The Challenge of Rating ESG

Performance
When I began working at Sustainalytics in 2008, after completing an MBA in finance
and sustainability, the business of rating companies on their environmental, social, and
governance (ESG) performance was very much a niche field. Our company had only 20
people in a single office in Toronto, where we produced reports on 300 companies, most
of them Canadian firms traded on the Toronto Stock Exchange. Today we have 650
people based in North America, Europe, Asia, and Australia providing ESG research,
ratings, and data on tens of thousands of companies. And we’re not alone: A handful of
other big rating firms, along with dozens more smaller organizations, distribute some
sustainability data.

What has changed even more than the size of our team and the volume of research we
produce is the way ratings like ours are used. We’ve seen a dramatic increase in the use
of ESG information in the investment process. A decade ago this information was of
interest to a relatively small segment of the investment community. Today nearly all
large institutional investors utilize ESG research to some degree. That’s because
recognition is growing that this data has real value and can drive better investment
outcomes—not in every case, but in enough cases to make a material difference to
investors. Furthermore, while ESG factors can affect a company’s bottom line directly,
they also affect a company’s reputation, and business leaders and investors are
recognizing the potential costs of not managing firms’ ESG risks.

Creating the ratings is challenging work. There are no uniform requirements for
reporting ESG information, and many environmental and social impacts are hard to
measure. So the data inputs that we start with are fundamentally less structured, less
complete, and of lower quality than financial data, which companies are required to
present in standardized form and have audited by accountants. The lack of rules and
robust metrics makes our job more difficult—but also more valuable. Because we’re
compiling data and generating insights that many investors have not used in the past
and don’t have easy access to, very often this information is not priced into stocks.

It is important to us that the companies we assess understand how we arrive at our

ratings. We consider two elements: what risks the businesses are exposed to and how
well they’re managing them. We classify each company into one of 138 industries, and
we have a list of relevant risks for each. For instance, a mining enterprise will typically
face risks related to carbon and noncarbon emissions, environmental management
systems, water use, occupational health and safety, and corporate governance, among
other matters. To ascertain its risk exposure, we look at the specifics of its business.
Suppose the company operates in jurisdictions where complicity in bribery and
corruption is common or where managing community and labor relations is especially
challenging. It faces more risks than do competitors that avoid such jurisdictions, so
we’d adjust its risk exposure upward. A big part of our work is calibrating the degree of
ESG risk that firms face.
The next step in rating a company is to assess how well it is managing its risk exposure.
This involves looking at the types of programs, policies, and management practices the
company uses and its preparedness to avoid or mitigate certain risks. If we don’t have
evidence that the company is adequately prepared, it gets a lower score. Firms that do
have appropriate risk-handling measures in place should disclose what they are doing,
to ensure that those measures are taken into account. Levels of disclosure have
increased tremendously in recent years, but they’re still not as high as we’d like them to
be.

The way companies engage with us throughout the rating process varies quite a bit. A
decade ago only 10% of firms responded to our requests and talked with us about our
analysis. Today more than 60% of large companies share information with us, and that
number has been growing each year. In general, businesses that take special pride in
their reputation and those that have an ESG-minded investor base are willing to spend
more time communicating with us. In other cases, companies that fare poorly in our
ratings or are facing criticism of their sustainability or governance practices are
encouraged by their investors to interact with us.

Sometimes business leaders complain about “survey fatigue” and say they are hearing
from too many ratings firms that request too much information. I empathize with that.
Various international organizations are working to standardize ESG reporting, which
will make it less onerous for company managers. Regardless, I believe it’s worth their
time to engage more deeply with the firms that, like ours, have the biggest presence in
the market.

Once we have completed our ratings process, we send the profile to the company for
feedback. During those conversations, we’re looking for any additional information or
clarification that can enhance our analysis. New information doesn’t always lead to a
change in our rating, but we do listen. As ESG rating outcomes become more important,
we certainly hear from people inside firms who forcefully argue for their point of view.

Today nearly all large institutional investors use ESG research to some
degree.

Companies often see their ratings move if they begin addressing sustainability issues in
new ways or if a significant ESG controversy arises, which can indicate a management
gap. However, some of the more dramatic improvements result from changes to risk
exposure when companies embark on a strategic shift in their operations or business
model. For instance, the Danish power company Ørsted (formerly known as Danske Olie
og Naturgas) used to be involved in oil and gas exploration and production. In 2017,
however, it sold its oil and gas assets and invested heavily in renewables; it’s now one of
the world’s largest players in the offshore wind sector. The company still has some coal-
fired power plants, but it has announced aggressive plans to phase them out. From 2018
to 2019 its risk rating score improved markedly.

Companies’ ESG risk exposure can also move in a negative direction. For example,
Facebook’s ESG ratings have fallen because of increased public alarm about the
company’s handling of data privacy and security. Similarly, Amazon has seen its ESG
scores decline in the wake of growing antitrust scrutiny and concern over workplace
conditions for its employees. Peugeot, the French carmaker, has experienced a decline
in its ESG ratings since its 2017 acquisition of Opel and Vauxhall, which make less-fuel-
efficient vehicles. As a result of the acquisition, Peugeot will most likely miss the
European Union’s 2021 target for CO2 emissions, potentially exposing it to fines of
several hundred million euros.

For companies that want to put their best foot forward, good disclosure of their most
material ESG challenges—and how they’re addressing them—goes far. The best way to
improve disclosure is to issue a sustainability report that has been prepared in
accordance with the Global Reporting Initiative’s Sustainability Reporting Standards.
When companies invest the time to produce a thorough report, our analysis is easier and
the amount of time it takes to talk with us and the other ESG ratings firms goes down
quite a bit. But the most important part of the process happens when companies
scrutinize their business and their business model to understand which issues are most
material in terms of ESG risk. Reducing their risk exposure or finding a better way to
manage the risk typically results in the greatest benefits for the company and its
investors, as well as for the environment and society.

The amount of analytical rigor that goes into ESG ratings has increased substantially,
and that’s a good thing. These ratings are more relevant and more high-profile than ever
before, and investors are paying closer attention. A poor rating draws more scrutiny to a
company, and a strong rating can increase investment flows. That’s part of what makes
this work so interesting.