Hermes Investment Management’s co-head of credit has warned investors to look beyond “static” ESG scores awarded by third-party vendors because they fail to properly price companies whose ESG credentials are improving.
Integrating ESG into the investment process is generally seen as a risk management tool. Pictet Asset Management, for example, believes that ESG factors can mitigate the probability of investing in a company that may commit fraud.
However, Mitch Reznick, co-head of credit and head of credit research at Hermes Investment Management, argues that ESG vetting can also identify investment opportunities by using the static information that third-party ESG vendors provide.
But he said most ESG scores from third-party vendors are generated once a year, which means the data is not “as dynamic as it needs to be”.
Companies awarded high scores tend to have reduced risk. However, companies with low ESG scores are labelled as poor ESG stewards. The fact that management may be actively taking steps to improve the score is not taken into account.
“That is important because there is a risk of mispricing,” he said. “Eventually, the market will catch up on that and then spreads would tighten as the prospect of operating cashflows stabilises.”
The case is also true for equities. For example, Franklin Templeton Investments takes advantage of the backward-looking information that ESG vendors provide.
Reznick noted that engagement is key.
“You need to bring to life those static scores and understand where those companies are today and where they are going tomorrow. If they are earnestly trying to improve, then we’ll have a higher score than the third-party vendors.”
However, the third-party data serves a useful purpose. “It is a great place to start in terms of the discussions you want to have with the company.”
Vetting improvement
Reznick likes companies that are taking steps to improve their ESG scores and to verify the improvement path the firm has what it calls a “milestone programme”, which sets specific objectives for a company to achieve over a period of time.
“A red flag for us is when a company says that they are improving or working on things, but it is taking much longer [than promised] for them to hit the milestones.”
In some cases, companies do acknowledge that there is a problem, but have no specific plan to address it.
Reznick noted that some of these companies may not have a full understanding of ESG issues and therefore do not know much about the specific factors that are becoming increasingly important to investors.
“You have to try to articulate these concerns a bit more so they can have discussions internally and work on it.”
For example, in Hong Kong, a majority of listed companies do not integrate ESG into strategic planning, according to a KPMG China report.
Some companies simply fulfill the compliance requirements and adopt a “box-ticking” approach when reporting ESG information, the report said.
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