ESG Ratings: do they add value? How to get prepared?
ESG in defining value
Environmental, Social and Governance factors are becoming increasingly important not only due to the regulatory frameworks, but also changing priorities of banks, institutional and retail investors. Companies are redesigning their business models to adjust themselves to the changing environment. For many sustainable development is becoming an integral part of their operational and investment strategies without which further growth will be difficult to achieve. Recent experiences of the COVID-19 pandemic have shown that business models which account for the ESG factors are less exposed to the negative effects of technological or regulatory disruptions, thus ensuring long-term competitive advantage.1 Moreover, last months have demonstrated that companies which implement ESG aspects are often better prepared for crisis management. ESG data may help minimise the effects of the current crisis, accelerate recovery, spur innovations necessary to function in the new normal and reduce the risk of future crises.
Additionally, financial sector players that consider ESG aspects in their decision-making processes increase long-term investments in sustainable activities and business projects, significantly contributing to the mobilisation of capital necessary to achieve the goals of European Green Deal or global climate-related commitments.
As the demand grows, so does the importance of transparent and reliable data allowing assessment of investment options available. Leadership of companies in charge of more than one-third of professionally managed assets around the world worth over USD 20 trillion use ESG data to make investment decisions. Although these data may provide valuable information on factors that materially affect corporate financial ratios, their analysis may pose a problem due to limited access. Even if available, the data often present historical view as opposite to the current standing, and additionally, the qualitative approach, which disallows the traditional analysis method applied to financial data. Thus, ESG rating agencies grow in importance. Investors, asset managers, financial institutions and other stakeholders increasingly rely on ESG assessment and rankings. Biggest investors expect active and responsible ESG approach from their investees and are more interested in financing the ones demonstrating good ESG performance. 65 percent of investors declare to use ESG assessments on a regular basis, at least once a week.
On the way to standardisation
Over the past decade, corporate ESG performance have been closely correlated with their investment value, in particular with the perceived risk level. Institutional investors prefer companies that demonstrate lower risk levels, higher return and external demand. Those interested in identification of companies that meet these requirements may often find ESG ratings useful. In the period 2011-2018, the share of S&P 500 companies that published information on their sustainable development, ESG initiatives and performance increased from less than 20 percent to 86 percent.
There is no one-fits-all methodology to analyse ESG data used by rating agencies. At present, there are more than 600 agencies operating on the market and often issuing different ratings concerning the same entity. Therefore, many investors subscribe and use several data sources in this respect. For ratings whose scope is smaller than other, or that include more data on a given sector or geography, using a few at once may help to fill the gaps.
Many investors admit they do not use ESG ratings directly to make investment decisions. Often they serve as the source of base data, used by investors to perform research, develop KPIs or scores that underlie their own assessment. In such cases, ESG ratings are the starting point to understand the business environment of a company and find its peers for comparison.
Since most ESG data are of retrospective nature, for rating agencies it is vital that companies introduce software that provides real-time data. Further, ESG rating users point out the need for continuous improvement in transparency and reporting. Investors want companies to focus on issues important from the business perspective and to more efficiently integrate ESG information with their financial statements.
By joining ESG ratings, companies may improve their relations with shareholders, increase investments, gain access to lower-cost capital and make strategic decision in a more effective way. Recently, consumers have exerted strong pressure on ESG aspects. Over 60 percent of people aged under 71 believe that all investments funds, not only those labelled as sustainable, should include ESG factors in their investments.2
How does the ESG rating work in practice?
ESG rating works similarly to credit rating. Credit rating agencies assess companies based on financial factors. Usually, their results are closely related and systematic owing to the use of similar, well-defined ratios.
Most analyses performed by ESG agencies are based on non-financial data. This allows more freedom in selection of aspects, areas and categories. Therefore, these agencies often base their work on a variety of indicators and less structured assessment criteria. Thorough understanding of the surveyed area is crucial, especially in light of the differing evaluation systems. Certain agencies follow the credit scoring pattern (AAA-D), while other prefer numeric scores. The latter also differ by agency; in some, the highest score is the best, while in other, the same high score may mean the poorest performance. The largest ESG rating agencies analyse all companies, sectors and regions. The scope of analysis differs by agency; most, however, focus on the broadly defined E, S and G areas. There are some specialised data providers on the market, too, who focus on specific aspects only, such as corporate governance. Most comprehensive data providers maintain communication with companies; certain, though, prefer using publicly available information only.
