But with the rise of values-based investing over the past two decades, shareholders are demanding more than just transparency. Many don’t want to put their money into businesses they consider problematic. They want to steer investments toward companies that are improving the world through environmental, social, and governance (ESG) factors. In essence, they want returns that don’t make them feel guilty. So companies, naturally, are advertising all the many ways they are doing good business deeds.
But how does an investor really know how “good” a company is? That’s a much trickier question. The ESG industrial complex has generated plenty of third-party scoring firms, but without standard metrics and processes, transparency is elusive. In the U.S., Senator Pat Toomey, a Republican from Pennsylvania, lambasted ESG ratings firms late in 2022 for not disclosing how they arrive at their calculations. In a letter to one firm, Toomey wrote that “legitimate bipartisan concerns have also been raised regarding the veracity of third-party data, the opacity of rating methodologies, the processes by which ratings firms engage with rated entities, and the management of conflicts of interest.”
Patents have a part to play in the transparency aspect of ESG investing. And one of our partners, Quant IP, has developed an unbiased, quantitative system that helps investment managers tackle the environmental portion of ESG scoring. We spoke with CEO and co-founder Lucas von Reuss about the underpinnings of that metric, about ESG scoring in general, and about why so-called “dirty” companies need encouragement, instead of punishment.
As an aside, you may have noticed that this is our second go round with von Reuss. Our first one was so instructive on the ways that lenders are using patent information to advance capital distributions to young, promising companies that we decided to tap his insights again and ask him to explain yet another way that Quant IP uses patents in forward-looking ways to give investors the edge they’re always seeking.
The interview has been edited for clarity and length.
IFI CLAIMS: You’ve been a proponent of the idea that patents can help private and institutional investors understand whether or not the companies they are investing in are truly sustainable. Tell us about the issue overall.
Von Reuss: From the patent perspective, it makes sense to look only at the “E” part of ESG investing, which is the environmental dimension of sustainable investing. As for the S and G part of the equation, we cannot offer a better solution than what is already on the market. “S” and “G” are definitely important, but a lot of private investors think of sustainable investing mostly through the lens of environmental. With all the environmental concepts that have been introduced in the last couple of years, like CO2 footprints of products, people are more aware of the environmental impact when it comes to water treatment or anything related to climate change. Environmental, social and governance are traditionally handled with ESG scores. Some of the indicators that ESG scoring companies use come from public information about the companies. They might ask the companies through questionnaires and surveys and then rank them according to certain indicators about how harmful the impact of the business activity of a certain company is.
Basically that is it.
Of course, there are a lot of dimensions from polluting air and water to emitting greenhouse gases to recycling. In the last couple of years, this process has become more elaborate and includes supply chains to a very large degree. Collecting data on supply chains is hard, but with more regulations required on the company level, reporting on this has improved. The most prominent problem is a lack of taxonomy that would make it more or less clear what is environmentally sound and what is not. The recent efforts of the EU to introduce a taxonomy that would solve that made progress last year but didn’t completely get rid of the problems investors face when they look at different scores on the same company. In the “E” space, as well as “S” and “G,” you see a high variance of scores for the same company depending on which provider you look at for the ESG scores. So that means there is no objective way to score the environmental friendliness of a company because there are so many different views.
IFI CLAIMS: Why is that a problem?
Von Reuss: Just look at the results. You see the system is not working well at the moment. If there were common structures on how to objectively measure, quantify, and then rank environmental friendliness of companies and their business models, this variance would not be so wide. When you take credit ratings for example, they have a correlation of 99% on the same company, whether you look at S&P, Moody’s or Fitch ratings. But if you look at the same rating on ESG, especially the “E” part, those results tend to differ. A lot.
That’s hard for investors for many reasons. The regulatory part is one reason. If you want to do ESG investing in order to avoid regulatory problems, which score can help you be safe, in terms of not being called out for proclaiming that you’re investing the money of customers in a sustainable way. Years later, some regulatory body can say that it is not sustainable at all. As long as there is no common sense on that, the risk is high that you get called out a few years later.
