- ESG is becoming “baked in” to publicly traded companies’ operations.
- Companies that focus on ESG have performed well during the pandemic.
- As sustainability extends further along supply chains, private companies will have to consider ESG too.
- Preparedness for ESG engagement pre-empts regulation.
- The rating system is not foolproof nor is there a universal standard methodology.
Central to corporate sustainability is the term environmental, social and corporate governance, or ESG. While sustainability and ESG are often used interchangeably, they are not the same.
Sustainability describes the broader concept along the lines of the United Nations’ 17 Sustainable Development Goals. (See United Nations.) As such, it’s open to interpretation (see Defining Sustainability), and framed like this it’s difficult to measure, for the reasons mentioned elsewhere. (See Sustainability-linked Finance).
On the other hand, reporting a company’s ESG activities encompasses criteria, methods and guidelines for collecting information about a company’s performance in those areas so that it can be compared with others, often in the same sector, in an accessible index. This helps investors target investment in companies that are within their ethical boundaries.
Origins of ESG
For several decades, large institutional investors, such as asset managers and pension funds, have analyzed the intangible or non-financial aspects of a company’s operations – and not only environmental concerns – to inform what are variously called responsible or ethical investments. This practice has grown rapidly since the beginning of the 21st century and is surely the main reason that the portion of S&P 500 companies publishing ESG reports has risen from around 20% to 90%, according to the Governance and Accountability Institute.
More recently, the utility of ESG reporting has spread to providing corporate transparency for shareholders and communities; forming the basis of a sustainability-linked loan application; laying the groundwork for a private company’s plan to go public or be acquired; and acting as a screening tool for private equity investors.
“We’re seeing a huge uptick in ESG ratings, whether it be for sustainability-linked finance [that companies] want to participate in, whether it be for internal risk mitigation … they want to tie it to executive compensation, or want to use [them] for communicating more proactively with investors and with communities in which they’re operating,” Melissa Menzies, part of the sustainable finance solutions team at Sustainalytics, an ESG ratings agency, told Lubes’n’Greases.
A Typical ESG Rating Model (Thomson Reuters)
Generating a Rating and a Ranking
As mentioned, the aim of an ESG rating is for shareholders, investors, end-users, the public, governments, regulators or NGOs to easily compare the sustainability performance of one company with another. A rating agency, of which there are more than 100 globally, analyzes publicly available information to create a score, which is then ranked on a list.
Each agency applies its own methodology to arrive at the score, but they are broadly similar. A long list of metrics – sometimes numbering in the hundreds – is developed from which analysts select a subset depending on the target company. These metrics are aggregated, weighted and scored to produce a key metric for each pillar. Positive sustainability actions are offset against what are known as controversies – for example, a waste spill, human rights violations or CEO corruption – to produce an overall score that can be used by a proliferation of indices developed by Dow Jones, Bloomberg and Thompson Reuters, among others.
Companies are not obliged to initiate an ESG rating but one or even several could already exist. Agencies and ESG-linked indices work at the behest of the investor and not the target company. But companies can be proactive about their ratings by taking the steps outlined in the sections on Materiality and Reporting.
A common model in the ESG ratings segment is for an agency to base its assessment on publicly available information, such as year-end financial reports, sustainability and CSR reports, shareholder presentations, news stories, press releases and websites. The target company may then be approached to provide feedback on the voracity of the data. This method is used by agencies such as Sustainalytics and Morgan Stanley Capital International and is referred to as “passive” by the SustainAbility Institute, a think tank set up by sustainability consultancy ERM.
By contrast, “active” agencies request information from target companies through methods such as questionnaires and surveys, which can be combined with public information to produce a rating.
As yet, there is no universal ESG rating standard or disclosure standard, but there are numerous frameworks that form a foundation. (See Frameworks):
- The UN 17 SDGs, Global Compact and Principles for Responsible Investment.
- Global Reporting Initiative, a sustainability reporting organization established in 1997.
- The Sustainability Accounting Standards Board, founded in 2011 to develop standards for disclosures in annual reports, financial filings, websites and sustainability reports.
- The Task Force on Climate-related Financial Disclosures, which in 2015 developed a set of recommendations to improve and increase reporting of climate-related financial information.
- The Equator Principles, a risk management framework for determining, assessing and managing environmental and social risk in project finance. They form the basis of the International Finance Corporation Performance Standards on social and environmental sustainability, and the World Bank Group’s Environmental, Health and Safety Guidelines.
