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As ESG investing goes mainstream, critics worry that the business of rating companies’ sustainability efforts shifts the focus away from the non-financial values it’s meant to promote

Tariq Fancy, a former business professional, has made waves in the finance industry by arguing ESG investing is 'a giant societal placebo.'Fred Lum/the Globe and Mail

The world of finance is facing a reckoning over what defines sustainable investing.

Investors around the world are ploughing tens of billions of dollars a year into companies and funds that tout superior environmental, social and governance (ESG) attributes. Many assume they’re doing good for the environment or gender equality as they save for retirement.

But there’s growing concern – even among those who make their living in sustainable finance – that ESG’s emergence as an asset class alongside traditional stocks and bonds risks shifting the focus away from the non-financial values it’s meant to promote.

At the heart of the confusion is the broad scope of what constitutes ESG investing. The concept loosely covers everything from climate-related business risk to boardroom diversity to workplace safety – three disparate concepts that Tariq Fancy, former chief investment officer for sustainable investing at BlackRock Inc., the world’s largest asset manager, says have been lumped together almost arbitrarily.

Mr. Fancy has made waves in the finance industry by arguing ESG investing is “a giant societal placebo” geared more to helping professional investors improve risk-adjusted returns than to promoting the global action required to solve complex, long-term threats such as climate change and inequality.

Canadian sustainable fund assets

By asset class (excl. funds of funds), in billions of dollars

$40

Allocation

Alternative

Equity

Fixed income

30

20

10

0

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

2017

2018

2019

2020

2021

the globe and mail, Source: morningstar

Canadian sustainable fund assets

By asset class (excl. funds of funds), in billions of dollars

$40

Allocation

Alternative

Equity

Fixed income

30

20

10

0

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

2017

2018

2019

2020

2021

the globe and mail, Source: morningstar

Canadian sustainable fund assets

By asset class (excl. funds of funds), in billions of dollars

$40

Allocation

Alternative

Equity

Fixed income

30

20

10

0

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

Apr.

Aug.

Dec.

2017

2018

2019

2020

2021

the globe and mail, Source: morningstar

There’s a massive amount of money at play. At the end of 2021, assets in ESG-themed mutual funds and exchange-traded funds (ETFs) rang in at US$2.74-trillion globally, up 34 per cent from the year before, according to Morningstar. In Canada, assets in such funds doubled through 2021, to $34.5-billion. Many of these investors believe their money is going toward improving environmental and social conditions. In reality, however, they’re more likely acquiring a slate of traditional companies that have merely met or exceeded a certain ESG threshold as measured by a third-party ratings agency.

Ratings from organizations such as Sustainalytics, MSCI and S&P are used by investment pros to gauge whether a stock is a suitable addition to an ESG fund or ETF. But a Globe and Mail investigation shows the methods these ratings providers use vary to the point where the same company can be judged as both an ESG leader and a laggard, depending on who’s doing the measuring. It’s sowing skepticism not just among investors but among some of the companies being scored, too.

The repercussions can be far-reaching. Investors in passive funds might believe they’re buying into a group of companies with rock-solid ESG performance across the board, when not all of them are universally graded as such. Meanwhile, outfits that receive the ESG stamp of approval might avoid making improvements in an area prioritized by one ratings agency but not the others. And that can lead to significant business risk – say, if a company’s assets need to be slashed in value over the long term for failing to deal with a growing environmental risk that might not have been highlighted in its score.

As far as Mr. Fancy is concerned, regulation of the ESG space is key. “We all want to believe that good companies do better. Unfortunately, that doesn’t happen unless you have regulation. And I’d say on the values piece, okay, fine, that’s what it means for investing, but what does it mean for the world?” Mr. Fancy said in an interview from his home in Toronto. “I saw next to no impact. Even where you could find that ESG had greater value to investing, it was marginal at best.”


