EPA cuts could bite into the effectiveness of ESG scores

Wednesday 21 November 2018

Hands holding world over grass

Author: Oliver MacArthur, IMC.

 

Oliver MacArthur is a member of the ESG Working Group. He writes in a personal capacity and shares his views on how changes in the budget support and regulatory muscle of the US Environmental Protection Agency (EPA) could impact on ESG scores.

There is no shortage of Trump headlines and tweets that move markets in today's media. However, one of the lesser known measures of Trump administration is the reduction in budget support and regulatory muscle of the US Environmental Protection Agency (EPA). In the US budget of 2018, the EPA budget was cut to US$5.7bn compared with US$8.2bn in the prior fiscal year, a fall in funding of 31%. In addition, it is estimated that approximately 3200 were earmarked for redundancy. A recent analysis from the Washington Post highlights that spike in turnover in the organisation following the election of President Trump in what could be dubbed an 'EPA Exodus'.

It is clear that the roll-back of environmental legislation, the reduced funding and high team turnover may reduce the likelihood of the agency finding and policing environmental controversies in the future. But how do these issues relate to ESG scores? An element of a company’s overall ESG score and rating provided by leading providers such as MSCI, FTSE Russell, Sustainalytics, Thomson Reuters and RepRisk et al is attributed to evidence of controversies or regulatory misdemeanours.

Although the magnitude of the impact is dependent on the respective methodology in question, regardless of the impact to the specific provider, weaker compliance environments, in general, have adverse consequences for the validity and decision-useful nature of controversy-based ESG scores.  In my view, a weaker regulatory and more lax compliance environment has worrying implications for the robustness of the controversy scores assigned to companies going forward and greater scrutiny is required given how such data subsequently feeds into a company's overall ESG score. 

In the context of a weakening compliance environment and lower controversies as a result, does a lower number of controversies (and thus better scores) mean that corporates are getting better from an ESG perspective? Companies could be unfairly rewarded, genuine good practice ignored and as a result, ESG and Climate Aware intentional capital misdirected. The potential problem is particularly acute when cast in the context of the growing segment of ESG passive strategies which 'tilt' or optimise the portfolio subject to ESG scores within a pre-defined risk budget.

It is beneficial that the proliferation of ESG strategies is bringing more attention to the methodologies underpinning ESG ratings. Investors in ESG passive strategies and users of ESG data need to be fully aware of the building blocks, shortcomings and embedded biases of the ESG scores. While active fundamental managers are more likely to navigate these data issues with qualitative analysis, where there is a reliance on third-party data in the investment strategies, the issues raised in the article could be used as a discussion point with investment teams and how it relates to the effectiveness of their research process.