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The shifting landscape in the investment space towards Environmental, Social and Governance (ESG) is moving rapidly. According to Price Waterhouse Coopers LLP (PWC), ESG-oriented assets are projected to double in the United States to USD10.5tr; rise 53% in Europe to USD19.6tr; and more than triple in Asia-Pacific (APAC) to USD3.3tr by 2026.
Amidst the climate crisis, investors and corporates are now recognizing that companies that prioritize ESG are likely to perform better financially in the long run. Typically, companies which place an emphasis on ESG are better equipped to manage risks, build better relationships with stakeholders, and foster innovation.
However, with the projected growth of ESG, comes a significant challenge. The lack of comparability among these factors creates a confusing landscape which makes it difficult for investors to differentiate between managing crucial ESG risks within their investment mandates and pursuing ESG outcomes that might require a compromise in financial returns.
According to McKinsey & Company, the problem with ESG comparability lies with how different ESG ratings and scores providers measure phenomena differently. For example, the Global Reporting Initiative (GRI) considers amounts invested in employee training more important for ‘Social’, while the Sustainability Accounting Standards Board (SASB) measures employee training hours. This lack of agreement leads to a divergence of ESG scores, also known as aggregate confusion.
Nonetheless, ESG scoring and reporting provide valuable insights into a company’s ability to create long-term value while managing risks. However, for ESG investing to be truly impactful, it needs to be more transparent, consistent, and comparable across different metrics and rating methodologies.
Growing investment in sustainability ratings to support business success
According to Morgan Stanley’s Capital Index (MSCI), companies with lower ESG ratings tend to have higher capital costs, and are more susceptible to controversies and governance irregularities, resulting in higher volatility. Conversely, companies with higher ESG ratings tend to have lower idiosyncratic risks, making them more resilient and less vulnerable to risks.
The importance of a company’s ESG rating lies in its ability to enable investors to evaluate risk, potential return, and external demand. Recently, to meet investor demand, publicly listed companies are spending on average between USD220,000 and USD480,000 per year on ratings-related costs, with private companies spending upwards of USD425,000.
A poor ESG rating can have significant consequences for a company as it may be viewed as an unsustainable asset by investors, leading to exclusion from investment portfolios. This trend is particularly evident in emerging markets such as Latin America and Asia. Among new signatories to the Principles for Responsible Investment (PRI) between 2021 and 2022, growth from Latin America was more than 30% year-over-year, representing one of the highest regional increases globally. Additionally, new PRI signatories in Asia for 2021 stood at 421 – a 23% increase from 2020.
ESG ratings can also affect a company positively, by enabling internal benchmarking and guiding decisions towards better long-term sustainability. By understanding their ESG scores and using them as a tool for improvement, companies can attract more investment and be more competitive in their industry. Additionally, external evaluations of a company’s ESG performance can highlight areas of weakness and strength, providing a valid source of information to help promote change from within.
No one-fits-all methodology
ESG ratings can be helpful for investors to identify high-risk companies that may pose a threat to long-term financial performance. Though, the lack of standardization in ESG indicators and their respective weights among rating agencies presents a challenge. This can result in inconsistent ESG scores diminishing their reliability.
Despite this challenge, companies are increasingly recognizing the importance of sustainable development, ESG initiatives, and performance, with the percentage of S&P500 companies reporting on these metrics rising from less than 20% in 2011 to 86% in 2018. However, according to a report by consulting firm Environmental Resources Management (ERM), almost a third of 104 companies surveyed on the accuracy of ratings said they had a “low” to “very low” confidence that ESG ratings accurately reflected ESG performance.
To address this issue, investors are now seeking out providers who offer more customized frameworks for assessing ESG metrics by blending multiple data sources. Demand for transparency and reporting is also increasing, and companies can meet these demands by subscribing to software providers who can provide the necessary data in real-time or by introducing the software themselves that focuses specifically on sustainability issues.
Looking forward: Alignment between business narrative and ESG scores
With ESG investing becoming a mainstream strategy by corporates and investors, standardization of ESG reporting and improving data transparency and comparability are critical. The level of scrutiny applied to ESG data is almost comparable to that of financial disclosures. This is particularly true in a context where having strong ESG credentials is associated with high value and reputation.
Rating agencies play a significant role in shaping investors’ perceptions of a company’s sustainability progress and commitment. While larger institutional investors have the financial capacity to investigate data from different rating agencies before making investment decisions, smaller investors typically lack the resources to conduct similar due diligence. This creates a greater reliance on ESG scores and emphasizes the importance for rating agencies to ensure their scoring approach accurately reflects a company’s ESG performance and makes the data easily accessible.
Companies that have poor ESG scores or are in the early stages of their ESG journey can regain market confidence by developing a robust ESG strategy. Additionally, to attract investors, companies should ensure they disclose accurate and verifiable ESG data that demonstrates value and impact. A company must establish the tone and offer transparent disclosures that convey its ESG agenda. By doing so, the company can shape the narrative of its disclosures, which is crucial in controlling ESG value.
Sources
https://www.oecd.org/finance/ESG-Investing-Practices-Progress-Challenges.pdf
https://www.mckinsey.com/capabilities/sustainability/our-insights/does-esg-really-matter-and-why
https://academic.oup.com/rof/article/26/6/1315/6590670
https://www.msci.com/esg-101-what-is-esg/esg-and-performance
https://www.quant.global/esg-rating-current-methodologies-and-the-challenges/
https://sustainablefuturenews.com/esg/companies-pay-up-to-500000-for-sustainability-ratings/
https://www2.deloitte.com/ce/en/pages/about-deloitte/articles/esg-ratings-do-they-add-value.html
https://impact.economist.com/sustainability/net-zero-and-energy/big-question-esg-score
https://news.bloomberglaw.com/esg/lack-of-uniformity-in-esg-ratings-system-poses-risks-opportunities