Same company, different ESG rating

The Globe’s investigation of ESG ratings showed a wide

divergence among some Canadian companies. The Globe

compared ESG ratings of companies in the S&P/TSX

composite index from six different providers and roughly

assigned them into higher (green), middle (yellow) and

lower (red) tiers.

Higher

Middle

Lower

Bloom-

berg

Sustain-

alytics

CDP

Climate

Company

S&P

MSCI

ISS

ISS

Ritchie Bros.

Auctioneers

AAA

28.5

18

N/A

N/A

4

20.28

A

FirstService Corp.

13.6

15

N/A

0

8

17.45

AA

Toromont Indust.

24.0

9

N/A

0

6

27.66

A

AltaGas

52.9

23

N/A

7

5

27.94

BBB

BCE

59.7

54

18.9

7

1

59.50

IGM Financial

BBB

53.1

74

11.7

7

8

49.25

How the ratings work

Bloomberg ESG disclosure

Scores range from 0 (no

information provided) to

100 (all possible information

provided)

Sustainalytics rank

0-10 Negligible; 10-20 Low;

20-30 Medium; 30-40 High;

40+ Severe

The S&P Global ESG rank

A percentile score with 1

being the worst and 100

being the best

CDP Climate score

Scores range from 0 (failure) to 8 (A)

The MSCI ESG rating

The system ranges from best

(AAA) to worst (CCC)

ISS Governance scores

Range from 1 (best) to

10 (worst)

ISS ESG Performance scores

Range from 1 (worst) to

100 (best)

the globe and mail, Source: Bloomberg; ISS;

Globe research

Same company, different ESG rating

The Globe’s investigation of ESG ratings showed a wide

divergence among some Canadian companies. The Globe

compared ESG ratings of companies in the S&P/TSX

composite index from six different providers and roughly

assigned them into higher (green), middle (yellow) and

lower (red) tiers.

Higher

Middle

Lower

Bloom-

berg

Sustain-

alytics

CDP

Climate

Company

S&P

MSCI

ISS

ISS

Ritchie Bros.

Auctioneers

AAA

28.5

18

N/A

N/A

4

20.28

A

FirstService Corp.

13.6

15

N/A

0

8

17.45

AA

Toromont Indust.

24.0

9

N/A

0

6

27.66

A

AltaGas

52.9

23

N/A

7

5

27.94

BBB

BCE

59.7

54

18.9

7

1

59.50

IGM Financial

BBB

53.1

74

11.7

7

8

49.25

How the ratings work

Bloomberg ESG disclosure

Scores range from 0 (no

information provided) to

100 (all possible information

provided)

Sustainalytics rank

0-10 Negligible; 10-20 Low;

20-30 Medium; 30-40 High;

40+ Severe

The S&P Global ESG rank

A percentile score with 1

being the worst and 100

being the best

CDP Climate score

Scores range from 0 (failure) to 8 (A)

The MSCI ESG rating

The system ranges from best

(AAA) to worst (CCC)

ISS Governance scores

Range from 1 (best) to

10 (worst)

ISS ESG Performance scores

Range from 1 (worst) to

100 (best)

the globe and mail, Source: Bloomberg; ISS;

Globe research

Same company, different ESG rating

The Globe’s investigation of ESG ratings showed a wide divergence among some Canadian companies.

The Globe compared ESG ratings of companies in the S&P/TSX composite index from six different provid-

ers and roughly assigned them into higher (green), middle (yellow) and lower (red) tiers.

Higher

Middle

Lower

Company

Bloomberg

S&P

MSCI

Sustainalytics

CDP Climate

ISS

ISS

AAA

Ritchie Bros. Auctioneers

28.5

18

N/A

N/A

4

20.28

A

FirstService Corp.

