The emerging importance of ESG rating agencies

We recently had an interesting set of conversations with Charles Nelson, Head of UK at Morrow Sodali, about the role of ESG rating agencies and their impact on the investment decision making process. This guest post by Charles summarises key takeaways from recent Lighthouse publication and takes a look at ESG rating agencies, their focus and their influence today as well provides a few very helpful pointers for IR teams about engagement with investors on ESG topics.

Background

  • ESG ratings are becoming more prevalent and are commonly used by institutional investors in assessing the ESG performance of their portfolio companies.

  • According to the Principles for Responsible Investment’s (PRI) 2018 Annual Report, the total value of assets managed by institutional investors (AUM) who integrate ESG into their investment process is US$89.65 tn and is growing rapidly.

  • The sheer scale of the portfolios where ESG is integrated means that the largest global asset managers are increasingly having to rely on often external, quantitative assessment of ESG performance.

  • Just like the credit ratings, ESG ratings are based on past performance, whether policies, practices or in some cases controversies.

  • However, “ESG-worthiness” may not be as straightforward as credit worthiness, and the use of event indicators means that ESG agencies may penalize companies for controversies long after they have addressed and rectified the underlying problem.

  • Furthermore, unlike financial information that underpins credit worthiness assessments, ESG information varies a lot in scope and quality as international standardisation is in its infancy. For Emerging Markets, one key issue is that disclosure is often less extensive than it is in equivalent DM sectors and markets. The outcome may be that they could be penalised in their ratings for lack of disclosure, not for poor performance.

  • For this reason, understanding 1) the rating agencies and how they determine their ratings, and 2) how investors use these ratings, is essential when planning corporate reporting and it is recommended that it is based on shareholder outreach and engagement, to make the dialogue productive and efficient.

Rating agencies and their focus

  • ESG rating agencies use publicly disclosed information (ie that is broader than just the annual report, for example sustainability disclosure or information available on the company’s website). Additionally, especially when it comes to event indicators, indicators may draw on media and social media reports, and sometimes information gathered from direct data inquiries and requests (for example, via survey questionnaires).

  • Data points analyzed by the rating agencies typically depend on the materiality assessment they conduct on market, industry and/or company level with respect to Environmental variables, Social aspects and Governance areas.

  • Most of the large ESG rating agencies operate internationally, employing their own methodologies to generate their own ESG ratings. The raw data collected tends to be uniform across markets, with ratings then adjusted to reflect relativities. This means that data biases such as for size (eg indirectly penalizing smaller companies who usually have more limited disclosure), market or sectors (eg penalizing sectors with more pronounced environmental impact) are addressed but some could remain.                                                                                                         

  • While some ESG rating agencies are taking a more risk-based approach and therefore position themselves as a natural tool for investment decision-making, others employ methodologies that are more ethically driven.

  • While companies and their investors are typically aware of business material factors, the visibility of companies over reputational sensitivities of their shareholders and their beneficiaries is limited.

  • As a result, one of the first steps in the process of understanding the impact of the ESG ratings on a company and its shareholders is to ensure that the difference between the business materiality (value) and reputational risks (values) is acknowledged and addressed.

 

How do investors use ESG ratings?

  • Investors use sustainability ratings in their investment decision-making process, as well as investment management process and prioritization of company engagement.

  • The ratings are considered complementary to traditional investment processes and existing strategies, in that they allow investors to screen for good and poor ESG performers with the aim of reducing their risk exposure, particularly in the long term.

  • We are aware of a growing interest and in some cases use of ESG ratings in investors’ custom voting policies, use of proxy voting platforms with proxy research which allows investors access to ratings that can automatically determine their vote for a specific resolution, and as basis for engagement and targeted call for action to other investors.

  • An interesting trend to note is the rise of investors compiling and applying their own, in-house ESG assessment on portfolio companies. This is based on their own interpretation of raw data and in some cases also systematically capturing information gained through direct company engagement for internal sharing.

  • The rationale behind these initiatives, as we understand it, is that investors are aiming to put forward their own view of the ESG themes and on how it is applied to their portfolio companies.

 

ESG-focused engagement

  • Naturally, companies are wishing to optimize the communication with their shareholders and demonstrate responsiveness to consensus expectations, but to do this they need to have clear insight of the shareholder base. In Emerging Markets shareholder bases can be rather board, with a mixture of domestic investors and international ones.

  • As a roadmap to understand the ESG views and expectations of your shareholders:

    • MAP your existing shareholders – consider investment strategies, geographic spread, stewardship profile.

    • TARGET investors you wish to become your shareholders, even if their current level of holdings reflects an underweight position. Particularly important is to identify responsible long-term providers of capital – for example investors targeting “real world” impact that is within the scope of your commercial activity.

    • CLARIFY Gain clear and granular understanding of your investors’ agendas. Do your homework before reaching out - it will support higher quality of engagement.

    • EMBARK on a programme of ongoing dialogue. Do not confine the contact with investors to pre-meetings touch points.

    • EVALUATE – as regulatory appropriate and commercially possible – to share ideas with your investors and to consult on significant changes of direction.