UK utility Southern Water was fined a record £126 million ($158.9 million; €139.9 million) by regulator Ofwat in June for failing to prevent sewage spillages over seven years and manipulating figures about such incidents to avoid penalties. The fine was in addition to sanctions for similar leakages over that period.

Despite these offences and Ofwat’s investigation into the company being in the public domain, marketing materials produced by UBS Asset Management – one of Southern Water’s owners alongside JPMorgan Asset Management, Hermes Infrastructure and Whitehelm Capital – showed the utility had received a five-star rating from GRESB, an ESG benchmarking organisation, in its 2018 results.

In other UBS marketing documents for investors produced by the manager after the fine and dated 13 September 2019 – shortly before the 2019 GRESB results were released – this rating was still being presented. The 2019 overall GRESB ranking for Archmore International Infrastructure Fund I, which holds Southern Water, was four out of five, though at the time of going to press, it was not known if the score had been revised.

An asset slapped with a record fine for serious environmental breaches received a clean bill of health from an ESG benchmarking organisation. That means investors unfamiliar with the Southern Water controversy are being led to believe there is little wrong with the asset when it comes to its ESG practices.

In a world where managers and investments are increasingly judged not just by their returns but by how much good they do, this raises two questions: what’s the best way to tell if managers and investments are living up to ESG standards? And are the third-party benchmarking systems being developed to assess these managers and assets ready for prime time?

Tricky task of defining ESG

For the best part of a decade, institutional investors and fund managers have been grappling with what it means for their portfolios to be ESG-compliant. Accordingly, due diligence has expanded to cover everything from pollution to transparency and workplace equality.

These metrics are far more nuanced than standard financial ones. To convey that their strategies uphold ESG values, infrastructure managers are turning to ratings from organisations such as GRESB, the UN and S&P Global Ratings. But trying to standardise measurements that are hard to explain is “exceptionally difficult”, says Chris Newton, executive director for responsible investment at IFM Investors, a firm that manages A$152.4 billion ($105.1 billion; €95.2 billion) on behalf of Australian pensions.

“It took over 500 years to develop accountancy standards and now on the sustainability side we’re expected to develop reporting standards in 10 or 20 years. There’s still a lot of room to improve”

Frank Siblesz
DIF Capital Partners

He adds that reporting on ESG should be more about being transparent with regard to an asset or company: “It’s not so much about the score. The ratings have got to serve a purpose, ultimately.”

Paul Shantic, who directs the $246 billion California Teachers’ Retirement System’s inflation-sensitive portfolio, says “it’s not a simple ‘yes’ or ‘no’” when it comes to measuring ESG, and that “no one thing will drive the overall review process”.

“The more important thing in my mind is for managers to incorporate it into normal due diligence on any infrastructure asset under consideration, and then communicating those ESG efforts consistently and diligently to their investors throughout the year,” Shantic says.

However, Bill Watson, chief executive of the A$3.1 billion First Super, an Australian superannuation fund, argues that this consistency is not always provided by managers. “We look for a documented, rigorous process to evaluate ESG,” he says. “With a lot of managers, it seems like it’s slide 45 in the pitch deck. I get reports from managers where they’ve got little vignettes each month about what they’re doing on ESG. That is a substitute for having a thorough analytical process.

“Essentially, we’re after a repeatable process, rather than just talking to infrastructure operators or owners of underlying assets. The repeatable process is the issue, rather than just talking about it.”

On the surface, what goes into an ESG rating or measurement probably isn’t that surprising. Agencies that compile ratings look for firms and the companies they manage to self-report their performance in areas like greenhouse gas emissions, workforce diversity and oversight procedures.

But that self-reporting – and the differing ways in which managers and assets are rated – present complications.

The UN Principles for Responsible Investment, one of the first organisations to start awarding infrastructure ratings in 2014, is more focused on managers and their working cultures. GRESB Infrastructure – an extension of GRESB’s real estate benchmarking practice, established in 2016 – scores its signatories and their portfolio assets. The ESG evaluation launched by S&P Global Ratings this year requires an entity to request an evaluation.

One example of those different standards is the fact that GRESB may not rate all the assets in a given fund. For managers that have submitted details of 25 percent or more of their assets, its scores are weighted 70 percent towards asset assessments and 30 percent towards fund assessments.

Rick Walters, director of infrastructure at GRESB, admits the voluntary nature of ratings means “it comes down to [the firm’s] own decision about which assets they are comfortable with, which assets they feel they can report to GRESB”.

He says GRESB offers managers “allowable exclusions” from its ratings, covering recent investments and assets under construction. Otherwise, unreported assets count as a zero on a fund’s overall score.