13.6

15

N/A

0

8

17.45

AA

Toromont Industries

24.0

9

N/A

0

6

27.66

A

AltaGas

52.9

23

N/A

7

5

27.94

BBB

BCE

59.7

54

18.9

7

1

59.50

IGM Financial

BBB

53.1

74

11.7

7

8

49.25

How the ratings work

Bloomberg ESG disclosure

Scores range from 0 (no

information provided) to

100 (all possible infor-

mation provided)

The S&P Global ESG rank

A percentile score with 1

being the worst and 100

being the best

The MSCI ESG rating

The system ranges from

best (AAA) to worst (CCC)

Sustainalytics rank

0-10 Negligible; 10-20 Low;

20-30 Medium; 30-40 High;

40+ Severe

ISS ESG Performance scores

Range from 1 (worst) to

100 (best)

ISS Governance scores

Range from 1 (best) to

10 (worst)

CDP Climate score

Scores range from

0 (failure) to 8 (A)

the globe and mail, Source: Bloomberg, ISS, Globe research

The Globe reviewed the ranges of companies’ ratings and assigned them roughly into higher, middle and lower tiers. It then identified companies that had divergent ratings across providers. The review showed wide variances in scores for some companies.

Ritchie Bros. Auctioneers Inc., for example, received a high score for its ESG practices from MSCI, but low ratings from ISS, S&P and in Bloomberg’s ESG Disclosure system. Real estate company FirstService Corp. and heavy-equipment seller Toromont Industries Ltd. similarly received a high MSCI score, but low scores from the other providers.

Energy company AltaGas Ltd. ALA-T received a high score from MSCI, CDP (formerly known as the Climate Disclosure Project) and from Bloomberg’s climate disclosure metric, but low scores from ISS and S&P. Telecom giant BCE Inc., meanwhile, has middling scores from MSCI and S&P, but higher scores from the other providers. And money manager IGM Financial Inc. has an average score from MSCI, but high scores from Bloomberg, S&P, Sustainalytics and CDP. Its governance rating from ISS is low, but ISS’s ESG rating for the company is above average.

New rules could push Canada to get tougher on corporate disclosure

What gets scored, and how, often accounts for the difference. It can be unclear in some instances whether ratings are meant to show a company is living up to its environmental and social claims, or if investors are adequately protected from financial risk if it doesn’t. “In most cases, it’s a check-the-box exercise. There’s no audit, and certainly there’s no recourse,” says Bonnie-Lyn de Bartok, founder of the S Factor Co., a Toronto-based provider of social impact data. “A lot of these indexes are funded by the same folks who are listed within them. There’s a lot of conflict of interest.”

She adds that investors who aren’t experts in ESG can get overwhelmed by the disparities and controversies around the legitimacy of such ratings. In that case, she says, “they’re just going to do their own thing because they don’t believe or trust what’s out there.”

Regulators are starting to respond. Last year saw the formation of the International Sustainability Standards Board, an offshoot of the International Financial Reporting Standards Foundation, and it’s seen as a milestone in the move to standardize ESG reporting. The ISSB issued its first draft rules for sustainability and climate-related disclosure in late March.

Meanwhile, the U.S. Securities and Exchange Commission has created a climate and ESG task force that will target “ESG-related misconduct.” The idea is to get tough by closing disclosure gaps and police the market to root out bad actors operating under the guise of ESG righteousness.

Bonnie-Lyn de Bartok is founder & CEO of the S Factor Co., a Toronto-based provider of social impact data.Shay Conroy/The Globe and Mail

The umbrella group of Canada’s securities commissions also recently published guidance aimed at improving disclosure of ESG-themed funds. The new guidelines are meant to prevent greenwashing, and the agency has said it would monitor such funds for disclosure so investors aren’t misled.

The ratings providers contend they’re not misleading anyone. Instead, they say they play a valuable role for a range of different audiences – from financial institutions to retail investors – highlighting material, non-financial measures that could affect a company’s long-term health, as well as uncovering risks that could lead to legal and regulatory trouble. “The reality is there are different approaches to measuring ESG. There are different motivations,” says Simon MacMahon, global head of ESG research at Sustainalytics, a unit of Morningstar that provides analysis of corporate risk for institutional investors. “In some cases there’s an investor education component here. It will take some time to get people to better understand what ESG is under different scenarios.”

