The Expanding Report Card for Companies: Fast Adoption of ESG Ratings
A company’s “ESG performance” as an investment factor in stock and fixed income selection has been evolving rapidly over the last five years. Considering a company’s ESG performance is now mainstream for European funds and catching on rapidly in the U.S. and elsewhere, companies that do not proactively address this trend are at a significant risk to be left behind by investors.
The ESG performance review judges how well a company is managing risks related to environmental, social and governance (“ESG”) issues that may have a material financial impact over the long-term. Specifically, this is the framework that most firms are using to rate companies on ESG performance (“ESG Rating Firms”).
This increasing focus on ESG performance is in part driven by investor and social pressure and in part by the competitive nature of the fund management business; once one steps on the bus, everyone else feels they are at a competitive disadvantage if they do not follow suit. The total number of funds which claim to consider ESG performance as part of their investment process is rising rapidly. For example, more ESG-themed ETFs were launched in 2018 than non-ESG themed ETFs in the U.S., and this has continued in 2019.
Today, there remains a significant difference between qualitative versus quantitative adoption of ESG screening. The qualitative piece is a much easier path for investors and involves the wholesale avoidance of certain industries deemed undesirable (e.g. tobacco), as well as an increased focus on proxy voting and engagement with companies to identify their ESG shortcomings and ask for change.
To Come, a Quantitative Framework
The quantitative approach is still developing. Investment managers primarily rely on ESG Rating Firms to provide a quantitative framework and rate companies on ESG performance. Today there are more than 100 ESG Rating Firms: an unsustainably high number and a major cause of confusion for companies. The number of EGS Rating Firms is also a deterrent to some managers, as no two ESG Rating Firms have the same methodology and produce the same ratings. Most are requesting ESG data from public companies and this collective “ask” is creating an overwhelming workload. Our expectation is that this will be a short-lived problem, with investors (and consequently public companies) focusing on only a handful of ESG Ratings Firms, with the survivors being those favored by the index providers and the funds which use them. For example, RobecoSAM, an international investment company with a specific focus on sustainability investments, is now almost guaranteed a seat at the table, with S&P choosing to use its data in creating the suite of S&P ESG indices in early 2019.
Equally interesting is the S&P approach, which is to attempt to keep industry balance in the new indices, by cutting the bottom 25% of ESG performers in each sector. This minimizes tracking error versus the mainstream S&P indices. S&P has also removed some industries (those involved in controversial weapons and those with significant tobacco exposure) but has otherwise, for the most part, looked for the lower-performing ESG companies within each sector.
Two likely trends should be very much on public company radar. First, the ESG investing push will continue and become mainstream globally. Growth is likely to be driven by index funds, given investor’s appetite and given the high cost for an active manager of doing something proprietary and hard to recover in a shrinking fee world. Second, the focus will start to shift as the metrics for ESG performance improve, and consensus develops around which metrics matter across and within industries. Even today, the focus is on ESG disclosure; tomorrow the focus will most likely shift to ESG metrics and performance. Today it is not good for a company to be excluded from an ESG index, especially one based on a proxy that has historically seen substantial success at attracting assets (such as the S&P 500). Tomorrow, staying in an important ESG index may be driven by ESG performance, as opposed to ESG disclosure.
Public companies will need to ensure that they are monitoring and actively providing feedback to ESG Rating Firms, as well as embarking on a plan to create a path to the highest possible ESG rating for their company.
Active and Passive Channels
As the traditional investment management world has divided into the active and the passive channels, so will ESG investment initiatives. Indexes are appearing, but they have been slow to materialize, in part because of confusion over how to structure ESG index funds that can compete with traditional index funds on cost and performance basis. In addition, with so many current ESG Rating Firms, often featuring very different information, it has taken time for index providers and mutual fund providers to get comfortable with what they are offering.
In 2018, many of the active managers of equity ESG funds in Europe claimed victory as their funds for the most part outperformed the broader markets. It can be argued that this might have been more a case of luck than good judgement, as commodities and commodity-driven equities had a poor year. Most active ESG managers are underweight these sectors and this likely contributed to the win. While this perceived success may provide some short-term bragging rights for the active managers, it is still likely that the low fee indexes will begin to dominate ESG investment inflows as they have in the industry in general. The introduction earlier this year of the S&P 500 ESG index, as well as other S&P ESG indices may be an important point of inflection. S&P has focused on performance and tracking error versus the broader indices against which the ESG indices are constructed and consequently has largely driven the composition of the ESG indices by sector – maintaining the same sector weightings as in the broad index. In short, S&P has not cut the bottom 25% of ESG performers; it has cut the bottom 25% of ESG performers within each sector. Companies with lower scores may survive versus those with higher scores if the sector has a lower average. This allows the ESG index to show limited tracking error versus the larger index and is part of the marketing pitch.