“We don’t see cherry-picking too much,” Walters explains. “Investors want to see all of their funds reporting all of their assets.”

GRESB’s 2019 results involved the participation of 107 infrastructure funds, of which 64 submitted 25 percent of their assets or more. The overall asset score fell from 48 out of 100 in 2018 to 46, though Walters says that was due in part to new participants submitting only part of their portfolios. He calls the results “mixed”.

“You like to see people improving and some have and some haven’t,” he says. “It would be great to see a bit more progress given the challenges infrastructure and the world faces.”

Trust and kind of verify

So how does information from these managers get validated? At GRESB, Walters says, there’s a three-tiered process that was designed in conjunction with PwC.

The first tier involves checking “a number of aspects across all indicators”, Walters explains, “but only [the] basic answers [submitted through the form]. We don’t open all the evidence documents which are attached [to submissions].” He adds that GRESB is reviewing this process.

The next step, which he calls “validation-plus”, sees “an indicator each year – selected on a risk basis – chosen to go through more thoroughly. We check the evidence in one section and check it matches the claims made, and then make a decision based on that”.

“The final layer is that we pick random entities or funds and check all of those [indicators],” Walters concludes.

“We look for a documented, rigorous process to evaluate ESG. With a lot of managers, it seems like it’s slide 45 in the pitch deck”

Bill Watson
First Super

S&P Global Ratings includes a preparedness opinion, which goes a step further in evaluating ESG standards, according to Mike Wilkins, the agency’s head of sustainable finance, corporate and infrastructure ratings. He says that after the first stage of self-reporting, analysts will conduct “interactive meetings” with the participating company’s senior management. This is similar to how it conducts its credit ratings, and helps identify long-term risks and actions that can be taken to reduce them.

“This gives us insight and allows us to use our analytical judgment to come up with a preparedness opinion,” Wilkins explains. “It’s based on us asking questions and gaining insight, especially at the board level, about whether the company is able to deal with future disruptive risks.”

However, the S&P model is at an early stage. Wilkins says three evaluations have been completed since it began, and a dozen are close to completion. It has also received several hundred expressions of interest.

The UNPRI is also at an early stage when it comes to verification. The agency has collected 2,500 signatories since launching in 2006 and has offered ratings specifically for infrastructure for four years.

“It’s become a bit like a badge of honour,” says Simon Whistler, a senior specialist at UNPRI. “An A-plus rating sends a signal that you’re among the more advanced investors when it comes to responsible investing.”

He describes “process-driven” questions all signatories must answer about governance, organisational structure, hiring practices and investment due diligence. UNPRI has developed modules that then detail specific questions for each asset class. “When it comes to infrastructure, it’s whether you have an ESG policy specifically for infrastructure investments,” he says. “How do you integrate ESG into your due diligence process? What types of issues do you monitor when operating infrastructure?”

Whistler says that, as the rating matures, efforts are underway to hold firms to greater account than simply what they report. UNPRI has undergone a review to draw up minimum standards that will “address the accountability of being a PRI signatory. We need to make investors more accountable for what they are saying and what they are doing on responsible investments”.

More art than science

The lack of clarity around ESG ratings and measurements is leading some LPs to be cautious when a firm promotes them during due diligence.

“Benchmarks aren’t sufficiently developed yet for people to be incorporating them into their investment policy,” says Anish Butani, director of infrastructure at bfinance, which advises institutional investors. “One investor we’ve been working with has a big sensitivity to offshore tax havens for fund structures. That’s a ‘no’ for them. It wouldn’t be most people’s idea of ESG, but for them that was on reputational grounds.”

Shantic says evaluating ESG is “more of an art than a science” and that there is more than one way to measure how much good a firm or asset is doing. To start, he says, CalSTRS requires managers to know and understand the pension’s ESG risk factors. Managers also have to certify and report on those factors to CalSTRS on an annual basis.

“We also encourage managers to subscribe to ESG principles, as we do believe it demonstrates that a manager realises the importance of ESG in the formation and management of a portfolio,” he says.

“We’re very much by industry for industry. We will try to keep working with everyone in the industry and will try to standardise if we can”

Rick Walters

Marcus Frampton, chief investment officer of the Alaska Permanent Fund Corporation, says evaluating ESG is “qualitative as opposed to formulaic” for the $65.8 billion state sovereign wealth fund.

“At some point, we may look at formalising some sort of an ESG policy,” he says. “But today, it’s simply that we review managers’ approach to ESG on their prior investments, just as we’d evaluate their responsible use of leverage or the reasonableness of the valuation decisions they make.”