The second reason is that there is so much room to judge whether companies are environmentally friendly or not. You might ask how this can be because, for example, measuring CO2 emissions should not be the subjective views of a group of people working in a scoring company. It should be very easy to compare. It seems that the problem a lot of scoring companies have is that they actually cannot measure all that much because they’re relying on the companies to supply the information. And a lot of companies don’t comply fully with all those requests from eight to ten scoring companies. That means that even in developed markets, in large-cap publicly listed companies, the ratio of full surveys coming back from those companies with all the questions answered is about ten percent or so, according to what I’ve recently been reading. That’s super low. If you take the global average, it’s single digits. So a lot of those numbers you see in those ESG scores are based on estimates or backfills or whatever methodology is used to fill those out.
Japanese companies, for example, tend to be low-ranking in the scores. It’s not because they’re not trying to be more sustainable. It’s more that the corporate culture tends toward not answering questions about internal information. Which means the ratio for Japanese companies answering those surveys is very low. As a scoring company, you have to treat those companies with a negative impact on a score. So it’s just a very blurry picture.
IFI CLAIMS: Any other reasons that make the current system challenging for investors?
Von Reuss: You’re always looking at data from the past. So even if you were to fill out the surveys correctly, you’re looking at how companies have performed on certain indicators up until last year. Based on that, you provide investors with a score that is always looking back.
IFI CLAIMS: What should these scores be doing for investors?
Von Reuss: The main idea with these scores is to make sustainability more transparent. Let’s stick with CO2 emissions as an example. Which companies produce CO2 emissions in their processes and supply chains? Scores allow you to call out dirty companies, and then increase their weighted average cost of capital. If a dirty company wants to go for funding through a bond issue, there will be certain investors who exclude companies below a certain score. And that means a company will not be able to raise the amount. Or, they raise it with a significantly higher cost because a significant number of investors won’t participate in the auction.
The same goes with equity. If equity investors, including institutional investors, make sure that they include sustainable metrics in their investment process, those investors are cut out because the company is not meeting thresholds in terms of the score. So the cost of capital is increased on the equity side as well. Both debt and equity are more costly for the company.
In the long run, a company feeling the pain of higher costs of capital would change its course and make the adjustments in order to reduce the amount of greenhouse gas it produces. That’s the theory.
IFI CLAIMS: Is it the practice too?
Von Reuss: The problem is that it’s not working that way. For many companies, it’s easier to just dispose of businesses dragging down their ESG scores instead of changing course. Take a conglomerate with six business lines, one of them being a coal mining operation in Australia. That coal operation would lower the overall ESG score, and that would hurt the conglomerate. How do you transform a coal mining business into something that is green? It’s impossible. So the conglomerate would find a buyer to sell to and would likely sell into an international market where there is not so much scrutiny when it comes to ESG scores. That buyer would mine and operate the business as before. What happens is that there is zero reduction in greenhouse gas and a higher score for the company that just sold its mining business. For many, the fast solution is pushing non-green assets into the darker corners of the financial markets, which is the opposite of what we want to do.
There are companies that actually do want to change but are in industries where sometimes the whole industry gets caught out because of the high emissions. Steel, for instance, is a very high-energy, intensive operation. You can switch to low-emission steel, but that would most likely mean a transition to green hydrogen as a source for energy. And that, as you can imagine, means a lot of capital you need to invest in order to do so. It’s not like switching one gear. It’s basically changing a big part of your technology because there is not a lot of green hydrogen that can be purchased now, but maybe in ten years there will be. So you need a long-term investment plan and a massive amount of investment, so that in the long term, you’ll be able to produce green steel. Going back to the idea of those ESG scores, those companies that need the most capital are deprived of the capital or see their capital costs going up. And that leads to the fact that this green tech transition, which is hard in the first place, will get even harder with the current set of incentives.
