ESG in High Yield: Shortcuts Versus Thoughtful Integration, Part 2

Posted on August 6, 2021

In a recent blog, we discussed how some high yield managers, facing increasing pressure from their clients for greater integration of ESG in the management of their portfolios, take shortcuts in an effort to accomplish their ESG objectives. This week, we further explore some of the problems and intracacies associated with “shortcut” approaches.

A common challenge associated with ESG integration is that managers often try to capture all the complexity and interplay among different ESG factors into a single rating. It is no secret that various environmental, social and governance goals may conflict with one other. For example, shutting down a coal mine may have very positive benefits for the environment but have terrible social implications for the mine’s employees and its surrounding community. In addition, in the developing world in particular, cheap electricity from coal can provide a great social benefit for hundreds of millions of people but nonetheless result in undesirable consequences for the global environment.

As a separate example, a shareholder-friendly governance approach may be viewed positively by the shareholders who might receive an increased dividend but at the same time be a terrible outcome for the workers who are terminated in order for the company to preserve the cash needed to fund this dividend. Furthermore, such a dividend may also not be in the interest of bondholders that would rather see the company reduce debt rather than distribute cash to its shareholders. Therefore, at DDJ, we fundamentally disagree with the notion that there are “good” and “bad” ESG companies, in absolute terms, that can be simply expressed through a single rating. On the contrary, a thoughtful analysis of ESG considerations with respect to an investment in any issuer is typically far more nuanced.

Furthermore, various ESG rating methodologies differ, which causes investors to question their applicability. It has been documented that there is little correlation between the ESG ratings assigned to the same companies from different third-party ESG rating providers. For example, credit ratings assigned to the same companies from the major credit rating agencies have historically had correlations over 95% while ESG ratings from the leading ESG rating providers correlate on average only 54% of the time.1

Another shortcut when dealing with responsible investing is that many investment managers and third-party providers view ESG as just another set of risks that can potentially damage investment performance. We see two main problems with this approach. First, in our experience, many institutional asset owners as well as private investors do not seek ESG integration only to manage risks and thus to enhance financial returns, but rather because they believe that it also aligns with their non-financial and ethical objectives. For them, ESG factors should be considered in the investment decision-making process not only if they are risks that are “material” enough to affect financial returns but also to confirm that the investment is consistent with their overall ESG objectives. Second, a strict “risk management” approach to ESG integration also ignores the fact that incorporation of ESG factors into the investment decision-making process can provide a positive societal or environmental impact.

Interested in taking a deeper dive on ESG in the high yield space? The above post is an excerpt from our 2021 white paper, Dedicated ESG High Yield Strategies: Can They Achieve Their Objectives?  We invite you to download your free copy of the white paper, available below. 

Dedicated ESG High Yield Strategies

 


1See MIT Sloan School of Management Paper: “Aggregate Confusion: The Divergence of ESG Ratings” December 2020.

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