Mr. MacMahon points out that his company’s clients tend to be large institutions such as pension and sovereign wealth funds, which often have their own research capabilities, and use ratings and the underlying data as part of a wider analysis of ESG.

Indeed, investors need to investigate the methods used to to arrive at a particular rating and make decisions based on their own tolerance for risk, says Simon Fischweicher, CDP’s head of corporations and supply chains, North America. “Looking at an ESG score without understanding how they’re factoring different risks into it, just sort of taking it at face value, doesn’t allow you to do that sort of assessment,” Mr. Fischweicher says. “I think what’s really critical is for those ESG scores to be a tool, but not the only tool, by which environmental, social and governance factors are integrated into investment decisions. Maybe the first step, and then you dig deeper.”

Richard Manley, head of sustainable investing at CPP Investments, says if money managers understand the limitations of ESG scores and have their own expertise for spotting nuance, contradictory ratings might not be a problem. Instead, they become “breadcrumbs” that shape discussions with the company. When he sees a deficiency in reporting, he says it prompts questions: “Why are you not reporting this data that is material or that your largest peers are reporting? Is it because there’s no internal capacity to do it? Because you’re performing badly and don’t want to tell the world about it? Because you haven’t prioritized it yet? There is a conversation to be had there about culture.”

Still, the difference in methods, along with the metrics tracked and the variable weight given to different factors, have created uncertainty for individual investors. This contrasts with agencies that rate corporate credit; companies either risk defaulting on their debt or they don’t.

Quarterly global sustainable fund assets

In billions of U.S. dollars

Europe

U.S.

Rest of world

$3,000

2,500

2,000

1,500

1,000

500

0

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2019

2020

2021

the globe and mail, source: morningstar

Quarterly global sustainable fund assets

In billions of U.S. dollars

Europe

U.S.

Rest of world

$3,000

2,500

2,000

1,500

1,000

500

0

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2019

2020

2021

the globe and mail, source: morningstar

Quarterly global sustainable fund assets

In billions of U.S. dollars

Europe

Rest of world

U.S.

$3,000

2,500

2,000

1,500

1,000

500

0

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2019

2020

2021

the globe and mail, source: morningstar

ESG risks can be large. If investors find out too late that corporate performance or strategies have been overstated, with resulting environmental or physical damage, it could lead to legal action and a loss in asset value. There are parallels to the financial crisis, when credit rating agencies gave top grades to mortgage-backed securities, despite complexities that hid their incredibly risky nature and eventually caused financial contagion.

The problem is being studied in depth by researchers at MIT’s Sloan School of Management, who first published the Aggregate Confusion Project in 2019. Their data measure the divergence in ESG ratings among six providers, examining 709 indicators in 64 categories. They concluded that the correlation among ratings for individual companies ranged from 38 per cent to 71 per cent, for an average of 61 per cent, compared with an average of 92 per cent among credit rating agencies.

The researchers blamed the divergence on a host of factors. Agencies rate aspects of ESG differently, and not all look at every aspect. They also give different weightings to certain metrics in their final scores. As an example, one rater could include a company’s government lobbying activities, while another might not take that into account.

Greenwashing is real as companies and funds ride the ESG express. The goal is to make it rare

Sustainalytics, for example, rates companies based on unmanaged ESG risks to come up with a score. CDP rates companies’ performance based on climate, forest and water metrics. (Companies that garner its top “A” score form the basis of the STOXX Global Climate Change Leaders Fund.) MSCI says its ratings are designed to help institutional investors integrate ESG into their mainstream portfolios by identifying issues that can cause risks or create opportunities. They are geared to the “specific purpose of enhancing long-term risk-adjusted returns,” according to the company.

A common worry is that investors buy ESG funds thinking they’re acquiring companies focused on environmental or social solutions while earning returns, when in fact many of the underlying investments are the largest companies on the broader stock indexes.

