ESG ratings have become a common instrument to measure companies’ performance.
Firms achieving high ESG ratings attract investors, lower their cost of capital and attract talent. Moreover, if your company doesn’t share material information, rating agencies will penalize you and trillions in global institutional and retail capital will flow away from your firm.
Therefore companies pour thousands of hours into creating beautiful sustainability reports, filling investors surveys and engage in one-to-one meetings with shareholders to discuss ESG topics.
But with more than 600 ESG ratings and 4,500 metrics, a bit of a wild Zoo, is there anything that firms can do to improve their scoring without drowning in an “alphabet soup” of standards, frameworks and ratings?
In this article you will learn about companies’ shift in purpose, what are and hot to improve ESG ratings and the future of ESG.
Purpose-driven companies
There are two megatrends behind the rise of sustainable finance and ESG ratings; the shift in companies purpose and the rise of intangible assets.
Shift in purpose
Companies focus on value creation has changed dramatically over the years. This shift is reflected in companies’ mission statement, a paragraph that explains the existence of a business.
In the 1970s, mission statements centred on firms becoming the best (e.g. Honda: “We will destroy Yamaha”). In the 1990s, the focus was on quality and in the 2000s was on customer-centricity.
Over this period, companies’ primary goal was to generate profits for investors. This theory is known as Milton Friedman’s shareholder capitalism doctrine.
In the last decade, pressure from employees, customers or regulators to reduce ‘negative externalities’ such as carbon emissions has pushed companies to rethink their purpose.
Companies that don’t move fast enough or remain silent risk having their products rejected and reputations damaged.
Purpose-driven companies aim to create value by positively impact the planet and society while producing profits. This theory is known as stakeholder capitalism.
The importance of focusing on stakeholders interests was behind the failure of the Football Super League. Football club owners announced the intention to create a competition between top clubs without considering the impact on their stakeholders. Pressure from angry fans, players, and coaches made that clubs shares plummeted, with Juventus dropping 11% of their value. On top of that, clubs face millions in financial penalties. Even JPMorgan, the bank financing the operation, declared regretting its support.
“We clearly misjudged how this deal would be viewed by the wider football community and how it might impact them in the future. We will learn from this.”
JP Morgan
Rise of Intangibles
The shift in companies value creation has contributed to the incredible rise of intangible assets such as human capital, customer relationships or brand value. In 2020, intangible assets were 90% of S&P500 value compared with 17% in 1975.
Moreover, intangibles assets such as corporate reputation are more prone to be affected by climate risks or social justice making ESG issues material for companies and shareholders.
Sustainable Investment and ESG ratings
The rise of intangibles that are much more sensitive to environmental and social issues has played a crucial role in the growth of investment which considers Environment, Social and Governance factors (ESG investment).
ESG investment has almost doubled over the last four years, reaching $40.5 trillion in assets in 2020 (2021 sustainability trends).
Institutional investors, asset managers and financial institutions increasingly request ESG data to understand how the company generates profits and benchmark its performance in material ESG themes with its peers.
Traditionally, rating agencies like Standard and Poor’s Global Ratings (S&P), Moody’s and Fitch Group have been guiding investment decisions by assessing firms’ financial strength.
The increasing demand for ESG data has pushed rating agencies to incorporate ESG topics into their credit rating methodologies. Moreover, agencies acquired entities that have brought ESG knowledge in-house. As an example, S&P bought Trucost and the ESG rating business from RobecoSAM.
Examples of ESG ratings and rankings are Dow Jones Sustainability Index (DJSI), Institutional Shareholder Services (ISS), MSCI, CDP, Sustainalytics or Ecovadis.
Benefits of ESG ratings for Investors and Companies
Investors use ESG ratings to estimate companies’ value and the risks associated with their business. In particular, companies with high ESG ratings should present lower risks.
An interesting trend is the increasing number of investors using passive ESG investing products. In this strategy, Managers of ESG index-tracking funds (e.g.ETFs) use ESG Ratings as part of their methodology.
As a consequence of this trend, multinationals whose shares are held by pension funds or prominent passive asset managers interested in ESG-friendly investing are already feeling the pressure.
ESG ratings also have value for the companies. A high ESG rating is a market recognition of the firm’s social responsibility efforts and performance, which helps to improve brand image.
