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Demystifying ESG scores – the difference between ESG and ethics

We take a closer look at ESG scores, their shortcomings and how investors can use them to help build a portfolio they’re comfortable with.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Investors are becoming more and more focussed on how their money is being invested. Investors are wanting to know where their money’s being invested and want it to be invested ‘ethically’.

At the same time we’ve seen data providers launch Environmental, Social and Governance (ESG) ratings as a tool to help pick responsible investments. For many, picking stocks based on ESG scores has become synonymous with ethical investing, but that’s not the best way of looking at two quite different things.

Ethical investing has been around for decades and, naturally enough, is heavily influenced by people’s own personal beliefs. ESG scores attempt to measure and compare company behaviours across the market in a standardised way. It scores companies that are proactive on ESG issues well and marks down those that make less effort. Inevitably subjective ethical investing and objective ESG scores will sometimes clash.

ESG scores should instead be looked at as a tool to sit alongside your other analysis. Using it side by side with more traditional investment metrics, like price-to-earnings (PE) and debt ratios, can be a good way to evaluate whether a company’s worth investing in.

Just as a blanket search for the lowest PE ratio won’t give you a sure-fire value stock (there’s much more to take into account), selecting an ethical investment on ESG scores alone is equally as dangerous.

Putting ethics to one side, there are arguments for investing in companies with higher ESG scores. Their focus on sustainability means they’re less likely to be caught out by regulatory fines, and are better prepared to succeed as consumers become more demanding. On top of that, lots of funds are now excluding companies with low ESG scores, which dents the price of those shares.

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The trouble with ESG

One problem ESG scores face is that every ESG rating provider will use their own unique formula. Every company is evaluated based on the data they provide, what their peers are doing, their size and what kind of press they’ve been getting.

It doesn’t help that lots of providers score companies who don’t give detailed ESG information badly. That means a business which doesn’t report its carbon emissions will score badly, even if its emissions are actually quite low. The rating agency doesn’t know, so it assumes the worst.

Even if the weightings were consistent across the board, lots of people would say some ESG issues are more important than others.

Should carbon emissions be more important than water use? Does a gender diverse board of directors outweigh a poor record on child labour in the supply chain? These and dozens of other decisions mean ESG scores alone can’t and shouldn’t define ethical investing.

This article isn’t personal advice. All investments fall as well as rise in value, so you could get less back than what you invest. If you’re not sure if an investment is right for you, please seek financial advice.

ESG in practice

Take the Refinitiv ESG scores for example. Mining company Glencore has one of the top five highest ESG scores in the FTSE 100. That score is based on self-reported data from Glencore, so the more data Glencore produces compared to its peers, the better its ranking.

To counterbalance that, Refinitiv offers a “combined ESG score” which takes into account “controversies” the company has suffered that year. Refinitiv defines controversies as, “a company’s exposure to environmental, social and governance controversies and negative events reflected in global media.”

When Glencore’s controversies score of D is taken into account, the group’s combined ESG score drops from an A to a B-.

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It’s the same for British American Tobacco (BAT), another surprising high-scorer on Refinitiv’s ESG rankings. The cigarette company also falls from an A to a B- overall when you take into account its controversies score of a D.

A large part of this is because of the group’s alleged sidestepping of various sanctions between the US and some of the countries it operates in. Notably, the fact the group produces tobacco is clearly displayed within the ranking, but has little bearing on its overall score. Between 2015 and 2018, BAT didn’t receive a controversies score lower than C, and was awarded an A+ in that category in 2018.

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That’s not to say the scores are meaningless – both BAT and Glencore score better than peers in their industry. But it’s something investors might want to think about when choosing to invest in a particular company or sector.

Company ESG Score Combined ESG Score
AstraZeneca 94.2 B-
GlaxoSmithKline 91.1 B-
British American Tobacco 90.7 B-
Glencore 90.1 B-
Coca Cola HBC 89.7 A
Standard Charter 89.6 B-
Barclays 88.9 C+
Unilever 88.6 B
Marks & Spencer 88.4 A-
Mondi 88.2 A

Source: Refinitiv 22/03/2021.

One size doesn’t fit all

It’s clear that ESG scores are complicated, but that doesn’t mean they can’t be useful if investors use them appropriately. Investors with strong views might consider avoiding sectors that violate their personal beliefs before going on to use ESG scores to assess individual stocks.

Ratings make the most sense when compared to others in the same sector. Airlines, for example, are likely to have big piles of debt because of the cost to acquire and maintain their fleet. It wouldn’t make sense to compare airlines’ debt to the debt of an online service provider, who might not need as much.

It’s the same with ESG – measuring miners against hospital operators opens the door to an unfair comparison. It’s also worth considering size and where the company operates, as these will also affect the base level of a company’s ESG score.

Investors can use ESG scores to find a best-in-class stock within a particular segment, in the same way they would using other metrics like cash flow or a P/E ratio. ESG scores make sure that sustainability and social responsibility are a part of the overall investment case for a particular company. But it’s up to the individual how much weight they want to give to the score and it’s important not to look at these metrics on their own.

The future for ESG

ESG scores are still in their infancy and reporting is still being standardised – by companies as well as rating agencies. However, as long as you understand the shortcomings, ESG scores can offer a useful insight into how a company operates. Just be careful not to mistake ESG for ethics – they aren’t the same thing.

Investing in individual companies isn’t right for everyone. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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