“The real problem at the moment is not necessarily ESG ratings. I think the much bigger problem is the promise that if you buy a fund based on ESG ratings, you have an impact – you change the world,” says Florian Berg, one of the authors of the Aggregate Confusion Project. “There’s no proof.”

Take the BMO MSCI Canada ESG Leaders Index ETF. It’s billed as being “for investors looking to align socially responsible values with their investments using a best-in-class approach.” The ETF’s holdings replicate the MSCI Canada ESG Leaders Index, but a scan of that grouping shows a close correlation with the broad S&P/TSX Composite Index. In fact, its top five holdings – Enbridge Inc., Canadian National Railway, Bank of Nova Scotia, Brookfield Asset Management and Bank of Montreal – are among the top eight companies in the composite. Three of the companies The Globe found to have among the widest divergences in Canadian ESG ratings – Toromont Industries, Ritchie Brothers and FirstService Corp. – are in the ESG Leaders ETF.

Similarly, the top five holdings in the TD Morningstar ESG Canada Equity Index ETF are Royal Bank of Canada, Enbridge, Scotiabank, BMO and CN – again, all among the top eight in the composite. TD says the fund is designed to track an index of large and mid-size companies that have higher ESG ratings than their peers. BCE, FirstService and IGM Financial – which The Globe found to have a wide variance in scores – are among the holdings.

This doesn’t mean fund managers are breaking rules, but it puts the onus on investors to familiarize themselves with the criteria of the funds they buy and what the objectives are.

Besides, there are other ways for investors to influence corporate behaviour, says Mr. Berg – for instance, through shareholder activism. An example is the push by the investment fund Engine No. 1 to replace three directors at Exxon last year, in opposition to the company’s insufficient response to climate risk. The campaign was successful. “Overweighting ESG stocks doesn’t necessarily mean this has an impact on the real world,” he says. “But it is marketed in a way that it has.”

The Sloan researchers wrote that the divergence in ratings has some important consequences, apart from just making it difficult to analyze the ESG performance of companies, funds and portfolios. It could produce disincentives for companies to make improvements in certain areas, as different ratings prioritize different sustainability factors. It could also lead to markets mispricing assets based on their ESG risks or benefits, and make it difficult to link CEO pay to ESG performance – an increasingly common practice.


None of this is to say companies shouldn’t be getting serious about ESG-related obligations and strategies. There’s more than enough evidence showing those with the most complete programs are best able to withstand economic shocks like the COVID-19 pandemic. There are also other options for investors, such as impact funds, whose holdings are chosen specifically because their businesses generate measurable environmental or social improvements.

Still, concerns about how investments are judged as sustainable or not are shared across the spectrum, from environmental and social activists to the top voices in the financial world. Mark Carney, the former governor of the Bank of Canada and Bank of England, and co-manager of Brookfield Asset Management’s Impact Fund, has been a driving force in directing many of the world’s financial institutions to put climate considerations among their top investment objectives in his role as UN Special Envoy on Climate Action and Finance.

Mr. Carney has acknowledged the problems with third-party ESG ratings. In his 2021 book Value(s), he pointed out that different data vendors can have dramatically different ratings for the same company. That means returns can also be vastly different depending on which vendors investors rely on. “Unfortunately, ESG data can fall short due to incomplete coverage and a dependence on self-reporting by companies,” he wrote.

The ISSB’s global standards could eventually render some ratings agencies’ practices obsolete and force them to reinvent their offerings to the market, says Emmanuel Faber, the board’s chair. With generally accepted accounting principles, for example, there’s less need to score companies’ financial disclosure practices, and this will be the case with ESG, says Mr. Faber, the former CEO of Paris-based food company Danone SA. There will still be demand for analysis of ESG performance that’s conducted by the agencies, and that will improve with standardized reporting.