Besides, ESG questionnaires increase the importance of ESG management throughout a company provoking internal debates. These debates often lead to the discovery of opportunities to generate competitive advantage.
Above all ESG ratings drive companies to strengthen their stakeholders’ relations, increase investment, lower their cost of capital, and drive strategic decision-making.
ESG ratings Zoo
There are +600 ESG ratings and rankings, 4,500 ESG KPIs and several ESG-related research from other organisations such as investment banks that can be used to produce ratings according to WBCSD.
The issue is the low correlation (0.61) among ESG ratings vs the 0.99 correlation between Moody’s and S&P’s financial credit ratings (MIT Sloan’s Sustainability Initiative). This low correlation represents a challenge for investors trying to contribute to an environmentally sustainable and socially just future.
The different methodology, scope, and coverage used by ESG rating agencies is one of the causes for the low correlation.
Rating agencies define ESG in different ways to offer customized products to their users. Some investors may care about water stewardship and others about renewable energy. Therefore, investors need to understand exactly what the rating takes into account.
Another cause for low correlation is the low quality and availability of data received from companies. Agencies try to fill data gaps by extrapolating or making assumptions that produce inconsistent and sometimes incoherent ESG ratings.
“ESG ratings… it’s a bit of a zoo”
Peter Bakker, WBCSD’s President and CEO
Example: Tesla rated bottom 10 per cent by JUST Capital and “A” grade from MSCI. The problem is the lack of standard ratings and the lack of confidence in the underlying data.
It took the financial world 30 years to align on standards and to achieve data that is comparable, consistent and reliable. We don’t have that luxury of such time but we need to understand that the process will take still some time.
Standing out in a wild Zoo
Accelerating the pace of homogenization of standards and rating methodology is something that companies can influence by publicly advocating for it.
Besides advocacy, most experts will agree that the first part is for the firms to work on crafting its ESG story.
Don’t let media, consumers or investors write your company’s purpose and ESG story. Take control of the ESG data narrative.
Furthermore, to be credible, you should back your ESG story with consistent, material and relevant data.
For that purpose, I propose four steps to consider for improving your ESG ratings.
Step 1 – Materiality Assessment
Investors want to know that a firm has considered the problems that have a significant effect on its finances and its ability to survive as a business.
As a result, the first step is to complete a materiality analysis. The assessment identifies what “material issues” the company needs to report and serve as an input for the company strategy.
Material problems are unique to each organization and industry. Each firm should decide what is essential to its industry, community, values, stakeholders, and business model in an ideal world. An external supplier can assist you with the assessment by leveraging available research, peer benchmarking, and a robust stakeholder survey.
Besides, SASB Standards can be helpful to identify the subset of ESG issues most relevant to your company’s financial performance in your specific industry.
Focusing on improving ESG performance in material topics offers the greatest chance of improving the company’s ESG rankings and ratings.
Notice that material topics are dynamic. Imagine the relevance of the subject of remote working three years ago vs currently. Therefore, best practices advise performing an assessment every 1-2 years vs the typical 3-4 years in the past.
Step 2 – Prioritize and develop capabilities
Businesses reporting their ESG performance metrics are trying to satisfy increasing investor and stakeholder demand for more and better data. Meeting this demand is especially challenging due to the number of standards, frameworks, reporting platforms and surveys. As a result, disparate information may be reported across companies in the same sector. Similarly, companies could report different data points from one year to the next.
Develop a general understanding of the various frameworks and standards available for measuring, managing, and reporting sustainability information. Talk to your company’s key investors. And finally, research industry practices and your competitors to allow you to prioritize and set goals.
Then the company needs to establish a strong ESG governance structure. Setting proper governance ensures that there are sufficient and effective ESG management policies and systems, internal controls, goals and targets, KPIs and implementation measures to improve ESG performance and ratings over time.
Step 3 – Improve data quality
55% of respondents stated that lack of robust data is the most significant barrier to greater adoption of ESG strategies (BNP Paribas).
Besides, only 29 per cent of S&P 500 companies utilized external assurance for their sustainability data.
Therefore, your goal should be to apply to your sustainability data the same level of scrutiny and rigour your company uses in the metrics used in financial reports, and public filings.
