Rivista Corporate Governance ISSN 2724-1068 / EISSN 2784-8647
G. Giappichelli Editore


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ESG Indexation (di Andrea Angelone)

A growing awareness of environmental, social and corporate issues and their potential negative financial impact has led investors to consider environmental, social and go­vernance (ESG) factors in their investment process. Borrowers, fund managers and index providers need tools to be able to evaluate and compare different sustainable investments. While several industry operators are providing scores aimed to rate companies’ performance towards ESG targets, non-uniform information disclosed by the companies are aggregated and reported in non-standardised manner by the rating agencies producing confusing and occasionally conflicting outputs.

Keywords: ESG ratings – ESG factors

Articoli Correlati: ESG factors - ESG ratings


1. What are ESG ratings? - 2. How are they used? - 3. Who does the scoring? - 4. How are ratings compiled? - 5. How do ESG ratings differ? - 6. How big is the ESG market? - 7. What are the challenges? - NOTE

1. What are ESG ratings?

Sustainable and responsible investment (SRI) has seen an increase in interest from investors, shareholders, and governments with firms incorporating environmental, social and governance (ESG) aspects in their strategy. ESG criteria are now treated as part of the performance indices used to assess the competitiveness of firms. Consequently, the market for sustainable and responsible investment has grown noticeably, allowing ESG rating agencies to establish themselves, as a response to the surging demand of investors for a reliable assessment of firms’ sustainability strategies. These agencies use different criteria to assess the corporate sustainability performance of firms: i. A sustainable equilibrium between the corporate dimensions: financial/econo­mic, environmental and social; ii.  An intergenerational perspective: short/long-term; iii. Addressing stakeholders; and iv. Life cycle thinking. The rating agencies assess the sustainability performance of many firms. Some ratings are exclusively established on extra-financial information, others combine financial and non-financial data to evaluate long-term value and sustainability. A rating can cover a long list of diverse factors including carbon emissions, water usage, pollution prevention, gender equality, fair labour practices, human rights, crime-prevention controls, board composition and shareholder rights.

2. How are they used?

ESG ratings might help companies to obtain sustainability-linked loans and to better manage risks. Once a firm has been assessed as sustainable by ESG rating agencies, it becomes eligible for a Sustainability Linked Loan (“SLL [1]”), where the loan’s interest is linked to sustainability key performance indicators. Any KPI target suitable for a company’s sustainability strategy can be worked into the loan but it can also be derived from ESG scores. ESG rating agencies, therefore, play a big part in the growth of sustainable-linked loans [2] as both interest and margin will be reduced if companies improve their ESG ratings (Exhibit 1). An ESG viewpoint can help to identify risks that are not identified by normal financial analysis (Exhibit 2) such as operational costs or costs of litigation. Different ESG risks have different impacts on different industries. However, corporate governance is a universal issue and addressed in all ratings. Evidence shows that the most successful S&P 500 companies tend to lead in ESG ranking. Fund Managers Investors use ESG ratings for: fundamental/ quant analysis, portfolio construction/ risk management, engagement & thought leadership, and benchmarking/ index-based products. More than 1,500 investment managers have signed up to the United Nations Principles for Responsible Investment. The trend has driven a surge in the number of ESG indexes, making it the fastest-growing part of the market.

3. Who does the scoring?

In the last 10 years, the ESG rating industry has grown to a large extent and has seen a phase of consolidation both due to mergers and acquisitions between existing ESG rating agencies and new entrants in the market. Morgan Stanley Capital International (MSCI) is the result of the osmosis of several different ESG research providers such as RiskMetrics Group, MeasureRisk, Governance Holdings Co. to name a few. Furthermore, the MSCI ESG branch “ESG Research data and ratings” is used to construct and develop the MSCI ESG Indices and are used by big investors such as BlackRock Inc., often as a basis for their ETFs [3]. The main ESG rating agencies are: Refinitiv, ECP, FTSE Russell ESG Ratings, MSCI ESG Research, ISS-oekom, RobecoSAM, Sustainalytics, Vigeo EIRIS and Bloomberg. Some collect broad market data, while others focus exclusively on environmental factors or rating green bonds. At least a dozen different companies’ratings have been tied to ESG incentives on loans and bonds. Sustainalytics provides ratings for about 70 of the more than 100 ESG-linked loans completed since 2017.

4. How are ratings compiled?

When compiling their ratings, ESG rating agencies follow a non-standardized approach outlined here: 1. Data disclosure: Companies are not required to disclose ESG information, hence available information varies by company and industry. 2. Data collection: rating agencies do not necessarily seek information directly from companies but only rely on publicly available information. 3. Data analysis: the analysis is very opaque and sometimes focused on a few factors only. Weights are attributed according to industry-relevance, time horizon, and impact. They are then generically applied to all companies within an industry. 4. Data scoring: scores are combined and normalized relative to industry peers. Scores between agencies can vary immensely. 5. Data publishing: scores are denominated similar to credit ratings (Exhibit 3) but are not comparable between rating agencies.

