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The “G” in ESG is a tricky issue for investors who want to focus on climate change. Often the acronym — for environmental, social and governance — is used as a synonym for “environmentally friendly”. But a strong governance scoring can bring up a company’s overall rating when it might not be particularly climate focused at all.
Take Salesforce, for example. Morningstar listed the software group as one of its top sustainable companies of 2022 on the grounds that it has a chief trust officer, publishes pay equity data and has high targets for equality and diversity. These are all good things. But they’re not necessarily relevant to investors interested in the environment.
Investors often argue that good governance is a prerequisite when picking any company for a long-term investment, as things are less likely to go wrong and bad decisions are less likely to be made.
This, I suspect, is one reason why so many fund managers are able to say they take ESG considerations into account when investing, allowing them to give their fund a whiff of sustainable sparkle for marketing purposes. That sort of thing is going to change with firmer regulation that will define which funds are allowed to call themselves sustainable.
Good corporate governance isn’t totally unrelated to environmental concerns, of course. A board that is poorly governed or makes bad decisions will struggle to set meaningful internal emissions targets or establish a systematic way of meeting them. A company without good management protocols might be more likely to breach environmental regulations. Plenty of people raised questions about BP’s corporate governance in the wake of the disastrous Deepwater Horizon oil spill in 2010.
But I’ve long thought it would be helpful to have a G that was more related to the E. So it was interesting to see that Sustainalytics, the ratings company acquired by Morningstar, has started analysing corporate governance in a climate-focused way. It has started a series of reports looking at one industry at a time, coming up with a management score for companies based on key climate-focused areas.
One of these is how good their reporting is. One of the first steps companies need to take if they’re serious about cutting their emissions is figuring out what they actually are, and a surprising number still haven’t even bothered to do this.
The next question is whether they have worked out what their so-called “scope 1, 2 and 3 emissions” are. Most companies tend to only focus on the first two, which broadly speaking are emissions directly under their control. Scope 3 emissions, those produced by their suppliers or consumers, are far less well monitored, yet often account for the bulk of a company’s total emissions.
The management score also looks at whether companies are setting targets, doing stress testing or scenario analysis, whether they are using internal carbon pricing and, crucially, whether they are tying remuneration of key board members to hitting climate targets.
This score is then combined with a company’s actual emissions and climate targets, if any, to show how far away they are from a net zero target by 2050.
The first report in the series, on utility companies, found an average implied temperature rise of 2.6 degrees Celsius, which Sustainalytics called “significantly misaligned” with a 2050 net zero target. The second, on oil and gas producers, unsurprisingly finds that companies in the sector are “severely misaligned”, with an average implied temperature rise of 4.2 degrees.
A high management score for an individual company doesn’t necessarily mean it will be more aligned with a net zero target. A small oil company might be terribly mismanaged but not emit that much and therefore look better overall. BP, for example, has a relatively high management score but is “highly misaligned”. Other companies like this include ConocoPhilips in the US and Ecopetrol in Colombia.
If I were a fund manager combing through this data, I might be inclined to select companies with a high management score but the most room to improve, on the basis that they’re most likely to be able and willing to make changes. It also looks as if it makes more sense to invest in companies in developed markets, which tend to have higher management scores and are less likely to be state-owned, which results in a lower management score.
Discussing the research with the FT, Pustav Joshi, a research analyst at Morningstar Sustainalytics, says that could be one option, but also points out that emerging markets companies have a tendency to leapfrog developed market countries in terms of new technology, which could be particularly applicable when looking at battery storage or hydrogen.
However, I’d only be thinking about using the research in this way if I were a fund manager with a keen appetite for engagement. There’s a growing awareness that climate change investing doesn’t necessarily mean divestment: another approach can be for fund managers to engage with the companies they invest in and push them towards setting, for example, emissions targets for 2030 rather than just 2050, or tying what they pay their top executives explicitly to hitting those targets.
As a retail investor, though, you’d like to know whether the fund manager you choose is really engaging or just saying that they’re engaging, and this is now very difficult to figure out in any systematic way. The industry needs to get better at this.
How does all this help with the G of ESG? The short answer is it doesn’t. Instead, it’s a new way of analysing corporate governance from a climate-focused point of view. That is a good thing for investors tiring of the ESG acronym, which is at times so broad as to be meaningless. Measuring companies in a more specific way — and giving fund managers better data to decide where to invest — is no bad thing.
Alice Ross is the FT’s acting international economy news editor. X: @aliceemross
