ESG investing 101: what investors want to know and the role of ESG rating agencies

As introduced in a previous blog, an important group of recipients of the non-financial information of companies are investors. But what are they using the information for and what does this mean for a company?

What is the state of ESG investment?

The concept of Environmental, Social and Governance (ESG) investment, also known as responsible investment, was first coined  in 2005 in a study entitled “Who cares Wins“. Over the last three to four years, ESG investment has exploded and investors are increasingly taking into account the ESG performance of corporations in their investment strategies. In fact, according to a survey by Morgan Stanley, a massive 84% of investors are at least “actively considering” integrating ESG criteria into their investment processes. Over the past few years ESG investments are growing at a compound annual growth rate of 11,9% and European ESG investments currently account for 476 billion euros of Assets Under Management (AUM).

Different factors are contributing to ESG investing becoming the new norm. First of all, the growing awareness and adoption of the principles of corporate responsibility, which is closely related to ESG. This has come about as companies are increasingly aware of how corporate responsibility is an influencer of brand value and customer perception, which in turn affects a company’s financials.

Furthermore, it was previously thought that ESG investment had lower returns than “regular” investments. However, after years of building a credible track record, recent studies have shown that investing in sustainable assets is actually equally as profitable. This has lowered the barrier for investors to integrate ESG into their investment strategy.

Thirdly, there is an increase in the regulatory requirements for reporting on ESG information. An example is the recent introduction of the European Directive on mandatory non-financial reporting which requires large companies to publish non-financial information. This, in combination with improved data management systems, has led to an increase in the availability, quality and comparability of data for ESG investment.

Meanwhile, further regulation is underway. With a focus on professionalising ESG investments, the EU is working on a legislative package for sustainable finance. This includes a taxonomy to classify ESG investments. In addition, it covers requirements for companies to provide evidence about the claims they make regarding the ESG performance of their financial products. These measures will not only increase transparency but will also create a common approach to ESG investment. Legislation relating to sustainable finance can also be found elsewhere in the world. Examples include the UK and China, the latter of which has even become one of the frontrunners in this domain. We certainly expect that this trend will continue to accelerate in the coming years.

What information are the investors using?

Each investor has its own investment policy when it comes to ESG investing, dependent on their goals and expectations. For instance, some investors may apply a “negative screening” or “exclusion” policy, meaning that they steer clear of certain sectors (e.g. weaponry or tobacco). On the other side of the spectrum, investors may practice “impact investing”, where they invest to both achieve a financial return and a positive and measurable social and environmental impact. Regardless of their ESG policy, an investor requires accurate and comparable data to inform their decisions and to put their plan into practice.

As the number of ESG investors has grown, so too has the number of ESG data providers and rating agencies (find an overview below). This includes companies such as Bloomberg, MSCI and Sustainalytics who analyse, consolidate and present ESG data on informational platforms. The source of this data includes media articles, sector reports, annual reports and questionnaires. Investors can subscribe to these platforms and extract data such as ratings, competitive benchmarking and risk analyses. A company that has a high ESG rating or performance according to these data providers can be considered as a “sustainable asset”.

Based on the different information acquired by investors, we can roughly distinguish two types of investors: passive and active. Active investors will use multiple data sources and perform their own analyses rather than solely relying on data of a third-party data provider. Passive investors, however, don’t go as far and are satisfied using single-source third party ESG-data. This means that a single ESG rating or score can determine whether they invest in a company or not. Passive investment management appears to be gaining popularity worldwide due to the lower time investment and costs. The share of total passively managed funds increased from 16% in 2010 to 27% in 2017.

Source (adaptation): Responsible Investing: Guide to ESG Data Providers and Relevant Trends (Douglas et al., 2017)

Would you dare to take the risk of a poor ESG rating?

We’ve discussed what ESG investment is and how it works, but how does this impact your company? In general, you could say that investors use ESG ratings to determine how “future proof” a company is.

Let’s take an example. Say that your company receives a poor rating from an ESG data provider, for example Sustainalytics. This will have several implications.

Firstly, if this rating is used by a passive investor, it may result in your company’s stock being excluded from their investment portfolio as it is in seen as an “unsustainable asset”. If multiple investors do so, this can eventually negatively impact your stock price.

Secondly, by definition investors aim to minimise risk while maximising return. For an ESG investor, your low ESG rating may indicate a higher risk profile as it gives the perception that your company is not in control of certain ESG aspects. A famous example can be found in the automotive industry. Months before the actual Dieselgate scandal in September 2015, Sustainalytics and MSCI had already raised concerns about the independence of Volkswagen’s governance structure, resulting in a lower ESG rating.

In addition, the impacts of negative public exposure are magnified in today’s increasingly connected world where news, in particular bad news, travels further and faster than ever before. Since your company’s reputation can impact your brand value, a poor ESG rating can be perceived as a higher risk exposure to reputational damage. This can in turn indicate a higher risk to your brand value. As the brand value can be a large part of a company’s balance sheet (for AB Inbev’s brand value this accounted for 18% in 2017), investors might not be too enthusiastic about this. A perception of higher risk might thus dissuade investors from investing in your company’s stock.

What can we expect in the (near) future?

Given the impressive surge in ESG investment over the past couple of years combined with the growing interest of investors, and the regulatory developments, we expect that the importance of ESG data and ratings will become even more crucial in the future.

However, we think it would be beneficial for both the reporting companies as well as investors if ESG data providers worked together towards a standard approach that can be widely adopted and verified. In the meantime, we should stay critical of the ratings provided and the methodologies behind them. A single data point or ESG rating may not always reflect the reality. For instance, if the nature of a business is not taken into account, a nuclear weapon manufacturer can be labelled as “sustainable”, because it has a low water footprint and a high diversity level. This is where the European taxonomy, discussed above will hopefully offer guidance.

All in all, you can be sure that the non-financial information your company reports is being read by data providers and (indirectly) by investors. By enhancing the quality and reliability of your non-financial data and improving your ESG ratings and indices, your company will have higher visibility for investors in the growing market of ESG investing.

Author: Johanna Haerens, consultant at Sustainalize Belgium