5. How do ESG ratings differ?

ESG ratings differ from conventional credit ratings in their methodology of compilation, rating agency landscape, regulation and standardization involved, and in their final scores. These differences are at first not a problem, as the goal of ESG ratings [4] is to assess a company’s ESG compliance, whereas conventional credit ratings are used to evaluate companies’ creditworthiness. One of the greatest differences is that the rating criteria tend to be adapted in relation to the industry of the company. Water usage is, for example, a big issue in the mining and precious metals industry, but of insignificant relevance to the financial sector. These differences are considered via industry-specific weights that are applied. However, this methodology may ignore firm-specific characteristics, skewing the risk exposure of a company to its industry’s most relevant issues. This relative measurement can result in unexpected outcomes. For example a tobacco company considered unsustainable for an typical ESG investor may still achieve an acceptable rating as it is the case for British American Tobacco Plc rated by Munich-based sustainability ratings provider ISS ESG weak, indicating high risk, while Sustainalytics gave the company a score of 24.4, which represents a medium risk on its scale. Further issues that are commonly noticed are: 1. Companies that disclose more information are rewarded with higherESGratings, as the selection of information published is biased towards positive news and ESG rating agencies rely solely on publicly available information. 2. Large-market cap companies typically score higherESGratings, partly due to their bigger budget used to disclose ESG information. 3. Companies in certain regions, particularly Europe, that have to disclose moreESGinformation score higher ratings. 4. Companies’ ratings vary significantly between different ratings agencies. 5. Non-public and governmental enterprises are excluded as no information is disclosed. 6. Industry weightings are too strictly used and eliminate firm specificESGrisks and characteristics

6. How big is the ESG market?

The market for green investment has been opened for several years, with considerable amount of issuance of “green bonds”, which tied funds to specific investments with outcomes beneficial to the environment. Green bonds though were viable only for a project with a sustainable goal. The emergence of sustainability-linked loans (SLL) has diversified the market for green finance and allowed more companies to borrow for sustainable development, particularly those who didn’t qualify for green bonds [5]. According to BloombergNEF data, the total sustainable debt issuance has reached $1 trillion in 2019. Investors’ demand for these securities is growing as companies become increasingly open to better corporate social responsibility (CSR) strategies. Although, green bonds remain the most mature instrument with $788 billion in total issuance, SLL have surged reaching a $108 billion in issuance to date. Companies tap into “green capital” to achieve more favourable loan terms and to improve their CSR. According to estimates by capital markets consultant Opimas the responsible investment market grew to more than $30 trillion in 2018, with half of assets located in Europe. This amount is expected to rise to $35 trillion by 2020 (with surging number of ESG ETFs), with the market for ESG data and ratings spending to grow to a projected $745 million in 2020, an increase of almost 50% from 2018 and up by almost 300% since 2014.

7. What are the challenges?

Companies who have missed to manage their ESG risks have historically faced higher costs of capital, higher volatility in earnings and valuations, and more prone to accounting irregularities. Hence, the incorporation of ESG is highly recommendable, however, the current process faces some concerning flaws which need to be addressed [6]. The proposal set forth by the European Securities and Markets Authority (ESMA) [7] addresses possible solutions to a better standardization and auditing of ESG ratings. It focuses on transparency obligations, convergence of national supervisory practices, and supervision. The following measures should be considered welcoming: Standardization of the disclosure ofESGinformation of companies to eliminate biases linked to the volume and quality of disclosed ESG information. Ensuring compliance with disclosed information by companies via regular audits. Reporting of trends, risks, and vulnerabilities (TRV) of sustainable finance in a dedicated report. Focus on the convergence of national peculiarities so thatESGratings become comparable. Moreover, standardize the ESG rating compilation to eliminate interagency rating deviations. Establish quality controls and audits of rating agencies. While there is great potential in ESG ratings and sustainable lending, a harmonisation of the current standards is needed to establish a system that yields real value and force impactful behavioural changes. From this point of view, numerous international initiatives such as the United Nations Principles for Responsible investment, UN Global Compact and Global Reporting Initiative have emerged to make clear what constitutes responsible investment and to promote it through the support of extra-financial reporting. In Europe, the new European Union taxonomy – set to be fully enforced by the end of 2022 – will introduce disclosure requirements for index and benchmark providers that use “sustainable” and other labels. A final comment in relation to the role of ESG rating agencies. While the consolidation of smaller ESG agencies in bigger financial institutions aggregates more resources and professionalism, ESG rating agencies remain commercial entities driven by economical market dynamics which could lead to biased sustainability principles in their ratings assessments. Until [continua ..]