Sustainability fund ratings: can they be trusted?

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In order to help people decide whether companies have good environmental, social and governance (ESG) practices, organisations such as Morningstar have created sustainability ratings.

But John Ditchfield, partner of financial advice at Castlefield, points out one major flaw: the ratings tend to favour larger companies that have the scale to produce the data necessary to be included.

For instance, oil and gas company Royal Dutch Shell spends a lot of money to produce extensive data on its ESG practices, says Ditchfield, whereas a small renewable energy business in the US might not score so highly because it doesn't produce enough data about itself.

He points out that Shell has pursued various projects that are highly damaging to the environment such as the extraction of tar sand in Western Canada.

FINDING LESS DESTRUCTIVE INVESTMENTS

'In an economy that is trying to move away from destruction towards energy efficiency, electric vehicles and cleaner forms of energy,' he says, 'we need to find less destructive forms of investment.'

The Morningstar score consists of a qualitative measure (how prepared the company is to deal with risks like worker fatality), a quantitative measure (how the company performs relative to its industry) and a controversy score (what does the media say about this company, is there any legal action).
 
Out of 100 points Shell has scored 76. In comparison BP has scored 70 and electric car manufacturer Tesla is a 56. A Morningstar spokesperson explains that Tesla’s score is weighed down by its bad social and governance aspects. Interestingly, Volkswagen has a score of 62, and it used to be higher before the emissions scandal. But the spokesperson says she would not recommend comparing across sectors and that the aggregate score means the rating is not straightforward.

Steven Smit, European head of sustainability at Morningstar, explains: 'The Morningstar Sustainability Ratings use company-level data from partner firm Sustainalytics to measure how well the companies held in a fund are managing their ESG risks and opportunities.

'At a company level, large-cap companies score higher for a reason - these companies tend to do better at managing ESG, so are more sustainable. In the case of Shell, Sustainalytics data shows that Shell scores a controversy score (which is one aspect of the overall score) of 4, with the worst rating for controversy being a 5.

'This controversy score would result in a significant deduction to the Morningstar Sustainability Rating. The ratings are not based on ethical judgements concerning particular industries, as these may change from one person to the next.'

It is important to note that Morningstar is attempting to draw a distinction between objective ESG and subjective ethical ratings. However, the definition of 'ethical' is nothing other than 'being in accordance with the rules or standards for right conduct or practice'.

In this case, the ESG ratings should measure whether companies meet the required environmental, social, and governance rules or standards.


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