Welcome to the sustainability jungle

Chief strategist and Head CIO Office of VP Bank Group
Reading time: 6 Min
Sustainability has become an integral part of our lives. Even when it comes to investing money, investors can no longer avoid this topic. Since August 2022, the EU has required banks to record the sustainability preferences of their customers and take them into account when making investment decisions.

Even though much has been researched, written and discussed about sustainability in recent years, one thing has not changed: What is considered "sustainable" is still not clearly defined. For years, the financial industry has relied on ESG ratings, which take into account the three central dimensions of environment (E), social (S) and corporate governance (G). Rating agencies such as MSCI, Refinitiv, S&P or Sustainalytics each assess thousands of companies.

But there is no consensus on the measurement and weighting of the factors E, S and G, so that each of these agencies can arrive at different assessments for one and the same company. This was demonstrated by researchers from MIT and the University of Zurich in a study that won the VP Bank Best Paper Award. The average correlation across the six largest rating agencies is just 0.54. By way of comparison: in the area of credit ratings, the major agencies almost always arrive at the same verdict with a correlation of 0.98. For investors, this is very confusing. For investors, this is very confusing and does not inspire much confidence. The European legislator is therefore introducing its own, objective metrics.

A matter of perspective

In assessing what is considered sustainable, the regulator and the financial industry take two different perspectives. The ESG ratings used by the financial industry focus on the financial impact of climate and social change on a company. Both risks and opportunities are included. In the course of this, many rating agencies rely on a relative view: They assess who is doing the most sustainable business within the respective industry.

The regulator, on the other hand, assesses the impact of a company on the environment and society. A distinction is made between negative and positive contributions; good corporate governance plays only a secondary role. Investors can choose which criteria their bank should take into account. The three main concepts are the avoidance of adverse effects (Principal Adverse Impact - PAI), sustainable investments according to the disclosure regulations (investments that contribute to the achievement of an environmental or social goal) and the even stricter taxonomy (activities that make a significant contribution to an environmental goal and meet strict, sector-specific requirements). What makes a demonstrable, positive contribution is considered sustainable. However, this contribution must not be at the expense of another environmental objective ("Do No Significant Harm" criteria) and a minimum level of protection ("Minimum Safeguards") must be observed.

Unlike ESG ratings, the EU criteria do not measure whether a company is sustainable or not, but what percentage of its activities make a positive contribution. Due to the different perspectives of ESG ratings and regulation, the assessment of a company can also be quite contradictory. For example, the two food manufacturers Unilever and Danone as well as the beverage company Coca-Cola receive the top rating from MSCI ESG Research with a AAA rating. According to MSCI, all three companies do not meet the criteria to be considered a sustainable investment under the Disclosure Regulation. The same applies to the stricter taxonomy requirements. The world's largest salmon fisherman company SalMar, on the other hand, only receives the third-worst rating from MSCI with a BBB. In terms of taxonomy, however, the Norwegians are among the most sustainable companies with 98% taxonomy-compliant turnover.

Investors are likely to be confused by the different concepts used to measure sustainability.

Bernd Hartmann Chief strategist and Head CIO Office

Difference in relevance

Investors are likely to be confused by the different concepts used to measure sustainability. Investors who have not yet dealt with sustainable investment will be asked by their bank advisor about their sustainability preferences for the first time. Sceptics, on the other hand, will probably fear being patronised by Brussels and restricted in their investment decisions. Sustainability pioneers who have been taking ESG ratings into account for years are likely to ask themselves whether they should also express a high preference in terms of regulatory measurement. At the same time, they should question whether ESG ratings should continue to be taken into account.

Both views have their justification, but not for every investor. ESG ratings should be considered by all investors. As an indicator of the opportunities and risks of climate and social change, they provide added value for the selection of suitable investments, because ultimately they manifest themselves in future corporate profits. It is therefore worthwhile paying attention to ESG ratings even for investors who do not actually have a strong preference for sustainability.

The situation is different with the concepts of regulatory sustainability. Here, a greater distinction must be made between the different types of investors. The majority of investors probably state that adverse impacts of investments must be taken into account. After all, the so-called PAIs also include criteria such as worker protection and child labour. Investors who also pay attention to sustainability in other ways should invest a certain proportion of their portfolio in companies that contribute to an environmental and/or social goal. Investors who are concerned about the use and impact of their money should also invest a portion of their assets in taxonomy-compliant companies.

The right measure

Investors must not only choose which regulatory concept of sustainability is important to them. In addition, they must also specify the proportion of their portfolio that should be taken into account. This is because, unlike ESG ratings, the regulatory criteria are extremely strict. The companies have also had little time to align themselves with the new requirements. In addition, companies have only provided information for two of the six environmental goals of the Taxonomy Regulation. Of the world's 1,500 largest publicly traded companies, just 208, or just under 14%, qualify as sustainable investments under the Disclosure Regulation.

The values for taxonomy are even lower. On average, 48% of turnover qualifies as taxonomy-compliant. However, only 6% of the turnover is done according to the strict industry requirements and is thus considered taxonomy-compliant. Those who, with the best of intentions, give their bank overly ambitious targets will end up with an unbalanced, poorly diversified portfolio. Investors should therefore seek advice on what are sensible minimum ratios for their individual asset allocation.

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