What ESG investors want: ESG Ratings

In the 11th instalment of our “What ESG investors want” series, we considered, alongside investors, the benefits and flaws of external ESG ratings.

Hosted by NatWest’s Dean Shahfar from Debt & Financing Solutions, and Clement Houriez from Credit Sales, the panellists - Jonathan Walker, CFA at asset management firm, Gresham House; Marie Lassegnore, CFA at French investment company, La Francaise; and Aaron Young, CFA at RP Investment Advisors, headquartered in Toronto – agreed that ESG ratings are a good starting point in a world where the quality and availability of ESG data is still limited. However, investors’ credit research teams still play the key role during the due diligence process of investment opportunities.

“External ESG scores are often too high level, hence we turn to our credit research teams for ESG data, too. They help us identify an issuer’s or company’s material issues, and they have the tools to dig deeper into the available data or to gather further data for us,” Aaron Young commented on the typical investor’s selection process.

Other key take-aways from the specialists about ESG ratings and measuring ESG performance included:

  • Creating inhouse ESG scores: Investors’ own tools are usually based on 10-15 subfactors for each of the three pillars (environmental, social and governance), resulting in a questionnaire of roughly 50 questions that investors want answers to – in addition to sector data and information about material ESG issues. As data availability and granularity gradually improve, investors are expanding their ESG data-pool.
  • ESG scores and investment decisions: Exclusion criteria, such as the exclusion of certain sectors, are the first ‘hurdle’ before investors start looking at ESG data in a second step to determine the quality of an investment target. The third layer is crucial for the final selection: how is a company performing on ESG factors compared to its peers within the same sector and/or the same geography? This is where investors rely on the sector expertise of their credit research teams. While current data is important, it is the momentum over time that really matters.

To find out in detail where companies are on their sustainability journey, all three investors stressed that they are keen to engage closely with companies to provide an opportunity for them to tell their ESG story, which might not be fully reflected in the available data.

  • ESG scores and sectors: “Sector agnostic ESG scores will not work,” was the clear message from the investor community representatives. In their view, ESG rating agencies tend to cover a number of sectors really well but not all sectors. This is where investors leverage the knowledge of their credit research analysts. Furthermore, the three specialists pointed to the flaws of ESG scores which over-value environmental or socially focused sectors, which, by nature of their business, address environmental issues (for example, metal or mining) or social issues (for example, the social housing sector). This is where investors want to know explicitly what a company is doing on top of what would be expected from their sector anyway. Discussing hard-to-abate sectors, the specialists stressed that ESG investors are increasingly willing to look at companies’ transition plans in those sectors more carefully before deciding whether they stick to their exclusion criteria or actually invest.
  • ESG scores and sustainable bonds: Again, external ESG scores alone do not provide sufficient information about the quality of a green, social or sustainability-linked bond (SLB). Instead, issuers ought to disclose in detail the use of proceeds and how these fund new ESG initiatives. With regards to SLBs, the specialists agreed that issuers must show how well this financing instrument addresses material ESG issues. Furthermore, the sustainability KPI should focus on business metrics in order to be considered impactful.
  • Data quality and direct engagement: Despite ESG data continually improving, investors are still facing challenges to retrieve necessary data to make sound investment decisions; in particular data that cover social issues and a company’s progress in solving those are hard to get. Therefore, investors are proactively seeking the dialogue with companies to get a better understanding about how these firms are planning for their ESG risks, and how deeply they are engaged in tackling their material ESG issues.
  • ESG ratings – room for improvement: Standardisation is key, was the unanimous view from the specialists about how ESG ratings could be improved. Only if external ESG scores apply the same methodologies could investors reliably compare the ESG score for different companies, no matter which ESG rating agency is behind the score. The specialists were hopeful that regulations such as the EU taxonomy will help to promote a common understanding of what defines sustainability performance and therefore help to unify ESG scores.

Discussing the prospect of a regulated ESG ratings market, the investors expressed their desire for ESG rating agencies’ work to be monitored by a supervisory institution. However, they agreed that regulation of the market is still a long way away.

Looking at further room for improvement, the investors pointed to the importance of financial materiality, which current ESG scores do not properly reflect. To tie ESG risks with financial risks would help provide the complete picture of a company, which, of course, is desirable.

  • Companies, issuers and ESG rating agencies: While external ESG scores come with drawbacks, the specialists urged companies to nevertheless engage with ESG rating agencies for two main reasons: 1) Making sure they own their ESG narrative rather than leaving rating agencies to retrieve ESG data from a variety of (possibly old) sources, and 2) to find out how these scores are composed in order to understand what stakeholders focus on when looking at ESG performance.

Watch the full webinar

To hear more about ESG investors’ views on ESG Ratings, please click the following link to watch the highlights from our webinar.

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