Active managers are, for the most part, taking one or more of several approaches:
- There are aggressive ESG funds that will simply not own any companies engaged in tobacco products, weapons and increasingly “dirty” energy and other polluters of either the air or water. They are taking a stand and performance is a secondary concern. Today the more aggressive have limited assets, but there is a significant pool of assets boycotting tobacco and a growing pool boycotting weapons.
- Others are using third party and/or internally-developed ESG Rating Firms to screen out certain companies or sectors, but for the most part, are not taking big sector bets as performance is still the focus. Most are much more aggressive when it comes to proxy voting and engagement with the companies they own – pointing out changes that they would like to see.
- Others currently take a pseudo-quantitative approach and assume that low ESG scores translate into greater risk and consequently adjust valuation (terminal values in NPV models, forward multiples, etc.) to reflect that risk. This lowers target prices (selling triggers) for stocks they own and reduces the possible upside in stocks they might be considering.
The process is still more art than science today, in part because of the less tangible nature of some of the ESG data and the inconsistency between ESG ratings firms. This will evolve, and probably quite quickly, and it is likely that the number of relevant ESG data and ratings providers will shrink to a handful, dominated by those favored by the index creators and the large ETF managers.
For those indexers using a third party to determine the composition, public companies are further removed from the decision makers. If Vanguard creates a fund based on the S&P 500 ESG index, the decision on whether a stock is included is neither Vanguard’s nor S&P’s. The company making the decision is RobecoSAM, three steps away from the public company and most likely faceless to the company, except for their annual Corporate Sustainability Assessment.
While most of the focus is on equities, there are some ESG fixed income funds, but the business is less developed to date. Bloomberg has created fixed income ESG indices.
What of ESG in the Future?
Today’s landscape is unlikely a good proxy for the future. While funds under ESG management will almost inevitably continue to grow, companies should prepare for three distinct trends and one risk:
- A tightening of the definition of ESG Performance, especially in the E&S
- In Europe, the EEC Legislative Proposals on Sustainable Finance is an attempt to put detailed and consistent definitions around many of the measures – a move supported by many fund managers in Europe who welcome the clarity.
- In the U.S., performance metrics for each will largely be determined by third-party ESG disclosure frameworks, such as the Sustainable Accounting Standards Board (“SASB”) and the Task-force for Climate-Related Financial Disclosure (“TCFD”).
- Significant pressure on companies to increase disclosure to meet these tighter definitions:
- Today “inclusion” and “exclusion” from indices is largely determined by the level of disclosure and this is a strong incentive for companies to comply – and will only strengthen further if there is a measurable increase in the money flowing into ESG active funds and ETF’s.
- A shift from ESG investing based on what companies are disclosing, to ESG investing driven by how much companies are improving their ESG performance:
- Change (and rate of change) will most likely become more important than disclosure.
- The risk would be the broadening of industries that are in the penalty box regardless. Today the industries that tend to be excluded from ESG funds include tobacco, weapons (either in general or “controversial,” in the eyes of the S&P indices) and sometimes coal:
- With the ever more vocal climate change lobbyists and their impact on investors, fossil fuel more generally could come under threat rather than just coal, and we could also see greater focus on mining, power generation and cement manufacture.
The third point above is likely the ultimate goal of those looking for a soap box to discuss responsible investing in a more action-oriented manner. Those companies being excluded from ESG indexes today because of their lack of disclosure are reacting and improving disclosure. When the determinant becomes the quantum of what you are disclosing rather than the fact that you are disclosing it, it will be easier to set goals and benchmarks – whether it is greenhouse gas-related, or waste-related, or board diversity.
Furthermore, with the right branding and the right consumer sentiment, ESG funds could outperform for years, simply based on money flow and the different supply/demand dynamics that flow creates for the stocks in favor and those out of favor.
Any broader application and acceptance of EGS drivers which result in measurable valuation differences between the “haves” and the “have-nots” could then drive a number of secondary actions. Credit ratings could be impacted, M&A could be driven by opportunities to improve ESG ratings, and activists could use the potential to change ESG ratings as a reason to get involved in certain stocks. Other more tertiary consequences could be increased private ownership of companies in inherently bad ESG industries (once the stocks are cheap enough on a cash return basis), and a possible talent drain from companies if the broader workforce is discouraged from working for low ESG companies. None of the above bodes well for companies with low ESG ratings.
Preparing for an ESG Investing World
While ESG investing is a trend that is here to stay, companies do not have to sit on the sidelines. And those that do will miss significant opportunities to enhance their relationship with key stakeholders, including investors. Companies can take any or all of these steps now:
Be proactive about better understanding your company’s ESG ratings. Dedicate internal resources and form a cross-functional team to survey and analyze the company’s primary ESG ratings and feedback opportunities. There may be relatively easy short and long-term opportunities to enhance your ESG rating.
Benchmark your company’s ESG disclosures against an appropriate ESG disclosure peer group. Understanding what your peers are doing is critical given that a company’s ESG rating are largely relative to its peers. This means that standing still on ESG disclosure likely means that your company will lose ground as your peers continue to evolve.
