO2 emissions. However, it does not make sense to aggregate ESG-scores of companies that by themselves are already aggregated ESG-scores as the simple figures of a car manufacturer cannot be compared with those of an IT provider. Each industry has its own sustainability risks and opportunities. And 70 points at Sanofi say nothing compared to 70 points at Adidas, although both are considered “best-in-class” in their sectors. Moreover, the notoriously low correlation between the various ESG-Rating providers means that the results of the same portfolio can significantly fluctuate. The same applies over time, for example when particular investment cycles lead to important portfolio-rebalancing and thus to rating volatility. Despite some “bonus-malus” adjustments by means of the frequency or relevance of controversies, such an approach is not appropriate to give a meaningful evaluation about the sustainability quality of an investment. In some cases it could be – nevertheless – an additional valuable indication of how the aggregated companies in a portfolio manage their specific relative ESG-risks relative to their sector peers. In addition, there are weaknesses related to these quant-approaches, such as the fact that a rating already exists even if the ESG coverage is far from being exhaustive (sometimes 65% is sufficient). Such a simplified approach also discriminates against many SRI investment styles.

A best-progress approach, for example, focuses precisely on the rather poorly rated stocks, which, however, exhibit high momentum. An investor often achieves a higher impact with investments in “laggards” combined with specific engagement activities, for example, because it is precisely with such securities that even a small change already has a high impact.

In other words, the marginal utility of sustainability is steadily decreasing for companies that are already very “clean”. Aggregated portfolio ESG-scores are therefore only limited indicators of positive impact.

This simplified method also discriminates against approaches that do not necessarily rely on (backward-looking) ESG optimization but apply SDG concepts or the concept of planetary boundaries.

A SRI investment is more than just the individual securities in the portfolio. For this reason, a sound sustainability assessment of a financial product must not focus solely on the investments as such (= aggregated individual securities in the portfolio on a certain key date or in a certain period), but must always apply a holistic view of the entire infrastructure or elements of the respective financial product. In concrete terms, this means that in the case of a fund, all activities of the fund provider are scrutinised. This includes the company level of the asset manager as such, the SRI investment style and its investment process that goes along with it, the associated ESG research capacities and a possibly accompanying engagement process. This is complemented by a systematic controversy monitoring and the structural exclusion of certain business areas and -practices. In addition, elements such as reporting, an external sustainability advisory board and issues of good corporate governance play an important role. Quantitative methods can only assess this to a limited extent, they are supportive, but not yet integral. Individual and qualitative work is required here. It is a matter of a multi-layered evaluation methodology that can examine different SRI investment styles on an individual basis.

The inclusion of as many sustainability efforts as possible and the entire infrastructure of the fund provider in the analysis has the great advantage that the investor can assume that the ESG quality of the portfolio composition of the respective fund will remain rather consistent. This is because if there are structurally high and deep standards for the security selection, the sustainability quality in the portfolio will remain stable or change only to a very limited extent. This creates confidence in the integrity of the fund provider. It also prevents a fund from accidentally having a high rating, as it is not based solely on pure ESG-scores or individual (climate) KPIs. Therefore, it is mostly about structural and formal verification, not about one-dimensional and point-in-time (random) snapshots.

An investor then no longer has to regularly check whether the individual securities are still sustainable in his or her interest. Confidence in the comprehensive analysis using a holistic evaluation system thus saves investors information costs.

| brief bio