The race to embrace ESG ratings
Major investment firms are snapping up environmental, social and governance (ESG) research and ratings companies at a rapid clip — three hookups within just the past year. What do sustainability officers and financial officers need to know?
Last month, investment research firm Morningstar took a 40 percent stake in ESG company Sustainalytics. Steven Smit, head of sustainability at Morningstar, now serves on Sustainalytics' board of directors. The organizations already collaborated last year on the Morningstar Sustainability Rating, which shows investors how well companies within their global and exchange-traded funds are managing ESG issues.
In January, investment solutions provider ISS bought IW Financial, a U.S. firm offering ESG research, consulting and portfolio management services, promising to "help asset management firms and other institutional clients identify risks, enhance productivity and increase revenues."
In October, none other than the leading S&P Dow Jones Indices acquired Trucost, which has more than 15 years' experience assessing carbon and environmental data and risk. This move commenced what Mike Wallace, managing director of sustainability advisory firm BrownFlynn, calls the "latest wave" of ESG firm acquisitions.
"The writing is on the wall — we saw the trend start in 2009 with the move by mainstream institutions," said Wallace. It was significant that Sustainalytics sold only a minority stake in its firm, he said: "There is a confidence building in the ESG research world ... and also within these organizations because they are finally getting the attention they deserve for the great work they've been doing" to identify ESG risks and opportunities.
The "last wave" appeared in February 2009, when risk advisor RiskMetrics purchased Innovest, an ESG company founded in 1995. The merger was lauded for bringing together two firms with "deep expertise in the newly emerging field of climate governance and carbon management." Later that year, RiskMetrics bought KLD Research & Analytics — which creates SRI (socially responsible investment) benchmarks — for $10 million in cash.
On its heels was Thomson Reuters' purchase of Asset4, a Swiss firm collecting data on pollution, water use and violations of corporate governance from thousands of companies. And in March 2010, MSCI snapped up RiskMetrics Group.
The wave of major financial firms bringing ESG research firms in-house hasn't crested yet. Today, more than one-third of professionally managed assets consider ESG elements in their investment decisions and over 60 percent of global stock exchanges are implementing ESG reporting guidance, according to Trucost.
By the end of 2015, nearly $9 trillion assets under management were using SRI investing strategies. What do CSOs and money managers need to know to successfully surf this trend?
Mind the gap
Nearing the one-year anniversary of Trucost's acquisition, CEO Richard Mattison reflected on what it means that the world's largest financial institutions are paying up to embrace ESG-focused indices.
"To my mind, it can mean only one thing: This information is becoming increasingly valuable to investors, and that is being recognized by leading providers of intelligence to those investors," he told GreenBiz. "Over the years, the world of ESG information has become more complicated and financially linked — and ESG information is a leading indicator of cost and future cost. It presents a massive opportunity for companies to raise capital."
Thus, there has been an evolution "from screening and basic ethical standards associated with investment principles, where investors would exclude a small number of companies in their universe," to a world of complex disclosure reporting, and more evidence linking strong ESG strength and financial performance. "That's why organizations like S&P have recognized that environmental data is increasingly valuable to investors, asset owners and banks," Mattison added.
But there is an imbalance in supply and demand for ESG investing: While the global bond market is reported to total nearly $100 trillion, only a few research firms look at ESG components of bonds.
It's "essential for asset owners to have ESG investing in their profile," said Alka Banerjee, managing director of product management at S&P Dow Jones Indices, in a video interview. And bringing Trucost in-house allowed S&P DJI to have access to various data and skill sets, "whether focusing on carbon, water or other efficiency issues."
As for Trucost, Mattison said that "the power of a major global organization like S&P means we can get access to major investors that care about this topic and also have huge amounts of money to position themselves for sustainable investments."
Apples to apples
Beyond leveraging capital towards ethical and sustainable development, greater transparency in ESG reporting makes companies more competitive.
"Markets increasingly want exposure to companies that are positioning themselves to the future of sustainability," said Mattison, and they want exposure to companies that are looking towards the transition from the top levels of management.
"Markets need more transparency and visibility into exactly how 'green' a company is. Looking through reports and comparing companies, especially linking how a company is performing on sustainability and financially, is where the ratings companies come in."
Wallace says that monitoring companies for ESG factors isn't new. The work began with sustainability standards-setters such as the United Nations Global Reporting Compact and its request for regular communication on progress. The Global Reporting Initiative (GRI), CDP and other reporting initiatives were also instrumental to bring ESG data to the market. They incentivize and standardize the disclosure of thousands of companies on human rights, labor, environment and anti-corruption performance.
For investor relations and financial officers, the incorporation of ESG investment might seem like added complexity.
IROs and CSOs may feel this creates more burden and is yet another in the endless series of questionnaires they have to manage to ensure they are judged accurately," said BrownFlynn's Wallace. In fact, judgment already was being passed on companies' ESG as well as financial performance. Responsible investing doesn't always include direct engagement with a company, he added.
And that's why investor relations professionals may not receive ESG-related questions during quarterly calls although the information is being used by mainstream financial institutions. In other words, while companies may be unaware of being evaluated on ESG performance, it can be a silent capital killer.
Nearly 75 percent of investors responding to a CFA Institute study in 2015 said that they take ESG issues into consideration during the investment process. That means bringing ESG experts into a company can lead to greater engagement between its sustainability and finance professionals.
"Being an internal expert on acquisitions and how they're judging your company is a good career move," said Wallace.
Action for the C-suite
For CSOs, IROs and CFOs, the explosive growth of the ESG investment space means a new respect for and way of relating to one another.
"CSOs need to be increasingly literate as to exactly how the financial system works and rewards companies with a lower cost of capital," said Mattison. "As CSO, the first thing you should consider for the second half of 2017 is to speak to your treasury department and think about ways of raising capital to fund those ambitious sustainability plans that you're going to need to reach your targets."
“If you are an organization thinking of acquiring an ESG research firm, it's important to identify those with tangible results and market presence,” said Wallace: "Those that have been acquired have differentiated themselves through unique research projects with government agencies, academic institutions and of course big named clients."
Financial organizations are not only buying up ESG research firms, but are also developing their own talent. For example, in early August, State Street Global Advisors, the asset management business of State Street Corporation with $2.6 trillion of managed assets, appointed a head of ESG and asset stewardship, who reports directly to the executive VP and chief investment officer of Equity Beta Solutions, Lynn Blake.
"This is getting bigger and more serious," said Wallace. "Now it's time for mainstream players to step in."