Understand and monitor the primary ESG disclosure frameworks. While ESG disclosure is not mandated in the U.S., investors and other stakeholders have become strong advocates for certain ESG disclosure frameworks, such as the Sustainable Accounting Standards Board. Understanding these frameworks and incorporating them into your ESG disclosure plans is imperative to telling your ESG story.
Develop an ESG communication plan with your stakeholders, including the board of directors. ESG should be included in any stakeholder engagement strategy, including with investors. This will help inform the company’s ESG strategy. In addition, investors will expect the board of directors to be overseeing a company’s ESG initiatives and be able to communicate the company’s ESG priorities to investors.
A poor ESG rating can have a tremendous impact on your company - from negatively impacting the fundamental analysis of your company’s stock, to excluding your company’s stock from an ESG-themed investment product, or even impacting your company’s credit rating. It is therefore critical that all companies review and monitor their ESG ratings on an ongoing basis. While companies cannot possibly be everything to everyone, they cannot sit on the sidelines either. Companies need to be actively engaged in telling their own ESG story. If they are not, others will surely tell it for them.
Debunking Common Myths About ESG Investing
Understanding ESG investing can be very confusing for companies given the lack of common definition of ESG investing, the relatively low level of transparency of ESG funds, and the fragmented marketplace of ESG ratings and data providers. This confusion has resulted in several common misconceptions of ESG investing that we attempt to clarify below.
“We never get ESG questions on our earnings calls. So, our investors do not care about ESG.”
It may be true that sell-side analysts do not focus on ESG issues during earnings calls. It also may be true for portfolio managers and research analysts at active investment firms. But the ESG investing trend is not being led by either of those sets of individuals. Instead, it is being driven by passive managers like BlackRock, Vanguard and State Street – the largest investors in the world that collectively own a significant percentage of any public company’s stock today. The influential third-parties that investors utilize – including ESG Rating Firms and index providers – are also not typically on earnings calls. Finally, the governance teams at investment managers who help determine proxy voting decisions on ESG issues are also often not on earnings calls. So, the fact that earnings calls are relatively quiet on ESG issues is not a good proxy to gauge the importance of ESG issues to investors today.
“ESG ratings have no real impact on our stock.”
This is perhaps an accurate statement at this time. The amount of money invested in ESG index products today is relatively small. But over the longerterm, this will prove to be untrue. As we have discussed above, a company’s ESG ratings may be determinative as to whether its stock is included or underweight in an ESG index fund or not. For example, the new S&P 500 ESG Index excludes over 150 companies due to their poor ESG ratings from RobecoSAM. Investment managers will certainly produce more funds benchmarked to the S&P 500 ESG index to satisfy demand from millennials and others as issues like climate change become part of the mainstream geopolitical debate. Even if a small portion of the $10 trillion in assets benchmarked to the S&P 500 moves to the ESG S&P 500, it will certainly have an impact on your stock price.
“We will never get a good ESG rating because of the industry we are in.”
It is true that certain companies (e.g. tobacco) will be excluded from certain ESG portfolios regardless of their ESG rating. But outside of that small number of industries, ESG portfolios often contain a perhaps surprising list of companies. This is because most ESG ratings are done relative to an industry peer group. For example, if an ESG fund permits holding of energy companies (which most do at this time), many energy companies can be included in that fund if they are rated well by the ESG Ratings Firm relative to their peers.
“ESG investing is just a fad in the U.S.”
This was absolutely true 10 years ago. But today, we see mainstream investors embracing ESG in a big way – BlackRock, Vanguard, SSGA, Fidelity. For example, there were more ESG ETFs launched than non-ESG ETFs in 2018. Both active and passive managers have significantly expanded their ESG investing and governance teams. In addition, other mainstream companies are strategizing to expand their footprint in the ESG investing case, such as Moody’s, MSCI, S&P and Bloomberg. ESG investing has clearly made it to the mainstream investing marketplace.
“ESG disclosure is not required, so we don’t need to disclose.”
In the U.S., this statement is also true, as there is no current ESG disclosure framework required by law. However, Europe is a different story as regulators have been mandating certain ESG disclosure for many years, and those initiatives continue to expand. This has a real impact on U.S. companies because the many ESG ratings compare U.S. companies with non-U.S. companies on ESG disclosure, putting U.S. companies at a disadvantage. In addition, ESG disclosure initiatives such as SASB and TCFD are heavily supported by investors, making them a de facto requirement for all public companies.
We strongly believe that no public company can ignore the global trends in ESG investing and ESG Ratings. Like it or not, your company will be rated on ESG performance and investors will be using those ratings to help inform buy/sell decisions, as well as proxy voting decisions. All companies need be proactive and prepare for a world where ESG investing is top of mind for their stakeholders, especially investors. Those companies that do not will undoubtedly have their stock price impacted.