ESG Ratings and the Board

Talk of ESG seems to be everywhere but are boards saying “enough”?  According to Morningstar, ESG or sustainable funds grew to almost 400 in 2020, up 30% from 2019. But, as we come close to the end of 2021, ESG seems to be dropping from the board agenda according to a recent survey by Diligent. In that study, only 14% of director respondents cited climate risk as a top 2022 board agenda item.

Sustainable funds are those that emphasize the use of environmental, social and governance criteria to generate financial return and broader social impact. And, they perform pretty well. In 2020, three out of four sustainable equity funds beat their Morningstar Category average.

Better ESG education for boards about what ESG is and how funds are scored are essential board tools – and may help reengage board members as ESG pressure will likely continue unabated. As mentioned in my September blog, activists target boards that have failed to address environmental, social or broad governance issues. ESG-focused activism is gaining ground and continues to do so according to a study released on October 25, 2021. Blackrock has predicted that the ESG investing space will grow to $1 trillion by 2030 while the S&P Dow Jones has 39 ESG-related indices.

What is E, S and G? Environmental criteria refer to a company’s actions as a steward of the environment – for example, what steps a company is taking to address the depletion of the planet’s resources, pollution and greenhouse gas emissions, or the effects of climate change? Social criteria covers how a company engages with all of its stakeholders (i.e. employees, community, customers and suppliers) in addition to shareholders, including the treatment and diversity of its human capital (frontline or service, management and boardroom levels), and the sustainability of its supply chain. Lastly, corporate governance considers how a company governs itself taking into account the structure and refreshment of a company’s board of directors, the separation between management and the board of directors, executive compensation, equal and fair pay among employees.

Understanding ESG ratings. There are many ways ESG is scored or rated. All rating agencies rely on reporting by the company itself and ESG disclosures are not formally regulated in the United States. However, many companies use propriety analytics from MSCI, Sustainalytics, ISS and Principle for Responsible Investment (PRI). Each scorecard uses its own analysts and algorithms to synthesize ESG disclosures.

Morgan Stanley Capital International (MSCI) has been one of the major drivers of consolidation in the ESG ratings space, acquiring several competing data providers since its entry on the scene. MSCI also rates countries and financial products like securities, loans, mutual funds, and ETFs. It lists topics of concern for each of the E, S, & G categories which it then uses to analyze publicly available data and proprietary ESG data. More can be found here.

Sustainalytics started as an independent ratings provider, but since 2020, it is wholly owned by Morningstar. In addition to comprehensive ESG ratings for businesses, it also offers carbon-specific, governance-specific and country ratings. Its methodology is an automated analysis of ESG disclosures and reports. For more information see here.

Given that Institutional Shareholder Services (ISS) is the world’s largest proxy advisory firm, it should not be discounted that it only entered the ESG ratings space after acquiring Oekom Research AG in 2018. It already covers some 10,000 companies. It analyzes data by hand from ESG disclosures and states it contacts the company directly for clarification. ISS is catering its reporting to look beyond pictures of trees and blue skies and more towards quantitative measures, data, and policies. More information can be found here.

PRI works with signatories to identify key environmental, social and governance issues in the market and coordinates with the firm as to how to address them. PRI details its reporting process in this video. The number of investor signatories to PRI has increased by 29% last year alone.

Recently each of the three major capital markets rating agencies – Fitch, S&P and Moody’s – increased their focus on ESG hoping to provide a full assessment of ESG performance that allows for comparability.

Even with these guidelines it’s often difficult to know exactly what these raters are looking at – and what constitutes meaningful sustainability. Yet one thing is clear, it’s becoming a crowded market requiring a lot of homework for boards.

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