Specifically, to produce investment-grade ESG data, you should aim to produce data that is:
- Material: Data that reflects what is necessary for the company. Avoid over-reporting on non-material information.
- Comparable: Data that is comparable across companies and industries.
- Accessible: Provide data that can be accessible to investors and other stakeholders in different formats.
- Reliable: Data that has high-quality assurance. Think about the gap between the level of assurance of current company financial statements vs the sustainability data.
Producing this data requires tools, developing capabilities, and increasing collaboration (or even integration) between sustainability and finance teams.
Step 4 – Engage with investors
During investor meetings, the last few minutes were dedicated to discussing sustainability topics. For that task, a special sustainability rating analyst was called to discuss with the company’s ESG expert. These days, more and more analysts are equipped to inquire companies on major ESG topics such as climate change, governance or social issues.
Also, investors and NGOs expect that boards of directors are fluent in discussing key environmental or social issues in the company sector.
Stakeholders are trying to understand where you are, where you want to go, and how you will make it happen.
The more your company can show its purpose in delivering value to its customers, its employees, and its communities, the better able you will be to compete and deliver long-term, durable profits for shareholders.
Larry Fink, Chairman and CEO, BlackRock
Besides the information that companies share by pouring thousands of hours to collect and publish, rating agencies use alternative sources. They use financial transactions, sensors, mobile devices, satellites or artificial intelligence to analyze unstructured data from social media or news. In the case of MSCI, for example, 45% of their data comes from these sources.
Therefore, it is essential that the ESG story comes out naturally, with a consistent message across all communication channels.
Future of ESG ratings
During the last year, standards bodies and framework setters announced their intention for harmonizing ESG metrics.
The International Financial Reporting Standards (IFRS) Foundation is leading the most important initiative to improve ESG data and rankings. The IFRS presented during COP26 the creation of the International Sustainability Standards Board (ISSB) to drive international consistency of sustainability-related disclosures. The ISSB published two prototype climate and general disclosure requirements described by some as the biggest change In corporate reporting since the 1929 stock market crash.
Besides, the Value Reporting Foundation and CDSB announced their merger. Finally, SASB GRI, CDP, CDSB, and the IIRC published The Statement of Intent to Work Together Towards Comprehensive Corporate Reporting. The creation of the ISSB and the statements are leapfrogs towards improving data quality and reducing ESG survey fatigue among companies.
Likewise, policymakers are taking steps into shifting voluntarily to mandatory disclosure.
Many experts regard mandatory disclosure as a way to promote peer competition and avoid greenwashing by companies and the financial services industry. Besides, it may improve companies’ board and executive accountability.
Supporting the IFRS Foundation’s new sustainability standards board must be a top political, business, and investor priority.
Paul Polman, Unilever’s former CEO and co-founder and chair of IMAGINE
An example is the EU’s Corporate Sustainability Reporting Directive (CSRD, previously Non-Financial Reporting Directive) and its Taxonomy. The CSRD will produce the world’s science-based classification on what should count as sustainable investment. Additionally, the US Securities and Exchange Commission (SEC) observed that investors demand more and better ESG information. SEC highlights that current voluntary frameworks are not meeting that demand. The announcement indicates a possibility of a mandatory framework for climate-related disclosures similar to the assurance for financial statements.
Let’s hope that these initiatives converge and the IFRS succeeds in getting support from companies, investors and governments. It would become an excellent baseline that allows the production of quality data. Ultimately, better data will allow better ESG ratings that move capital and global action in the right direction.
Conclusions
- Companies shift in value creation contributed to the rise of intangible assets that are very sensitive to ESG issues.
- The demand for ESG information has driven ranking agencies to develop new ESG rankings.
- The lack of standard ranking methodologies and the quality of available data is a problem for sustainability progress.
- Companies can play their part in improving the quality and the materiality of the data they share.
- Future developments in the area include standards and framework harmonization and push from policymakers for mandatory ESG reporting.
Despite the market imperfections, millions of people invest trillions of dollars in a more sustainable future. This commitment plays an increasing role to put ESG themes on the companies, policymakers and politicians agenda.
We don’t have thirty years to have everything perfectly aligned.
Let’s be vocal about providing just the right quality data needed by stakeholders and focus on action where companies create value for shareholders, people and the planet.
