The importance of doing your own homework
External ESG ratings should inform judgement — not replace it
While demand for ESG-compliant investments remains strong, some investors’ willingness to engage in rigorous sustainability analysis has reduced, with many placing greater reliance on external ESG ratings, controversy screens and compliance assessments.
Third-party data providers are an important part of the investment ecosystem. They allow investors to monitor large universes, identify potential controversies and compare issuers using consistent frameworks. However, these tools are most valuable when they inform investment analysis rather than determine investment decisions.
Active investors are responsible for more than applying an external score or accepting a binary classification. We take the time to understand the underlying facts, assess their financial and sustainability relevance, and form an independent conviction about how they affect valuation, portfolio construction and engagement. The financial crisis offered a powerful historical analogy: investors who treated AAA credit ratings as a substitute for independent analysis were among those most exposed when the assumptions underpinning those ratings proved flawed.
Different methodologies produce different scores
Selecting an ESG data provider goes beyond choosing a dataset – investors commit to a specific methodology and, therefore, a particular perspective on what matters.
Tesla scores materially better than Shell utilising Sustainalytics ESG rating system. However, under MSCI’s methodology, Shell scores better than Tesla. Both companies score equally poorly under RepRisk’s business conduct and reputational risk methodology. Differences in ratings are often attributed to methodological choices. For example, an investor may consider Tesla’s contribution to transport electrification to be highly significant, while a provider may place greater weight on corporate governance, labour practices or management of operational controversies. Another methodology may focus principally on the financial materiality of ESG risks relative to industry peers rather than on a company’s absolute contribution to environmental or social outcomes.
There is legitimate value in this diversity of opinion – different views contribute to a healthy investment ecosystem. The difficulty arises when methodological judgements are treated as objective facts or when a single rating is used without understanding how it was constructed.
Backward-looking assessments can anchor investors to the past
Many European investment products exclude issuers considered to be in breach of the United Nations Global Compact. The UN Global Compact sets out high-level principles relating to human rights, labour, the environment and anti-corruption. Assessments of alignment with these principles have therefore become an important product offered by ESG data providers.
However, we frequently find that controversy assessments firstly, contain differing conclusions between providers, but also remain influenced by historic events long after the investment relevance of those events has changed.
For example, we have found some UNGC analysis of European banks from data providers continues to reference litigation and conduct issues originating in the 2007 global financial crisis. While it would be unwise to disregard legacy controversies given their potential lasting consequences, these cases have been extensively litigated, there has been significant macro-prudential reform alongside corporate governance and risk management over-hauls.
An excessively backward-looking classification can create an anchoring effect. It may cause investors to focus on the original controversy while underweighting evidence of remediation, deterioration or changes in the company’s operating environment.
Binary classifications can conceal complex realities
The limitations of binary assessments in ESG data provider assessments are particularly visible in conflict-affected and high-risk geographies.
Operations in these regions can expose companies and investors to severe human-rights, legal and operational risks that can lead to financial liabilities. However, the appropriate assessment of a company operating in a conflict-affected region depends on more than its geographic presence.
We have reviewed cases in which a company’s own environmental and social practices appeared comparatively robust, but the issuer was nevertheless assessed by a widely used ESG data provider as non-compliant with the UN Global Compact because of alleged complicity in wider human-rights abuses that are a) controlled by the host state and b) widely disputed. Such conclusions may ultimately be justified. However, investors should understand the chain of reasoning, the underlying evidence and the company’s capacity to influence or remedy the situation before adopting the data provider’s conclusion as their own.
Our comparison of two major UNGC screening datasets across issuers in the MSCI ACWI illustrates the potential consequences of provider divergence. Within the sample examined, one provider classified five companies as failing, while the other classified only two. Only one company appeared on both lists.
This is not a marginal difference. Depending on the provider selected, an investor could reach a materially different conclusion about the eligibility of individual securities and the composition of an investment universe.
Independent judgement is part of active investment management
We believe investors should build their own convictions about controversies affecting prospective investments and existing holdings. This is central to Carmignac’s approach to active investment: combining external information with fundamental research, forming independent convictions and using the full investment and stewardship toolkit to address difficult issues.
This does not mean recreating every underlying dataset or dismissing the expertise of specialist providers. External ratings and controversy screens remain valuable tools for identifying issues, structuring research and monitoring portfolios. But the final judgement should belong to the investor. The central principle is straightforward: ESG data should support judgement, not substitute for it.
