An interesting juxtaposition arose in some recent news articles about Pacific Gas & Electric’s (PG&E) bankruptcy. For example, a Wall Street Journal (WSJ) article posited that PG&E’s bankruptcy exposed “blindspots” in sustainable investing because some sustainability rating firms gave the company high rankings. This was also the theme of a Bloomberg article published in late January that asserted PG&E’s good environmental rating exposed “pitfalls” in “virtuous investing.” But a ThinkAdvisor article offered an alternative view, arguing that things like PG&E’s bankruptcy, Vale’s dam collapse and other value‑destroying incidents were foreshadowed by previous problems, and that sustainability analysis can help investors identify companies that may be skating on thin ice. Can both views be true?
The WSJ article, in my view, puts its foot in a very familiar trap — generalizing about sustainable investing from a few examples. Bloomberg fell into the same trap not long ago in another article, noting that, because it found one ESG fund that owned companies that seemed to be incongruous holdings for such funds, the entire field of sustainable investing is, therefore, more about spin than science.
Let’s deconstruct this problem: PG&E had a positive sustainability rating, but it went bankrupt over an environmental issue. Does that “prove” that sustainability ratings are flawed, silly, naïve or “blind”? Let’s pose the question a different way: Did sell-side financial ratings rate any large bank highly prior to the 2008 financial crisis? One paper that examined the sensitivity of forecasters — credit analysts, short sellers and equity analysts — to the looming financial catastrophe concluded that while equity analysts’ forecasts did show some sensitivity to increasing difficulties of banks, overall, “the mean of the analysts’ recommendation did not change meaningfully from the 2002-2004 period to 2005-2007.” In sum, equity analysts did see some impending signs of weakness, but they didn’t pinpoint the moment when those weaknesses would coalesce into a catastrophe. Does that mean equity analysts were altogether “blind”?
There are dozens of useful pieces of information that go into any rating, be it financial or sustainability-related. The fact that some companies experience difficulties despite high ratings may be explainable simply by understanding that companies are complex entities and some of their performance is based on strengths and some on weaknesses. There were many facets of PG&E’s performance on sustainability that warranted high ratings compared with its peers. The sustainability analysts didn’t necessarily miss the company’s vulnerability to increased risk from a warming climate and the physical risks it entailed, they were simply rating the company on a number of factors, and the company looked good on several of them. That is very similar to what equity analysts were seeing in banks prior to the financial crisis. An overall rating is a blend of strengths, weaknesses and average-ness, and users of such ratings understand that some of the most usable and interesting forecasts are to be found in the details, not in the overall rating.
The literature linking sustainability to financial performance shows that, overall, integrating the parameters of sustainability into financial analysis does help investors to understand risks better, and that often shows up in performance. Predictions of future performance are based on many things, but none of those things is a crystal ball. Yes, predictions may not accurately pinpoint the arrival of a particular event in space and time perfectly; in fact, arguably, that’s probably the case most of the time. If it weren’t, the gyrations of the stock market would be a lot calmer, all of the time. While this is well accepted on the financial side of the aisle, it’s still fodder for inappropriate generalization on the sustainability side, as we saw in the WSJ and Bloomberg articles mentioned above.
It’s time to stop using single-company examples to laugh and point and dance around a whole discipline.