“They would look at climate and social and nature-based topics, or specific industry sustainability issues, in much more detail in their links with the enterprise value assessment than what they are able to do with ESG alphabet soup today,” he says. “You would hopefully have a consolidated landscape with ESG metrics. They would be comparable. They would be of high quality.”

For its part, IGM, whose ESG ratings vary widely, isn’t overly bothered by the scores themselves. But it’s keen to make sure the providers gather and report the correct underlying data – and that it has the opportunity to vet the information. That hasn’t always been the case, says Andrea Carlson, senior vice-president, enterprise sustainability and financial risk for IGM, which is majority owned by Power Corp.

IGM rates well in measures around the “E” and “S” of ESG, but falls short on ISS’s pure governance score – a fact Ms. Carlson says can be attributed to attitudes toward public companies controlled by one majority shareholder. “For many of these organizations, they historically haven’t engaged companies in the rating process. They’re starting to get better at that – soliciting issuer feedback on the ratings,” she says. “But they don’t give you the recipe on how the score is created. That part is still a bit of a black box, and regulators are starting to get involved in the conversation.”

Some companies grumble about their ESG report cards. Moncton-based energy company Major Drilling operates in 20 countries and is working to improve ESG performance in all its branches, says Andrew McLaughlin, its general counsel. “Every now and then, we’ll get this report out of the blue. And then it just sort of deflates the process,” he says. “We’ve got to go chasing down [information] in areas where we just haven’t been tracking. Certain issues that are important to ratings agencies aren’t what we consider to be our priority, or investors’ priorities for us, but nevertheless they can impact your score.”

Richard Mattison, the president of S&P Global Sustainable1, says his agency has tried to craft its rating based on the real-world impact critics say is lacking. “If you’re dealing with an ESG skeptic, your first bridge for them, in capital markets, at least, is to bring them to a point where they understand there’s a financial risk associated with certain ESG topics,” he says. “However, we also think it’s important not just to understand the financial risk associated with ESG topics. It’s also to understand what kind of real-world impact has been driven by ESG. That is embedded in our score as well.”

Such real-world impact will eventually become financial impact, but over a longer period than financial markets assess company valuations, he says. For example, if a company is producing cheap clothing while polluting the environment or employing children, its reputation could take a major hit, along with its bottom line.

Still, as with every other rating, investors can pick at a well-scoring company and ask whether it deserves its high marks based on their beliefs of what’s important.

An example: S&P Global’s data form the basis of the Dow Jones Sustainability Indexes, which include companies evaluated for superior ESG performance. Canadian Pacific Railway is part of Dow Jones’s North American sustainability index, despite a continuing RCMP investigation and legal action surrounding its safety protocols after a 2019 train crash in the Rocky Mountains of British Columbia that killed three workers. The Transportation Safety Board of Canada ruled in late March the company’s safety deficiencies contributed to the accident. CP Rail disputes that conclusion.

S&P Global spokesperson Sarah Whybrow says S&P Global Sustainable1 considered the event “and reflected the incident in the company’s S&P Global ESG scoring, while awaiting material information regarding the event from both the Transportation Safety Board and pending legal cases.” She says S&P is currently reviewing the Transportation Safety Board report and monitoring the legal cases.

Mr. Fancy now heads the Rumie Initiative, an educational technology nonprofit he created after leaving BlackRock in 2019.Fred Lum/the Globe and Mail

Mr. Fancy, who now heads the Rumie Initiative, an educational technology non-profit he created after leaving BlackRock in late 2019, says the key to better corporate and finance-industry performance lies not in ESG scores, but in strong and deliberate government and regulatory action to enforce standards. Many people entered the sustainability professions to make positive impacts inside and outside their companies and have a sense of fair play. They need to lead the charge, he says.

“I think it’s ridiculous for anyone to work in the ESG community and not be arguing in favour of government regulation,” Mr. Fancy says. “It would be like a coach who teaches how to play clean hockey and then they’re okay with there being no referees. You don’t get any benefit from playing clean unless someone’s enforcing it.”


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