28.10.22 “Ratings equal power” Interview with Dr. Andreas Beck, founder and CEO of Index Capital GmbH • Reading time: 5 min.

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Summary

ESG ratings bring no benefits either for the environment or for investors, according to the mathematician and asset manager Dr. Andreas Beck. In this interview, he explains who really benefits from ESG and how capital could be directed to the right companies.

What role do ESG criteria play in your work as a portfolio manager?

They play a major role, because institutional investors are more or less forced to bring sustainability into their portfolios. And in August it became a requirement for advisors to offer private investors sustainable portfolios.

Dr. Andreas Beck, founder and CEO of Index Capital GmbH

Let’s assume for a moment that there are no obligations of this kind. Would you voluntarily take ESG into consideration on the basis of your own convictions?

The planet is important to me too. And of course I would like us all to live more sustainable lives and produce less waste. But I believe that attempting to achieve that by means of portfolio management is totally the wrong approach.

What exactly is it that you dislike about the ESG system?

I have three main criticisms. The first is that the goal of the UN and EU is to supply the economy with capital so that it can make the transition to sustainability. That was the fundamental idea of sustainable investment. And what has happened? We are seeing a small number of rating agencies dominating the market. It’s a bureaucratic nightmare that puts a huge burden on investors and businesses. And the ESG ratings also don’t measure whether sustainable investment is achieving its goal – the transition of the economy. Instead they simply measure past events. The investments are supporting start-ups and IT and platform companies that have no reason to take part in the transition. A good example is the automotive industry. If you take a look at the big rating agencies, in particular MSCI, you might think that the global car industry consists only of Tesla. The investments are totally missing their mark, because the money should actually go to companies that need to finance a transition. And industrial nations, such as Germany and Japan in particular, are suffering as a result.

What is your second criticism?

We are providing the wrong incentive. Imagine that you are managing a business. The auditors or management consultants advise you about what to do to get a better ESG rating. They tell you that one of your business units is causing a problem. So what do you do? You don’t close it, of course. Instead you sell it. This is happening everywhere at the moment: companies are splitting off problematic divisions and selling them to unregulated investors. They are bought for less than their market value by offshore companies in the Bahamas or other tax havens. They end up in the ownership of private equity funds or private individuals where they are subject to much less regulation than if they belonged to publicly listed companies.

And your third criticism?

Rating agencies should always be treated with caution. Ratings equal power, but the power has no legal or democratic legitimacy. I remember that in the financial crisis the rating agencies gave junk bonds the rating AAA, the highest category. This caused enormous damage, but the rating agencies got off scot-free. Their argument was that they were the equivalent of the press or publishing houses and that their actions constituted free speech and not investment advice. In the case of credit ratings, there is at least a disciplinary element. In retrospect you always know whether or not the rating was right. But sustainability ratings have no corrective mechanism of this kind. Every agency can rate investments however they want, which is why the major ESG ratings do not correlate with one another. And ultimately no one can be held accountable.

You say that ratings equal power, but who exploits this power?

It is used to maximize the profits of the rating agencies. It’s a no-holds-barred fight. And the ESG ratings are also a license to print money for a new bureaucratic bubble.

Do you believe that ESG can actually be measured?

No. And this is precisely why the ratings vary so much. None of the three categories – E, S, or G – nor their weighting in an index can be measured accurately. For this reason, a large part of the data is estimated. Companies that spend more money on consultants get better ratings. Small and medium-sized enterprises tend to have poorer ratings than larger businesses, because they simply cannot afford the expense of the bureaucracy.

If we look at ESG funds from an investor’s perspective, what are the returns and the risks?

The portfolios can’t get any better, because the ESG ratings separate companies out. Only around 350 or 400 of the 1,600 or so companies in the MSCI World index are left at the end. And as a portfolio manager, I have to restrict myself to this selection. That cannot be beneficial, unless the ESG rating were to come with additional information relating to performance. But I have not seen that happen.

Do you have a better idea about how we can invest sustainably and channel the capital to the right companies?

The only thing that has so far allowed the human race to make progress is innovation. For this reason, I have begun working with the database analyst Lucas von Reuss from Quant IP to find the companies with the highest value green patents in the pipeline, because patents represent actual innovations. They determine whether we will make the transition to greater sustainability. The good thing is that the patent pipeline can be measured objectively and the global patent databases are managed to a high standard, so there are no additional bureaucracy costs for companies.

Are you seeing any signs of a change in attitude to ESG investments?

Investors have at least recognized that this is the wrong approach and are becoming increasingly skeptical. But the oligopoly of rating agencies has acted very cleverly and imposed the ratings on the market. The agencies are earning a lot of money in the process. Banks or asset managers that want to use their ESG ratings have to pay millions in fees. A medium-sized asset management company will be spending around two million euros a year, if it enters into a ten-year contract. And a study by UBS has shown that one company alone is raking in 40 percent of all the license fees: MCSI.

What do the license holders say about this?

Everyone you talk to is highly critical, particularly in the banking and asset management industries. But hardly anyone is brave enough to express their opinions in public, because it would sound as if they were opposed to sustainability. And, of course, that isn’t true. On the contrary, because they are in favor of sustainability, they are against the way the ESG issue is currently being managed.

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