Basically there are three types of ESG rating agencies:
- Basic data providers: usually offer a broad range of publicly available, unprocessed data derived from corporate reports or websites. (Examples: Bloomberg, Refinitive)
- Comprehensive data providers: usually offer a combination of publicly available data (media, NGOs, corporate reports), own questionnaires and data processed by their internal analysts. Comprehensive data providers include all aspects of ESG. (Examples: Sustainalytics, MSCI, TruValue Labs, ISS ESG, Vigeo Eiris)
- Specialised data providers: most of them offer in-depth contextual data that include one or two ESG aspects. They are useful for investors who try to make progress in specific ESG areas. (Examples: CDP, TruCost)
Important aspects of good preparation for rating
Understand the research methodology and area analysed by a given rating agency. Remember that involvement of many organisational units is necessary to prepare well for rating. Collect data regarding the existing ESG policy or plans to adopt one. Your reporting and audit procedures should include all environmental, social and corporate governance factors and aspects. Reporting on and measurement of ESG efficiency of your business is also crucial. An analysis indicating key ESG-related business problems and including ESG in your corporate strategy will be necessary.
Contemporary businesses improve their understanding of how important ESG policies and practices are and strive to meet expectations of their key stakeholders, including employees and shareholders. As the awareness of ESG-related factors grows in companies, they are increasingly interested in pro-active and clear communication of their corporate responsibility initiatives.
The use of rating agencies may improve the reliability of actions related to a corporate ESG strategy. Companies may use their ESG risk assessment and data to obtain capital, carry out sustainability initiatives and to support their image, both internally and externally.
Regulatory context: sustainable financing agenda
Sustainable financing has been growing in importance. In recent years, a series of climate and energy related global initiatives, international and regional policies has been launched.
Over 2,300 signatories of UN Principles for Responsible Investment (PRI) holding collective managed assets in excess of USD 80 trillion have committed to include ESG issues in investment analyses and decision-making processes. Further, owing to UN support, such funds as CDPQ, CalPERS, PensionDenmark, Swiss Re or Allianz joined the alliance of net-zero asset owners having committed to transform their investment portfolios to become climate-neutral by 2050.
The climate policy framework is regulated in the European Union. Under the 2030 Climate Target Plan the European Commission assumed that by 2030 the CO2 emission level in the EU should drop by 50 to 55 percent compared to 1990. The zero-emission goal should be reached by 2050.
In January 2020 the European Commission adopted the investment plan for European Green Deal whose goal is to fund sustainable investments in Europe. The Commission pointed out the outstanding role of financial sector entities in the sustainable transformation of the economy. This involves new obligations to be accepted by these entities and the development of a new regulatory framework for non-obligatory activities. In March 2018, the European Commission adopted the action plan on financing sustainable growth. It assumes establishing a clear and detailed EU taxonomy, which is a classification system for sustainable activities, introducing clear guidance for investors regarding the inclusion of ESG risks in decision-making processes, as well as developing a new category of sustainability benchmarks for investors.
The Sustainable Finance Disclosure Regulation that came into force on 10 March 2021 is among the key EU regulations in this respect. Its provisions regard disclosures on sustainable development in financial services. The Regulation is aimed at obtaining greater transparency with respect to the analysis of sustainability risks inherent in business activities of financial market participants and financial advisers.
On 18 June 2020 the European Parliament and the Council adopted a regulation on the “green list” for sustainable economic initiatives, aka the Taxonomy Regulation, which provides a general framework to allow gradual development of a general classification system for environmentally sustainable economic activities.
The regulatory environment and stakeholders’ preferences affect the ESG approach adopted by private equity funds. In line with SFDR, investment portfolio managers will have to explain how their investment decisions affect ESG-related issues. By 30 June 2022 the funds will have to publish quantitative reports including 18 obligatory and 46 optional ESG ratios. The information is to be made public and displayed on corporate websites. Private equity fund managers will have to determine whether SFDR requirements apply to their current or future funds. Although the Regulation does not specify product related requirements applicable to the existing funds, they may be assumed to affect the current reporting. Although private equity funds have experience in the collection of financial data from their portfolio companies, the type and scope of ESG data needed to report compliance poses a new challenge.
1) Graphic: 'Sustainable' funds a safer harbour in coronavirus market meltdown | Reuters, https://www.reuters.com/article/us-health-coronavirus-funds-esg/graphic-sustainable-funds-a-safer-harbour-in-coronavirus-market-meltdown-idUSKBN21O1AF
2) Global Investor Study 2019 -Investing - Schroders global - Schroders https://www.schroders.com/en/insights/global-investor-study/2019-findings/investing/
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