The story surrounding California Public Utility Pacific Gas and Electric (NYSE: PCG) is a case study of the nuanced implications of different sustainable investing strategies. PG&E filed for bankruptcy after estimating a $30 billion liability from two years of wildfires, becoming one of the largest utility bankruptcies in history, and one of the first to be tied directly to climate change. 1
Despite investigators having already determined PG&E’s equipment to be liable for at least 17 major wildfires in 2017, and disclosing climate related risks at length in the financial disclosures and annual reports, the traditional rating agencies S&P, Moody’s, and Fitch all rated PCG as an investment grade company through the first half of 2018. 2,3 Why didn’t markets price in these risks?
To some degree they did, by demanding higher premiums for greater risk in lending, and through tools like insurance and credit-default swaps; however, markets don’t always price every kind of risk correctly, and research suggests that this is often the case with issues related to climate change.
A recent Bloomberg article by Nir Kaissar titled “PG&E Exposes the Pitfalls in Virtuous Investing” builds a case against ESG investing’s efficacy to mitigate risk when relying on overall scores from ESG databases. Kaissar cites that PG&E’s environmental, social, and governance scores from several major data providers, such as RobecoSAM and Sustainalytics, were above average in 2018.1
In reality, Sustainalytics rated PG&E 71 out of 100, designating it as an average performer, but if you looked deeper than their top line ESG score, the data told a different story. 4
Did ESG Funds Hold PG&E?
The stringency of ESG criteria varies widely among fund managers. Some funds only buy stocks with overall ESG scores in the top 20% of their industry, while others will buy a stock as long as the overall ESG score is above the industry average. In the case of PG&E, Sustainalytics’ score of average overall performance may have been enough to trigger some passive ESG funds to buy the stock.
Out of 2,008 ESG strategies globally, analysis from Morningstar Direct shows that only 75 funds held PG&E. Meaning that only 3.7% of ESG funds held PG&E. 4
While this is a low percentage, Kaissar’s article does propose an interesting question: if ESG investing is supposed to mitigate event-based risk, then why were any ESG funds invested in PG&E? The answer is materiality. Investors focus on different ESG data points as material at the sector and industry level. Staying with the example of Sustainalytics data, under their newer risk rating framework, PG&E scored dead last out of its entire universe of 2,952 companies when it comes to product governance, a category that encompasses quality and safety events. This led Sustainalytics to mark PG&E as “severely risky” as this was a data point that it had deemed very important to its business model. The current state of ESG data is far from perfect, but the data made it clear to investors that PG&E was not operating safely.4
The graph below was created using Sustainalytics data, demonstrating the high-risk exposure and poor risk management of PG&E for product governance performance as compared to its industry peers, a material data point:
What types of ESG funds held PG&E?
This can be answered by investigating the diversity of ESG fund strategies, such as passive ESG ETFs, ESG-integrated funds, and/or thematic funds, commonly based on the United Nations Sustainable Development Goals (SDGs).
Let’s start by defining passive ESG ETFs and index fund strategies, as these made up 52% of the ESG funds in the sample that were holding PG&E stock. Passive ESG funds embody the concept Kaissar described, they often buy stocks based on the overall ESG score that their chosen database provider assigns to each company. 4
Funds that looked through a more thematic lens for impact picked up PG&E for other reasons. In contrast to ESG ETFs, index funds, and ESG-integrated funds, thematic funds designate a target theme that takes precedence over ESG data. Therefore, a thematic fund can hold stock in a company that drives revenue through promoting a theme, such as one of the United Nations Sustainable Development Goals, even if the ESG score for that company is low.
In terms of thematic funds, PG&E is an interesting company, because while its safety score is low, it plays a large role in facilitating California’s transition to a low carbon economy. California’s Renewable Portfolio Standard Law requires utilities such as PG&E to supply 60% of power from renewable sources by 2030. Given PG&E’s vast domain, serving roughly 6 million Northern California residents, it is one of the country’s most renewable utilities. Thus, a fund that is mandated to focus on United Nations Sustainable Development Goal #7, “Affordable and Clean Energy,” may hold stock in a utility company such as PG&E due to its role in the renewable energy sector, and regardless of its low ESG safety score. 2
“Additionally, PG&E’s recently-published 187-page 2018 Corporate Responsibility and Sustainability Report. Sustainability is explicitly called out in the company’s mission, vision, and values. Board committees are in place; ESG materiality assessment has been done, ESG is incorporated in the company’s financial incentive plan, and the organization has a dedicated Chief Sustainability Officer, along with an outside advisory group. They also have $34.5B worth of renewable energy contracts, which is more than the average utility.” 3
Conclusion
In our view, thorough ESG-integration goes much deeper than selecting stocks based on their overall average ESG ratings. A more active strategy merges financial analysis with granular aspects of ESG data to identify specific areas of risk within a firm.
Gitterman Wealth Management tends to stay away from passive ESG investing, instead opting for human analysis and active management through ESG-integrated investing. This is because many of the ETFs that have come to market do not have an institutional quality construction methodology for all the reasons discussed above. While the jury is still out on which ESG analysis type is best, the ESG-integrated investing approach we utilize certainly helps to build a case for its validity, as our investors were relieved not to be holding PG&E.
If you have any questions about our ESG analysis or how we can help you manage your sustainable investments, please feel free to contact us for more information.
Appendix
- https://www.washingtonpost.com/business/pgande-exposes-the-pitfalls-of-virtuousinvesting/2019/01/24/a8b7a020-1fd4-11e9-a759-2b8541bbbe20_story.html?noredirect=on&utm_term=.de4294c747b2
- https://www.bloomberg.com/news/articles/2019-01-22/why-a-pg-e-bankruptcy-could-change-climate-calculus-quicktake
- https://www.naturalgasintel.com/articles/114753-brief—-pge-credit-rating
- Sustainalytics, data