ESG investor scrutiny and the impact on corporates: Limits of ESG ratings

In our first article in this series we gave an overview of ESG investing and discussed the challenge in evaluating whether or not an investment really belongs in a ‘sustainable’ investment fund.

Little visibility behind the scenes

Increasingly, many asset managers (and index-based passive funds) use ESG ratings or ‘ESG scores’ as a basis for an investment decision or as a tool to evaluate the legitimacy of including an issuer in a sustainable fund. ESG ratings may also be the starting point for broader analysis, to identify the areas of ESG performance where an issuer may be lagging or leading, or as the basis for questions during road shows. There are also sustainable funds that restrict the universe of investible issuers based on scoring (e.g. absolute cut-off for scores, or no issuers in the bottom quartile). By using ESG ratings, investors are able to quantifiably show their portfolios’ sustainability performance, and, therefore, issuers should expect greater usage of such ratings as part of the ESG analysis.

There are several providers of ESG ratings, each using different methodologies to determine scores, but generally based solely on a company’s publicly stated information, both quantitative and qualitative. While the specific methodologies are something of a ‘black box’, most claim to only consider the material issues for a given sector. Which data is used, how it’s weighted and how the eventual score is communicated varies, and is usually kept private to protect commercial aspirations.

A complaint from some investors is that ESG ratings are not comparable or consistently calculated by rating providers, restricting how that data is used to support investment decisions. In the same way that credit ratings provide a view on an issuer’s credit risk, ESG scores attempt to provide a view on issuer ESG performance. However, while there is some consistency in credit ratings, ESG ratings can vary greatly between providers. Academic studies have concluded with the same findings. For example, a study* by the MIT Sloan School of Management in August 2019, updated in May 2020, showed that scores by different providers of sustainability-related ratings had a low correlation among the main providers.

Engagement with ESG rating agencies is essential

For issuers, ESG ratings can be an efficient means to communicate to investors and other stakeholders their ability to identify and manage ESG-related risks and opportunities. To ensure an accurate assessment of their ESG performance, issuers can also take a proactive approach to managing their ESG ratings to demonstrate improvement (e.g. change in ratings over the years) or to identify areas to focus on via peer benchmarking. Regardless of the use of ESG ratings, evaluating corporate performance on sustainability issues and then distilling that performance into a score or rating is an important part of the sustainability movement. These ESG ratings allow an accessible understanding of which companies are leading and which are lagging in a particular sector, and more generally.

The current lack of uniformity and opacity of ESG rating methodologies can lead to confusion for issuers when explaining their sustainability performance to their investors. It may also be difficult for issuers to explain why areas rated as strengths or weaknesses are perceived to be so by a particular ESG rating agency. Therefore, it is important for issuers to engage with a set of key rating agencies that are most relevant to their investor base, to be able to understand ‘why’ they received the rating they did, how to improve it – and crucially – to explain it.

Getting direct feedback from stakeholders can help inform which agencies issuers should engage. Issuers can use these discussions to make sure that information that they do want to be public is easily accessible and clearly labeled, with a strong rationale for why non-public ESG data is private or why it is not material to their business. That said, robust, reliable and regular disclosure – best published as part of annual reporting cycles – is the optimal method of ensuring strategic initiatives filter into ESG ratings. Of course, this disclosure should be material to the issuers and underpinned by action.

Efforts to gain a strong ESG rating should not be seen as a substitute to any efforts to improve sustainability performance, but rather as a way to describe current performance progress in managing material ESG-related risks and opportunities. Similarly, ESG ratings should also not be seen as a proxy for developing (and implementing) a credible sustainability strategy.

An ESG rating is a dynamic indictor, which can change over time based on evolving methodologies, and as a result it’s common for ratings to rise and fall. This is particularly true for a sector coming under transformative ESG pressures. With this in mind, in the same way issuers should engage with the ESG rating agencies to understand the ratings, they should also maintain a constructive dialogue with those relevant agencies to highlight strategic developments which could drive an improved assessment and help them to understand the intricacies of a particular business. A constructive dialogue can also aid issuers in understanding broader sectoral views held by investors.

NatWest can support meaningful engagements

ESG ratings are a useful indicator but should not be the core driver for change. At NatWest, we are experienced in brokering meaningful relationships between issuers and rating agencies, helping to develop the right approach for communicating ESG strategies, while improving scores, and diversifying investor bases.

One benefit for proactive engagement, is that if an issuer solicits an ESG score from an ESG ratings provider, the issuer can provide and the ESG rating agency can consider private/ confidential information. Ratings are an important aspect of communicating sustainability, but issuers should not solely be driven to action by their ESG score.

We encourage issuers to have confidence in their disclosures and policies, and use opportunities during marketing of a transaction, for example, to continue their dialogue with investors on what issues are material and rationale for disclosures. This may become more important even for labelled debt issuances, as potential investors will want to better understand how specific projects (for use of proceeds bonds) or KPIs (for Sustainability-linked) align to the overall sustainability strategy of an issuer.

Key takeaways

Source: NatWest
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