Forget ESG scores – investors need the whole story on sustainability strategy

Jun 1, 2021 | Articles, Monthly Briefing

ESG data is booming. As the global sustainable investment market reaches new heights, so does investor demand for data on companies’ environmental, social and governance (ESG) performance.

The ESG ratings landscape, once dominated by specialist agencies, has been transformed by the entry of established financial information providers such as S&P Global, ISS, Moody’s and Morningstar. Far from the “black box” ratings they used to be known for, providers now compete to offer the most granular data to investors – from Bloomberg’s new ESG scores, to S&P Global’s publication of underlying data from the Dow Jones Sustainability Index (DJSI) assessment.

For companies, this means an increasing amount of resources are dedicated to ESG disclosure. Narrative sustainability reports have become bottom-heavy, backed by lengthy appendices full of ESG data disclosure tables. Some companies, such as Novo Nordisk and Anglo American, have resorted to publishing Excel spreadsheets on their websites, to meet the conflicting requirements of multiple ESG rating agencies.

What rewards justify this level of effort? First of all, the undeniable fact is that investors pay attention to ratings. According to a survey by Edelman, for example, 98% of US institutional investors use ESG rating agencies as part of investment decisions or valuation criteria. Investor relations teams now come prepared to answer tricky questions on ratings performance.

The second, less-appreciated factor, is that ESG ratings are powerful internal tools. Corporate sustainability teams use them to benchmark with competitors, monitor trends, identify performance gaps and inform reporting. They are often also an effective vehicle for internal engagement – where senior executives’ eyes may previously have glazed over at the mention of sustainability reporting, they now light up when S&P or Bloomberg is mentioned.

Yet companies also face significant frustrations with ESG rating agencies. Common complaints, captured by a study conducted last year for the European Commission, include a lack of transparency and comparability between methodologies, a lack of contextual understanding or expertise on the part of ratings analysts, and a lack of responsiveness when inaccuracies are identified.

Many ESG raters also look beyond company disclosures to so-called “alternative data” sources, including media and NGO reports, regulatory databases, anonymous employee reviews, climate risk maps and even satellite data. These sources help rating agencies to fill in data gaps and differentiate from competitors. But for companies trying to influence ratings and communicate their strategy to investors, it can start to feel like their side of the story is being ignored.

On this point, companies should feel reassured. Investors are well aware of the limitations of external ESG ratings and data providers. Many large asset managers have sophisticated in-house teams, who combine ratings and data from multiple sources with their own research and insights. The Russell Investments 2020 survey of asset managers reports “signs of asset managers increasingly combining externally produced ESG data with internally produced ESG metrics to form ESG views on specific investment opportunities”. The most frequent sources of ESG information were identified as direct engagement with companies (77%), followed by company reporting (71%) and then by external ESG research vendors (63%). And when asset managers were asked as part of the EU study about the most valuable sources of ESG information, they stated that “meetings with companies generally provided the most useful information, along with in-house analysis. There was no mention of ESG ratings providers by any of the 22 asset managers who responded to this question.”

Direct engagement with companies gives asset managers an opportunity to surface material ESG insights, in an increasingly competitive landscape. According to Edelman, over 90% of US investors say they are “likely” to engage with boards during the 2021 season on ESG aspects, including climate risk, resource scarcity, human capital management, employee health & safety and diversity & inclusion. They are growing their ESG engagement teams accordingly. For example, BlackRock now reports that it has 50+ people in its global stewardship team.

Another large asset manager that provides some further insights into its analysis and engagement process, is State Street Global Advisors (SSGA). SSGA has created a proprietary scoring system called “R-Factor”, informed by data from four established sources – Sustainalytics, ISS ESG, Vigeo EIRIS and ISS-Governance. Informed by this score, SSGA analysts seek to engage with companies on issues such as “how boards are developing ESG-aware strategies” and “how they are overseeing and incentivizing management to consider and measure performance of financially material ESG issues”.

This approach to ESG analysis, focused on questions of business model and management approach to risks and value drivers, is the part of the puzzle that is currently missing from many ESG ratings. It is the difference between identifying the companies that are best at disclosure, and identifying the companies that are best positioned to adapt and succeed in the long term.

For the future of ESG ratings, look no further than the “big three” credit rating agencies, all of whom are looking to fill their traditional roles as purveyors of trusted third-party opinions, now in the arena of ESG. Credit ratings have always been formed through a mix of quantitative financial analysis and qualitative insights, gleaned through direct engagement and industry expertise. Fitch and Moody’s are now publishing scores that quantify the impact that ESG factors have on their opinions. S&P Global is taking a less-quantified approach to its core credit ratings, while also offering a supplementary ESG Evaluation for companies that want a “forward looking, long term opinion of readiness for disruptive ESG risks and opportunities”. Expect these approaches to continue to grow and mature.

Companies should seize this opportunity. Yes, improve your data disclosure and align with ESG ratings methodologies. But don’t stop there. Ensure that you have a compelling story to tell about how ESG considerations are embedded in your strategy, and equip your investor relations team to tell it. Ultimately, ESG scores and transparency will become a stepping-stone to greater engagement and alignment with investors on the drivers of business value.