Asset Managers and Financial Advisors should stop taking ESG scores at face value and see how to assess ESG friendliness more accurately to better achieve client demands.
ESG scoring may or may not reflect a company’s pursuit or adherence to high environmental, social and governance standards. Some high scores may reflect a company’s marketing program and disclosure efforts more than its true commitment to ESG and sustainability.
“When a measure becomes a target, it ceases to be a good measure.” This insight comes from economist Charles Goodhart, whose precept refers to the tendency of individuals or organizations trying to anticipate the effect of a policy but taking actions that alter its outcome. Investors who employ environmental, social and governance metrics should be well aware of this principle.
Goodhart’s “law” is best understood through a true story. When Vietnam was still under French rule, Hanoi suffered from an excessive population of rats. To combat the issue, the colonial regime instituted a bounty system providing a cash payout for each rat killed. Citizens were required to bring in the tails of dispatched rats as proof for payouts, which skyrocketed as the number of government-collected rat tails soared. However, the rat population did not decrease.
Much to the dismay of city officials, they discovered that citizens were not actually killing the rats, but removing their tails and releasing them back into the sewers to reproduce, effectively increasing the available revenue to any would-be rat bounty hunter. Consequently, the number of rats in the city actually increased. The behavior of the citizens had changed to suit their economic aims, simply because of the way officials had decided to structure their program and measure its result.
“Greenwashing” often provides a good example of Goodhart’s Law in the world of ESG investing. Greenwashing refers to a company or organization that spends more time and money claiming to be “green” through advertising and marketing or disclosures than actually implementing business practices to minimize negative ESG impact. As organizations focus on a particular key performance indicator (KPI), ESG metrics in this case, the quality of that metric can deteriorate. They may change the way they behave, but not in a genuine way. Rather, they’re effectively window-dressing to play to standard ESG measures, which as a result becomes less informative to potential investors.
A more recent example comes from the Washington Post:
A shipment of 36 million pounds of soybeans sailed late last year from Ukraine to Turkey to California. Along the way, it underwent a remarkable transformation.
The cargo began as ordinary soybeans, according to documents obtained by The Washington Post. Like ordinary soybeans, they were fumigated with a pesticide. They were priced like ordinary soybeans, too.
But by the time the 600-foot cargo ship carrying them to Stockton, Calif., arrived in December, the soybeans had been labeled “organic,” according to receipts, invoices and other shipping records. That switch — the addition of the “USDA Organic” designation — boosted their value by approximately $4 million, creating a windfall for at least one company in the supply chain.
Companies are aware of the premiums they can extract from the marketplace for various green/organic/sustainability-related labels. However, whether a company is truly walking the walk requires in-depth knowledge of management quality, corporate culture, risk profile and other characteristics that may not be truly reflected by a simple ESG score. In depth, qualitative assessments are necessary to evaluate genuine adherence to or real progress toward high sustainability standards. Just as standard financial analysis requires sharp scrutiny of a firm’s balance sheet, profit and loss statements and other fundamentals, ESG appraisals should go well-beyond broad-based scoring systems.
We believe accurate ESG assessments are crucial indicators of a management team’s focus on effective stewardship of capital. Strong management coupled with productive capital allocation can, in our view, lead to financial outperformance over time.