“The short answer is no,” says Chris Phillips, a spokesman for the Washington State Investment Board, when asked whether the $139.6 billion pension fund manager looks at ESG ratings when evaluating a firm. “Our asset class teams individually are responsible for evaluating all material risk factors as part of their due diligence. The WSIB has not adopted a single position or practice regarding various ESG ratings or metrics systems.”

He adds that the WSIB is reviewing its ESG-related mapping and measurement frameworks ahead of the planned appointment of a sustainability officer next year.

Need for standards

First Super undertakes its own research, particularly into the kinds of actions taken against Southern Water. “We look at how thoroughly [managers] investigate prosecutions and other enforcement actions taken by regulatory agencies,” Watson explains. “It’s things like looking at that, rather than, ‘We’ve talked to management, done a walk around and everyone seemed happy and cheery.’ That kind of royal tour is pretty easy to manipulate.

“We’ve got a low level of confidence [in ratings] because there’s not the degree of maturity, particularly when it comes to the social factors. However, this is a continuum and there’s now more focus on these social factors being placed now than there was 12 to 24 months [ago].”

As the Southern Water debacle showed, not every manager or benchmarker gets their ESG practices right. In a statement to Infrastructure Investor, Southern Water shareholder Hermes Infrastructure said “the company has undertaken several fundamental improvements which were recognised in the Ofwat report earlier this year [released at the same time the fine was issued]. We will continue to work with other investors, the holding and operating company boards and senior management at Southern Water to deliver a resilient water future for the south-east [of England].”

Southern Water’s other shareholders – UBS Asset Management, JPMorgan Asset Management and Whitehelm Capital – did not wish to comment or could not be reached.

GRESB does not comment on individual assets or funds, but Walters did say the benchmarker is “building indicators around ‘controversies and incidents’ that would go into the annual assessment”. He added: “[Investors] haven’t seen the need for having information any quicker than once a year at this point – something we consider [there is the] potential for and is in the medium-term plan.”

As well as using benchmarking scores to secure fund commitments, asset owners are increasingly using them to secure credit. In December 2018, Thames Water, another UK utility that is a regular recipient of Ofwat penalties, agreed a £1.4 billion revolving credit facility with the interest rate over five years linked to its GRESB score. Neither the score nor the rate was disclosed by BNP Paribas, which arranged the deal.

A similar deal has already been agreed on the back of an S&P evaluation, despite its short time in operation. Spanish telecoms group Másmóvil received a 67 out of 100 rating and agreed its €150 million credit facility in July tied to this score. “We’ve seen a number of loans from banks based on ESG scores or their own sustainability metrics as a way of differentiating the margin they pay on the loan,” says Wilkins.

Yet not everyone is convinced this is the best way to ensure good practice. “ESG is part and parcel of everything we do,” says Darryl Murphy, head of infrastructure debt at UK-based Aviva Investors. “It’s a very dangerous world if you start to have ESG financing separately. What’s the rest of it then?”

“It’s become a bit like a badge of honour. An A-plus rating sends a signal that you’re among the more advanced investors when it comes to responsible investing”

Simon Whistler

There’s also the question of standardisation – or rather, the lack of it. “I’d like to see more standardisation,” says Murphy. “It would help issuers more. There are varying degrees of information asked of the borrower. It can end up in data-rich, information-poor.”

This is not an idea dismissed by Walters either. “We’re very much by industry for industry,” he says. “We will try to keep working with everyone in the industry and will try to standardise if we can.”

This would certainly help overcome the significant barriers that benchmarking systems currently face, though there also has to be a meaningful desire for this to happen. In the meantime, DIF Capital Partners’ head of ESG, Frank Siblesz, calls for patience and sounds a note of caution. “We really believe it’s a combination of qualitative and quantitative information and engagement,” he says. “You can ask a company if they have a health and safety policy, you can answer ‘yes’ or ‘no’, but for us the real value sits in understanding who it applies to and how it transposes to how you run your project, so it doesn’t just become a paper exercise.

“It took over 500 years to develop accountancy standards and now on the sustainability side we’re expected to develop reporting standards in 10 or 20 years. There’s still a lot of room to improve. But maybe we should not have the objective that we can display all sustainability efforts in a single currency.”

Siblesz may be right. But when everything from loans to fundraising is being done on the back of still-developing measurement systems, a much more concerted effort from benchmarkers, managers, investors, lenders and regulators is arguably called for.

If the industry is to really meet the “challenges infrastructure and the world faces”, as Walters puts it, it will require a step change in mentality: from being seen to be doing good to simply doing good.