Building the Case Further
As mentioned, for many companies the disclosure of sustainability information is in large part voluntary, except in the European Union (see Europe), where large companies must disclose certain information on the way they operate and manage social and environmental challenges. This helps investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and encourages these companies to develop a responsible approach to business.
Competition in the marketplace for ESG reporting means that larger cap companies may be rated across multiple indices.
“[ESG ratings] are totally woven into the fabric,” said Menzies. “And a lot of the companies I speak to now say they have as many as 12 to 15 ratings agencies reaching out to them. So, they’re having to prioritize the agencies they build a relationship with.”
Also, indices commonly group companies by activity, such as energy, agribusiness, financial services or fashion. Investors often search for companies by virtue of sector. This pits companies against competitors and adds extra pressure for a company to differentiate itself by improve its rating.
Gathering ESG information (non-financial) is a qualitative rather than quantitative process, unlike year-end financial reporting. This makes it a challenge to measure and verify data for several reasons.
On the agency side, ratings are generated retrospectively from sources such as company news. They are snapshots of a company’s performance at specific times in the past and are not inherently a signal of future direction or performance.
There are concerns for the consistency and accuracy of methodologies from agency to agency in a competitive sector that relies on voluntary disclosure. A company with an A rating from one agency may get a C from another.
According to the OECD report mentioned above, “ESG ratings vary strongly depending on the provider chosen, which can occur for a number of reasons, such as different frameworks, measures, key indicators and metrics, data use, qualitative judgement, and weighting of subcategories.”
The subjectivity of ESG rating, albeit a phenomenon that investment markets are used to, could worry stakeholders in the lubricant business who rely on clearly defined processes and standards throughout their operations.
One the company side, disclosures are voluntary, raising concerns about their reliability and completeness. They may follow one or more reporting frameworks, which makes the development of consistent metrics a challenge.
KPI requirements used by ESG ratings can vary greatly from country to country. In 2015, France was the first country to enact a law that requires public companies, institutional investors and asset managers to report their climate-related financial risks. The rest of Europe may follow suit.
Some, including the OECD and the Union of the European Lubricants Industry, assert that these issues could be resolved by universal standards for disclosure and reporting, with sector-specific subsets of criteria.
“The ESG ratings space is largely unregulated, market-driven, and firms are building their own methodologies,” said Menzies. “Eventually, there will be some type of common principles.”
Agencies do use universally accepted reporting frameworks such as SASB, the TFCFD and GRI, and there are moves to develop an equivalent by the International Financial Reporting Standards Foundation, which regulates accounting.
Another point is that publicly traded companies are more likely to be aware of their unsolicited ratings and who rates them, making them more comfortable with the concept, as well as in a position to mobilize resources to sustainability disclosure. Whereas smaller companies may be caught off guard. This could make them back away from ESG altogether.
In addition, there have been a few occasions when companies have provided feedback that was not integrated into what turns out to be a poor rating. This has a material effect on investor appetite.
More regulation and standardization are on the cards, as ESG and sustainability activities fan out across the economy. This can be seen in Europe with the pending EU Green Deal and review of the Non-financial Reporting Directive. The current directive makes sustainability reporting mandatory for all public interest entities (traded companies) with more than 500 employees, and that threshold could come down to 250 if recommendations are adopted.
There were 27.5 million active enterprises in the EU, according to the most recent statistics from 2017. Of those, about 6,000 employ more than 500 people, whereas 34,000 employ more than 250.
There is also a positive connection between implementing ESG measures and financial performance, further solidifying the business case for sustainability. Companies on the Corporate Knights Global 100 Most Sustainable Corporations have consistently outperformed and outlasted the average company on the MSCI All-Country World Index, according to Bloomberg.
It also appears that strong ESG performers have also survived the ravages of the global pandemic in good shape, too. Sustainable stocks attracted a record U.S. $51 billion in new investments, according to market research firm Morningstar.
“Interest in ESG has not waned at all from the investor side of the market,” Menzies said. “Strong ESG performers, ESG-tilted funds and ETFs, have weathered the storm of COVID better than their counterparts that didn’t have an ESG tilt and were not strong ESG performers.”
Finally, a question remains of why a company would focus on ESG if not primarily driven by investors. As discussed, ESG and sustainability are being baked into the investment market; they are likely to be mandated by law at least in some areas; it will likely grow as a prerequisite for credit; and managers who are simply concerned about climate change, population growth, urbanization and economic uncertainty want their business to significantly decarbonize, better serve communities and workforce and be able to function into the long term.