IFI CLAIMS: So how can patents help solve this problem?
Von Reuss: In a lot of cases, there is already a technology solution out there, and we just need a lot of investment. Solar power is already there, and we need to deploy it on a much greater scale.
But sometimes the solution is not there yet and what you need then is innovation, unless you’re willing to cut down on consumption and production of products and services. But that’s hard to get people to not consume and spend as they like. So innovation is key. Instead of punishing companies for having a bad track record in the past, we need to encourage companies that show they want to have a green path of innovation in the future. Quant IP developed a methodology for identifying these companies, as opposed to companies being able to say what they are by survey or by selling off a dirty business.
We looked at different methodologies of defining green patents, and we chose the definition of the World Intellectual Property Organization (WIPO) for a couple of reasons. Investors always look for trust, and who would be better able to communicate that trust than an intergovernmental body like WIPO with no interest in business at all. WIPO’s main purpose is to administer the International Patent Classification (IPC) system that is in place. WIPO worked with the highest authority in the sustainability space: the United Nations. The UN put up the Sustainable Development Goals (SDGs), which they update regularly. A body of the UN defined environmentally sound technologies, which are technologies that help to reach certain sustainability goals. Not all sustainability goals can be linked to technologies, but a lot of them can. WIPO has mapped those environmentally sound technologies to the existing IPC system.
By labeling certain IPC codes as green or specifically green, it’s possible to label certain inventions as green. All of this has resulted in the IPC Green Inventory.
IFI CLAIMS: How did you use this at Quant IP?
Von Reuss: We aggregated those green patents on a company level, which makes it possible for our customers to see important information. At a company level, they get a quick view of the green invention footprint of that company. That means they can see not only how many green inventions a company has filed for in the last couple years, but how that has developed over the years. They can also see subcategories of the environmentally sound technologies the companies are investing in. We’ve created a green technology ratio, which shows how many green tech patents there are versus the overall patent portfolio. That’s a good indicator for how green the patent portfolio already is and how focused the company is on green technologies. It’s a very straightforward metric but a very powerful one. If an investor is looking for companies that have at least 50 percent of their patent portfolio made up of green inventions, that’s the most important filter they would use.
The other thing investors can do is search patents by subject matter. You can search for battery technologies without the use of cobalt, for example. Because cobalt is a tough thing environmentally and also from the perspective of child labor.
For green inventions, a lot of things we look at here are hardware-related inventions. Yes, software is important, but a lot of things we need for the energy transition are associated with hardware. If we want to have better batteries, we need materials science. There will be no software solution making those lithium cobalt batteries more environmentally friendly to the extent that we need it. The same goes for wind turbines. If we really want a better way to harness wind energy, we need hard materials science. If we want to find a better way to make concrete producing less GHG, then we need hardware to do that. Hardware investments are very risky compared to software because software is not that capital intensive. Hardware is capital intensive and longer investment periods are needed to actually turn hardware technology into product sales in the market. That means that investors in the hardware space can use Quant IP quality scores to help their decisions on whether this is a sound investment or not.
Quant IP’s product is very important in the hardware arena because of the long-term nature of the investment. When we talk to venture capital customers, they tend to come from the hardware part, not so much from software.
IFI CLAIMS: So your investor customers can perform the environmental portion of the due diligence on top of your core predictive score.
Von Reuss: We are currently the only company applying a predictive score to invention. We are the only ones being able to score patent applications from the day of publication, which is the earliest point in the lifetime of a patent that the information is public. And that means we can give investors an indicator at the most interesting part of the lifetime, which is after publication and for the next two or three years. After six years or more, you’re just counting quality indicators like citations, which means that you’re only looking back because you’re looking at very old inventions at that time and most of the information that you’re counting has already filtered through products, services and revenues that are associated. At that point, everybody knows it. So if you want to have an edge, you need to be early, and Quant IP gives you that edge if you apply it early.