ESG ratings: From Beta to AlphaMarch 10, 2021
Covid-19 has thrown companies under the microscope for how they treat their employees and customers, the quality of their supply chains, as well as their transparency, diversity, and purpose. As a result, 2020 has been a watershed year for institutional investors, who are now seeing that companies with robust Environmental, Social and Governance (ESG) practices are more resilient and sustainable, and therefore have greater ability to outperform their peers.
From 2011 to 2019, the number of S&P 500 firms reporting on ESG has jumped from less than 20 percent to 90 percent1. Sustainable investing assets in the US have grown 42 percent over the past two years, and now represent one-third of the total assets under professional management2. ESG assets in Europe are forecast to grow at a compounded annual growth rate of 28.8 percent over the next five years3.
Asia-Pacific is the world’s biggest carbon emitter4, yet considerable investment is required to support the energy transition required to meet the net-zero carbon pledges by China, Japan, and South Korea5. Asia-Pacific’s sustainable finance market is developing rapidly6, and 79 percent of investors in the region increased ESG investments “significantly” or “moderately” in response to Covid-19. Fifty-seven percent of investors in the region expect to have to “completely” or “to a large extent” incorporated ESG issues into their reporting and decision-making process by the end of 20217.
As ESG has grown in prominence, so too have the number of competing standards and frameworks. These are some of the more widely used frameworks:
- The Global Reporting Initiative (GRI) was one of the first reporting frameworks, and is among the most widely used. GRI is an international independent standards organization that helps companies communicate their impacts on issues such as climate change, human rights and corruption.
- United Nations Sustainable Development Goals (SDGs) address 17 global challenges that 193 member states of the UN had agreed to. The SDG framework is broad-based and does not provide industry-specific measures or guidelines, but has introduced new indicators following a comprehensive review in 20208.
- Morgan Stanley Capital International (MSCI) ESG ratings were created to inform investment decisions, and frequently used by investors looking to assess companies’ long-term resilience and risks.
- The Sustainability Accounting Standards Board (SASB) created ESG standards specific to 77 industries, and was primarily designed for public companies traded on U.S. exchanges.
- The Task Force on Climate-Related Financial Disclosures (TCFC) was set up to develop consistent, comparable, and efficient disclosures pertaining to climate change, so investors and other stakeholders could assess, manage and, price in carbon risks faced by the company.
- The Carbon Disclosure Project (CDP) was founded to link environmental integrity and fiduciary responsibility. Companies provide data on environmental impacts, risks, opportunities, investments and strategies so investors can evaluate risks and make informed decisions.
Many other frameworks such as PRI, GRESB, RSPO, and IPIECA exist, and approaches such as Integrated Reporting (IIRC), AI-based tools, and the IFRS Foundation’s establishment of a new international sustainability reporting standards board9 are attempting to reduce the complex, duplicative, and costly reporting process. At the same time, there remain questions of whether ESG reporting alone does enough. ESG rating systems are not regulated and methodologies and ratings remain opaque and inconsistent, which makes them difficult for fund managers to use in justifying their investment theses. Definitional challenges exist, such as what qualifies under “Social” ratings, the data reported voluntarily is subject to self-reporting bias, and single rating scores can see material issues either greenwashed with sustainable initiatives in other divisions, or hidden by outsourcing practices10. Some work has shown that existing ESG practices are not only inadequate in predicting sustainable growth11, they are not even always effective at preventing corporate scandals12.
Traditionally ESG was used as a negative screener, to reduce a stock’s risk or volatility (Beta). We believe that Strategic ESG Management can help companies seek sustainable growth or Alpha. When a company adopts a sustainable mindset – from a compliance approach to an entrepreneurial ethos – we have seen that ESG can be tremendously helpful as a holistic framework for socially-responsible business practices to stay ahead of ever-changing standards and regulations, while driving long-term commercial growth.
For example, a company that embraces a sustainable mindset uses carbon standards as a structured process not only to systematically take expensive waste out of its ecosystem, but as a guide to new business opportunities in a low carbon future. It sees interest groups not as bottlenecks, but as communities that can co-create and help popularise a new generation of products. It looks at regulators, multilateral organisations, non-profit organisations, social enterprises, and civic society as complementary partners that each bring unique expertise to co-create solutions with. It uses governance as a management tool to ensure organisational goals are met. It sees diversity not as an item on a checklist to tick, but as a way to make better and faster business decisions13.
Socially-innovative companies are always thinking about how they can use market-based mechanisms to solve societal challenges. As seen in numerous examples ranging from Danone’s Shokti-Doi to Vodafone’s M-Pesa, this drive to meet unmet needs often leads to new products for underserved customer segments. Corporate social innovators such as IKEA invest in their suppliers to take risks out of their value chains, while multinationals such as P&G empower thousands of Shakti women as new and more effective distribution channels. Companies such as Wilmar are finding that they cannot even conduct business effectively without a Social License to Operate. On the other hand, socially-conscious companies such as Ben & Jerry’s and Patagonia whose business practices resonate with the expectations of ‘woke’ consumers are able to build brand love and effectively differentiate themselves from the competition.
ESG issues will only continue to grow in importance, and ESG frameworks provide a structure for collecting valuable information. While it will take time to integrate the different ESG frameworks into one true global standard, developing a sustainable mindset right now will help investors and corporations adopt socially-innovative strategies that use ESG information to realise Alpha.