Why ESG ratings matter and how companies use them
“In the future, climate and ESG considerations will likely be at the heart of mainstream investing. Investors will tailor their investments and fulfil their fiduciary duties through: better quality and more widely available data on sustainability and performance, and more informed judgements of strategic resilience.” – Mark Carney, Governor Bank of England
It is increasingly clear that capital markets are not adequately pricing the ultimate costs surrounding sustainable business. What is the impact of a persistently unhappy workforce? How safe is a company’s data, and how vulnerable are they to climate change? These and other fundamental sustainable business questions are not captured in traditional financial analysis but are increasingly recognised to have a material financial impact.
To capture this value and position their portfolios with the greatest chance of long-term success, investors are increasingly turning towards ESG criteria to assess performance across non-financial factors. Environmental, social, and governance criteria (ESG), also known as responsible investment, refers to the three central factors in measuring the sustainability and ethical impact of a company.
An ESG criteria is thought to help investors take into account the ‘unmeasured’ or ‘unrepresented’ environmental, social and governance topics when making investment decisions. It reveals data that traditional financial analysis doesn’t usually capture, speaking to the sustainability of a company in its broadest sense.
And, ESG criteria has turned out to be incredibly valuable, with ESG portfolios continually outperforming traditional portfolios. A review of over 200 sources on ESG performance by Oxford University and Arabesque showed that in the overwhelming majority (88%) of companies that focused on sustainability, operational performance was improved, translating to higher cash flows. A meta-analysis of over 2000 studies confirmed that the responsible, as well as the economic case for ESG investment is tangible.
The markets have caught on now, and we have seen a boom in ESG investments in recent years. In Europe in 2018, the total assets committed to sustainable and responsible investment strategies stood at a remarkable 49%. There was an 11% increase between 2016 and 2018, and this trend is set to continue.
ESG ratings and why they matter
With growing interest in ESG criteria, investors need a way to objectively asses the ESG performance of a company. This has led to the flourishing of a number of ESG Rating Agencies such as Sustainalytics, MSCI, and FTSE ESG, who asses companies globally on their ESG performance and make this data available to their clients.
These ESG ratings are designed to help investors identify and understand financially material ESG risks to a business. Companies are evaluated based on publicly available information such as media sources and annual reports, with scores given for each material ‘E’, ‘S’ and ‘G’ topic, alongside an overall score.
These unique scores are used by investors as a proxy of ESG performance. Companies that score well on ESG metrics are believed to better anticipate future risks and opportunities, be more disposed to longer-term strategic thinking, and focused on long-term value creation.
How companies can use ratings
With investors using ESG scores in their investment strategies, the consequences of a poor rating can be significant. If, for instance, your company were to receive a poor rating from one ESG data provider, your stock may be considered an ‘unsustainable asset’ by investors and excluded from their investment portfolio. If multiple investors follow this reasoning, this can eventually negatively impact your stock price.
In Europe, where nearly 50% of assets are managed with ‘responsible investment’ criteria, understanding your ESG scores and improving year-on-year is important for your company to continue to attract investment.
It is important to recognise, also, that ratings are can be a very valuable internal benchmarking tool to guide decision making and improve sustainability performance. An evaluation by an external expert on your company’s ESG performance gives an independent view on performance, and how it compares to competitors and peers. This can be a powerful incentive for taking action and steps towards increasing performance.
Further, the assessment can provide a valid source of information to help internal advocates to promote change – as well as highlighting areas of particular weakness and strength.
A word of warning
A lack of consistency between rating provides’ scores has been picked up as a key short-fall of ESG ratings, with a company’s score sometimes differing significantly between providers. Critics have highlighted a need for methodological standardisation across the sector in order to build objectivity and credibility.
It is worth keeping in mind that in generating an ESG score, providers are often attempting to quantify the intangible and hard-to-measure, so the expectation of ESG scores should be realistic: it is a starting point, you get an indicator but not the whole story.
In our experience, delving into the more granular scores (for each part of E, S and G, as well as further breakdowns) can be incredibly useful for our clients. This analysis reveals the areas of perceived strength and weakness in relation to their sustainability strategy and programmes, and positions these within the wider industry group. The wealth of information under each ESG pillar can then be used strategically to set the direction of a company’s strategy and disclosure, not only improving ESG scores, but also raising overall sustainability performance.