In recent years, the idea of responsible business has gone from a minority concern to the mainstream. Studies show that firms committed to goals such as environmental stewardship and employee satisfaction tend to outperform their peers. Given the urgency of the climate crisis, it is no surprise that ESG (Environmental, Social and Governance) metrics have become part and parcel of corporate life.

Shareholders rightly hold firms to account for the actions of their whole supply chain. If you run a large multinational company, then it’s valuable to get help from ratings companies that measure the human rights track record or the ethical behaviour of your counterparties. Agencies like these may give firms a “scorecard” and award firms that do well Platinum or Gold status. Or they might offer a ranking between “leaders and laggards” and give firms a score from AAA to CCC, just like a credit ratings agency. And naturally, firms that score highly in these assessments are not shy in broadcasting that fact to the market.

Is ESG really AAA?

Yet these data points are harder to apply one critical undertaking — valuing investments. When a fund manager is compiling a valuation spreadsheet, they will model the future of the target business on the basis of historical P&L and cashflow statements. It’s not obvious where the target’s Platinum status or AAA ranking sits within the fund manager’s risk assessment process. Ratings agencies use proprietary ranking systems to weight different factors and arrive at a final score. This can make ratings hard to reconcile with cashflow assumptions, and in many cases, mutually contradictory between providers.

When it comes to the climate component of ESG, there is a better approach available. It is to analyse each company for how it will perform in a range of climate scenarios. Capital allocators need to take a view on what kind of climate transition we are heading towards, and adjust their valuations accordingly. By combining a top-down opinion on climate risks with a bottom-up analysis of discounted cashflows, investors can cut through the noise that is inherent to ESG.

This kind of analysis has clear advantages. Firstly, a company’s exposure to the climate transition can be expressed in the form of hard data, something that is harder to achieve for other components of ESG. Furthermore, climate is a general exogenous “shock” to which all firms are exposed to a greater or lesser extent. For that reason, we can perform the same exposure calculation consistently across multiple investments. That aids comparability between potential alternative ways to allocate capital.

Rising ratings, hidden risks

Capital markets have historically underplayed climate risk because of a perception about how long it takes to play out. Yet it is often the most significant risk an investment will face, and the hardest to mitigate.

Consider a real estate business with office properties across New York state. Its executives are compensated for driving up share prices with flashy announcements. Staff are underpaid and the business is overlevered. The firm’s ESG rating is poor. So the shareholders revolt, and new management comes in. The board is overhauled, compensation is aligned to business goals, staff get a pay rise, and the new management choose to sell off some off its prime properties in central New York to reduce leverage. By any stretch, the business’s ESG scores should soar.

But management has doubled down on its weaker assets: older office buildings, built at a time of lower energy standards, which are harder to let out. Over the next 30 years, as energy standards become increasingly stringent, these properties will requite substantial investment to stay open, investment that cannot be funded from the rents they generate. In the long run, the portfolio is underwater: the offices are stranded assets. An investor who only paid attention to the aggregate ESG rating would have missed the severity of the climate transition risks.

Climate change, and our response to it, is the megatrend of our time. Find out how we can help here.