Fund managers may be putting themselves at risk of lawsuits by relying on “flawed” ESG data, a new paper from the Fraser Institute argues.
In A Lawsuit Waiting to Happen: The Use of Non-Financial Metrics by
the Investment Industry, Bryce Tingle, N. Murray Edwards chair in business law at the University of Calgary, asks whether investment fund professionals who are fiduciaries can legally rely on ESG ratings when that data is not necessarily accurate.
While the vast majority of fund managers (88%) say they use ESG scores in overseeing US$3.2 trillion of investment funds, companies’ scores can vary widely among the third-party firms who generate them, casting doubt on their value, the paper says.
“Over a dozen studies have compared ESG ratings and found wide variation in the way the same company is rated by different ESG data providers,” Tingle wrote in the study, published last week. “The lack of correlation and consistency among rating firms suggests the ESG data from these firms is not reliably telling us much about the ESG qualities of the subject corporations.”
The report notes that while credit agencies rate companies the same 99% of the time, the same is true for ESG rating firms less than half the time.
Tingle points to a lack of correlation between ESG ratings and a company’s future environmental, social or operational performance as evidence of their low quality. ESG factors are often subjective, non-quantifiable, poorly suited to disclosure regimes and vary according to competing value judgments, according to his report.
Tingle also notes that ESG funds are marketed to retail investors in a different way than investment professionals. While the former hear about positive outcomes for environment, communities, labour, etc., the latter are told the ratings measure a company’s resilience to financially material risks. However, he argues they do neither because ESG involves elements that are impossible, too complex or too subjective to quantify.
There is limited research on the impact of ESG ratings on firm risk, but Tingle notes that one recent study of ESG funds “found their methods of portfolio selection actually exposed them to more investment risk, as it leads them to be overweight in small issuers, volatile tech companies, and firms that are abnormally susceptible to changes in inflation, interest rates, and (ironically) oil prices.”
Successful marketing
Although there’s been a growing backlash against ESG, particularly in the United States, the ESG fund sector has continued to grow in Canada. Tingle suggests that fund managers have continued to use ESG ratings despite criticism of their accuracy and failure to predict performance out of self-interest.
“For the past decade it has been a very successful marketing approach to suggest to potential investors that a fund will do more than pursue returns,” he wrote. “This has particularly been the case as the failure of most active fund managers to beat benchmarks has becomes better known and index funds have grown in popularity.”
Tingle argues that the use of ESG ratings is “not compatible with the fiduciary duty of fund managers.”
Even so, shareholder activists have suggested that fund managers — particularly pension fund managers — that don’t take into account climate-related risks and how a company plans to manage them are also failing to live up to their fiduciary duties.
The paper suggests that legislation would be a more appropriate avenue to solving some of the social and environmental problems that ESG ratings are supposed to address.
“Securities commissions and governments should make it clear that, in their view, reliance on ESG ratings is incompatible with investment fiduciaries’ legal obligations to the people whose money they manage,” Tingle wrote.
“Regulators should also follow the [U.S. Securities and Exchange Commission’s] practice over the past few years of examining investment funds’ marketing pitches and comparing it to their actual investment decision-making processes,” he adds. “If a fund claims to invest based on ESG considerations, the fund managers should have to show their own work and demonstrate it is rationally related to the ESG outcomes promised to beneficiaries.”