Kicking the tyres on rising ESG scores

Hello from London, where oil giant Shell is again at the centre of controversy after reporting the biggest quarterly profit in its history. “It’s not just a war profit,” chief executive Ben van Beurden protested yesterday, having unveiled the earnings of $9.1bn. Despite a multi-billion-dollar writedown on its operations in Russia, Shell profited handsomely from the fallout of the war in Ukraine, which has sent hydrocarbon prices surging.

The bumper profits for Shell and its rival BP — amid surging energy costs for households — have driven calls from the opposition Labour party and others for a one-off windfall tax on the companies. Those against that idea, including in government, argue that this will sap energy companies of funds needed to “green” their operations. Fury over Big Oil’s profits may recede along with commodity prices in coming months, as our colleagues at Lex argued in a punchy note. But the episode is another reminder of the sector’s increasingly vulnerable political position.

Another debate growing in intensity involves transparency, and the integrity of lofty claims around sustainable investing. Today we dive into two important angles on that conversation, in the booming sectors of sustainability ratings and impact investment. Have a good weekend, and we’ll see you on Monday. (Simon Mundy)

‘Grade inflation’? MSCI’s ESG ratings on the rise

The biggest beneficiaries of the enthusiasm for environmental, social and governance (ESG) investing have not been Wall Street banks or trading firms — but the ancillary businesses such as credit rating agencies and data providers.

For example, MSCI, the index provider, is making millions of dollars on ESG. In the first three months of 2022, MSCI’s ESG and climate division scored its second-highest ever quarter for new sales and client retention, according to Morgan Stanley. MSCI is expected to generate $224mn in ESG and climate revenue this year, the bank estimated, as hedge funds, companies and insurance groups lap up ESG data.

For years, there have been nagging concerns about the quality of ESG scores as an investment tool. Academics at MIT and elsewhere have pointed to “aggregate confusion” in the big difference in corporate ESG ratings from MSCI and other data providers. Why does the same company get an AAA score from one provider but a B from another?

DE Shaw, the hedge fund, has published new research showing that MSCI’s average environmental and social rating for companies in the broad Russell 1000 index rose 17 per cent between 2015 and 2021. What is causing this? Perhaps “something akin to grade inflation” could be afoot, DE Shaw said.

Companies are getting smarter about their ESG disclosures, and their scores are improving, DE Shaw added. For example, companies that reported carbon emissions for the first time in any calendar year “were significantly more likely to experience an increase in their ‘E’ score than companies that did not alter their reporting of carbon emissions”, DE Shaw said.

Still, after adjusting for structural factors such as increased disclosures, the scores are still going up, it added.

MSCI said in response that better disclosures and “more prevalent climate targets” had helped scores in the past five years.

Moral Money took a look at MSCI’s ESG scores for the Dow 30 companies. Sixteen companies’ ESG scores increased and four companies’ scores went down. The other companies were either unchanged or bounced around before reverting to the score they started with over the past few years.

The findings come as regulators probe ESG ratings. The European Securities and Markets Authority (Esma) asked in February for information about how ESG ratings work and has raised concerns about potential conflicts of interest. Such regulatory scrutiny might be warranted as more and more ESG exchange traded funds are built with MSCI ratings driving the portfolio weightings.

As with many aspects of investing — from analyst recommendations to credit rating — the numbers help, but investors need to look under the hood to understand whether the figures make sense. (Patrick Temple-West)

LeapFrog’s Kuper sounds the alarm on ‘impact washing’

When Andy Kuper, a young South African in his early thirties, set up LeapFrog Investments in 2007, he found his nascent field of “impact investing” was treated with widespread scepticism. “I was the weird guy in the corner of the room yelling at people about something they don’t want to hear about,” he recalled.

Fifteen years on, the idea of profit with purpose has taken much of the investment world by storm. Private equity giants including KKR, TPG, Apollo and Bain Capital have set up impact funds, each with at least $1bn in assets. Under a broad definition of impact investment, the world total is more than $2.2tn — about 2 per cent of global financial assets under management — according to a report last year from the International Finance Corporation.

LeapFrog itself has benefited from the surge of interest that Kuper helped to trigger. It manages $2bn for some of the world’s biggest investors — chief among them the Singaporean state investment company Temasek, which wrote a $500mn cheque last year. But when we met in London a few days ago, Kuper sounded uneasy about a possible erosion of standards amid his field’s booming popularity.

“Impact has gone from being an unfamiliar strategy, at best, to being something that helps you raise substantial capital,” Kuper said. “And in that context, a number of asset gatherers are presenting themselves as impact players. A number of firms are leading with impact as a marketing strategy before they have the substance in place.”

As an industry incumbent, Kuper might have an obvious incentive to raise concerns about new competitors. But this issue is worth taking seriously given the continuing boom in impact investing (or at least impact-branded investing), which shows no sign of petering out. The IFC reckons the sector has the potential to reach $26tn of managed assets, or more than a fifth of the global total. If “impact washing” is allowed to go unchecked, a large portion of those trillions could produce far less benefit than promised.

Promisingly, the sector has been responding to pressure for improved transparency. The Operating Principles for Impact Management — an initiative spearheaded by the IFC — has 160 signatories managing $450bn in impact-branded assets. All are required to file an annual disclosure detailing how their activities align with nine impact principles, with the claims subject to independent verification each year. To manage and assess the data, investors can use the sophisticated Iris+ reporting framework developed by the Global Impact Investing Network.

“It’s a lame excuse to say there are no metrics, no minimum standards in the industry — that’s just not true any more,” Kuper said. “That excuse from three or four years ago is gone.”

But an excessive focus on minimum standards could prove dangerous, he added. Kuper draws a parallel with the technology industry, where the direction of travel has been determined not by minimum standard-setters but by the likes of Amazon and Tencent. Similarly, he argues, the impact investment field is at a critical moment, as fund managers deploy the vast sums pouring into the young space. It will veer either towards what he calls “impact deep” — with a fundamental focus on changing the lives of vulnerable and disadvantaged people — or “impact light”, broadly conventional private equity work that achieves a bare minimum level of collateral social benefit.

Kuper didn’t name specific funds whose standards seemed questionable, and he said that a large number of rivals were taking a rigorous approach to impact assessment and reporting. And after what the World Bank called an “unprecedented” increase in global poverty amid the pandemic, the need for investment with genuine impact remains stark. “We need to open the gates to the capital markets,” Kuper said. “There’s not enough money in the philanthropy market. We have to get money to purpose-driven businesses to reach hundreds of millions of people.” (Simon Mundy)

Chart of the day

When we wrote earlier in April that ESG funds suffered outflows in the first three months of the year, readers questioned how the ESG sector compared with the overall market. Now, Morningstar has published its analysis of the first quarter, and showed that the ESG sector held up quite well.

Last quarter, flows into US sustainable funds dropped 26 per cent compared with the fourth quarter of 2021, Morningstar said. But demand for sustainable funds showed strength up against the broader market, where flows plunged 65 per cent to $85.7bn.

Smart read

Don’t miss this compelling profile in the FT Weekend Magazine of Robert Scaringe, founder and chief executive of electric truck producer Rivian. The vegan 39-year-old Clark Kent lookalike cuts a very different figure from his rival Elon Musk, writes William D Cohan. “He has no interest in Mars, or rockets, or building tunnels, or Twitter, either to use or to own.”