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ESG: Product vs. Process

When evaluating ESG portfolios, a very important question to ask is if ESG data is being used as a process of evaluation, or is it being sold as a product?  ESG as a product refers to the data that companies like MSCI, Sustainalytics, and Thomson Reuters put out.  These data products overweight high-scoring companies and underweight low-scoring companies to populate the constituents of an investment.

Alternatively, a widespread practice of asset managers today uses ESG as a process, because buying multiple data sets creates a 360-degree perspective of a company.  And by this, we mean that they have a process of looking at as much data as they can and making buy and sell decisions using that data along with traditional financial metrics.

What we really need to evaluate, and we have been saying this for years, is the scoring methodology behind the data, because different data providers may say very different things about any given company.  Scores among data providers can vary greatly, as each company has its biases about what the data means.  So, the scores are arbitrary to a degree, but the data itself is not arbitrary.

As an example, many years ago, several data providers gave Pacific Gas & Electric (PG&E) one of the best topline ESG scores, certainly of any utility, because it was converting a high number of its clients to renewable energy.  And yet, if you looked under the hood of those scores, PG&E had been self-disclosing for years that they had high risk of fires due to extensive droughts throughout California.  So, managers that were using ESG as a process looked at all of that data and avoided owning PG&E, while managers that simply looked at PG&E’s topline data as a product owned the utility in droves.

It is a lot of work, but any good manager, in our opinion, is engaging with ESG by process: buying and analyzing the data themselves and essentially throwing out the topline scores.  When we look at ESG data, we analyze c-suite governance, such as board composition. Is the board diversified, with a cross-section of voices representing the customers that buy the product or service?  Do they have an experienced compliance officer?  Have lawsuits occurred due to controversies or lack of oversight?  These are things we want to know.

Where does employee satisfaction rank as a leadership priority?  Wouldn’t you want to own companies that treat their employees well?  And do you think a company that does so has an edge, especially in a world of low unemployment where attracting good employees is difficult?

In terms of environmental factors, do you think there is a concern if a company is polluting local areas where their customers and employees live?  Do you think this is relevant to the future of a company’s valuation?  We view these insights as essential, and you won’t get this depth of information from a 10-K.

ESG data sets are robust, and they are also evolving.  It does take some work to bring them into an investment framework, but it is important to understand that clients are not picking companies because of ESG data.  Asset managers pick companies because they have a theme that they are tracking.

Let’s say that a manager wants to own 10% in airlines, and they have narrowed that search down based on financial metrics to three companies.  But then, if they look at the ESG data of those three companies, they might find that one company has an edge over the other two because of factors such as better governance, treatment of employees, customer relations, etc. This kind of data complements traditional financial metrics when used as a process to help measure intangible risks.

Think about companies like Google, Apple, Facebook, and Netflix.  Are people really investing in these companies purely due to financial metrics?  No. They are being bought because people understand that brand loyalty, especially with certain companies, is a huge factor in their investment.

In conclusion, not all ESG approaches are alike. While ESG scores may vary across data providers, it is the materiality of the data beneath the scores that we find most compelling. As more of a company’s value is derived from intangible risks, clarifying the difference between ESG as a process and ESG as a product enables us to maintain higher fiduciary standards for our clients.


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