Two Steps Forward

ESG ratings are confounding. For CSOs, that’s good news

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"Smart beta."

It’s a term of art on Wall Street, a blend of active and passive investing strategies that typically combine an underlying stock index with an investment manager’s savvy about a potential stock’s liquidity, volatility, momentum and other factors. The strategy is said to provide a risk/return profile that is more attractive than a singularly active or passive investment product.

That nerdy financial term will be among those increasingly relevant to corporate sustainability execs — CSOs, for short — as the astonishing rise of environmental, social and governance, or ESG, factors takes hold in the mainstream investing world.

ESG assets under management have grown the fastest among smart beta strategies — a compound annual growth rate of more than 70 percent over the past five years, according to a recent report from Bank of America Merrill Lynch.

"The opportunity is also too big to ignore," the report's authors wrote. "Bank of America estimates that over the next few decades, equity investments aligned with ESG criteria could attract assets equal to the size of the Standard & Poor’s 500 index today."

The S&P 500 in October had a market capitalization of just over $25 trillion. Real money, as they say.

For good reason. ESG investing is no longer merely a vehicle only for so-called socially responsible investors. Increasingly, the process goes to the heart of investing fundamentals. According to the B of A report, "ESG is the best measure we've found for signaling future risk," superior to leverage or other risk and quality factors. Moreover, "90 percent of bankruptcies in the S&P 500 between 2005 and 2015 were of companies with poor Environmental and Social scores five years prior to the bankruptcies," the analysts wrote.

They concluded: "Analyzing financial metrics alone simply won't suffice anymore."

True, there remains a huge gap between interest in sustainable investing and actual investments. A recent white paper (PDF) from Morgan Stanley’s Institute for Sustainable Investing reported that a whopping 85 percent of investors it surveyed said they are interested in sustainable investing, an increase from 71 percent who indicated interest in a similar survey in 2015. While most of that 71 percent in 2015 said they were only "somewhat" interested in sustainable investing, most respondents in 2019 said they are "very" interested.

According to the US SIF Foundation’s 2018 Report on US Sustainable, Responsible and Impact Investing Trends, as of year-end 2017, just over $1 out of every $4 under professional management in the United States — $12 trillion or so — was invested according to socially responsible investment strategies. 

Those assets under management are poised to grow. ESG interest among the world’s largest asset managers — Vanguard, Fidelity, BlackRock and Nuveen are among those that have introduced mutual funds or exchange-traded funds (ETFs) based on ESG criteria in the past year — is bringing new relevance to corporate sustainability reports — and, by extension, to CSOs.

For more than two decades, sustainability reporting has been a relative backwater of corporate finance, of interest primarily to a small niche of socially minded investors. Increasingly, it is expected to approach the importance of financial reporting. Along the way, ESG will become the coin of the realm for assessing a company’s sustainability performance.

The new CSR

Indeed, "ESG is the new CSR," declared Forbes recently:

This is good news for both people and planet, because while CSR was often a disconnected department with limited resources, ESG is a fully integrated strategic objective that’s closely connected to the mission of the company. As such, it gains power as it’s integrated into daily operations and everyday decisions, which is where a company’s impact is practically determined.

While this may seem like a hostile takeover of a dear agenda by CSR departments, this is actually good news for CSR professionals, who may experience a switch in title and job specs, but will get much closer to the CEO and strategic objectives of the company.

Good news, indeed. Today, CSOs are finding common cause with their investor relations colleagues, who not that long ago seemed to live on different planets and speak different languages. Now, they are finding themselves sitting together at investor meetings, explaining their company’s climate risks, water use and other ESG factors of growing interest to their largest investors.

Further good news for CSOs can be found in the rampant confusion about what information goes into an ESG rating, and the various metrics and methodologies being deployed by the leading ratings organizations.

"Good news" may seem counterintuitive. After all, the morass of competing frameworks and standards can make it difficult for a company to know precisely how to report its ESG metrics, including what factors are considered material by each ratings organization or asset manager.

But the confusion breeds opportunity for CSOs, who are best positioned to sort through the various methodologies, including the advantages and disadvantages of each, and who likely will be called upon to translate their company’s performance into the language of Wall Street.

And those sustainability reports? They’ll gain currency, too. Most portfolio managers of actively managed ESG funds go directly to companies to discuss the business’s environmental impact, but ESG-themed smart beta funds rely on data from sustainability reports and third-party providers to populate a portfolio.

But which data will they care about? There’s no standard or uniform practice. It may be up to CSOs to parse company sustainability data to make it understandable to investors on a case-by-case basis.

Robust correlation

Earlier this month, the Securities and Exchange Commission's Investor Advisory Committee held a meeting focused in part on the use of ESG data in the capital allocation process — how sustainability data is used to make investment decisions. The panelists — an academic and several representatives of asset managers — all viewed ESG data as important to decision-making, particularly in relation to potential financial impact, even for investment portfolios that are not screened for sustainability.

At the meeting, Satyajit Bose, associate professor in sustainability management at Columbia University, discussed the "robust correlation" between measures of sustainability and financial performance, which he said has been demonstrated in thousands of studies.

Bose noted that ESG measures are more aligned with financial operations performance than with market performance, according to a report-out of the meeting. He recommended that the market catch up to financial operations performance and that every investment manager implement ESG investing when managing client portfolios.

The leading ratings organizations are stepping in — Fitch, Moody’s, Morningstar and S&P Global all have introduced methodologies and frameworks aimed at helping clients analyze and evaluate companies’ ESG risks. The problem, a team of researchers at MIT Sloan recently found, is that ESG ratings diverge substantially among those agencies. A new working paper, "Aggregate Confusion: The Divergence of ESG Ratings," documents the disagreement among the ESG ratings of several prominent agencies.

The MIT Sloan team found the correlation among agencies’ ESG ratings was on average 0.61; by comparison, credit ratings from Moody’s and S&P are correlated at 0.99. That means that credit ratings are essentially the same while from agency to agency, while ESG ratings aren't. "The information the decision-makers receive from [ESG] ratings agencies is relatively noisy," as the authors put it. The ratings varied in scope, weight and measurement techniques from agency to agency, meaning that different organizations assessed the same data in different ways.

"What we need in the world of ESG is a convergence project," said International Accounting Standards Board Chairman Hans Hoogervorst during an event last month in New York, as reported by Accounting Today. "I think it would be great if those standard-setters make the world a little bit simpler for users. It’s too much now."

It’s going to be a while until that kind of happy convergence occurs. For now, it’s every CSO for herself.

We’ll be diving deep into this topic at the 2020 GreenFin Summit: Aligning and leveraging capital markets to drive the global economy toward sustainability, Feb. 3-4, just prior to the start of the GreenBiz 20 conference, in Phoenix. Details here.

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