To many companies, ESG is still a relatively new field, which is why it is of great interest to Erste Asset Management GmbH to understand how rating agencies evaluate sustainability and how the approach has changed over the years.
Sustainability is a controversial topic which concerns politics as well as the economy in a wholistic fashion. Is it sufficient for a company to avoid a negative impact on society, or does it have to drive sustainability proactively in order to be seen as sustainable? We wanted to understand the rating of ESG in this context better and have had a look at different methods. We have outlined the most important aspects in the following.
The Sustainable Development Goals, agreed on by the United Nations, constitute a particular milestone in the assessment of sustainability. The goals the UN settled on allow for a better understanding (through clearer categories) of what sustainability in the areas environmental (E), social (S), and governance (G) really means. Generally speaking, sustainability has to be regarded within a sector context. Whereas to an energy company the environmental factors play a decisive role, a bank will focus on social aspects and its corporate culture.
There are two popular ways of assessing a company. One is to analyse the corporate risks associated with ESG that could result from certain actions, the other one is to include the ethical component. In order to illustrate these two components, let us look at a company that pays its employees badly. While this does not trigger many corporate risks except for possibly a reputational one (i.e. its image), it is ethically dubious. There are of course also actions the company could take that would both minimise corporate risk and have a direct impact on sustainability. An example would be a company that attaches great importance to the work/life balance. In this case, the corporate risk is lower because the employees are more likely to stay mentally healthy and fewer ones will quit, and at the same time this situation directly affects society because the employees are possibly more satisfied and balanced.
Some industry sectors such as for example oil and gas are not regarded as sustainable but receive an ESG rating, given that they do have the option to proactively reduce ESG risks. Also, sustainability is interpreted differently across different countries – nuclear power being one example. In order to avoid misunderstandings and not to put any industry at a disadvantage, some rating agencies have decided to not only rate sustainability, but also a company’s ability to handle risk.
Essentially, agencies look at two specific aspects: risk and opportunities. How do companies handle these two sides of the coin? Are they reducing carbon emissions and water use? What role do fossil fuels play in their business model? The financial risk is also taken into account: for example, if car manufacturers do not reach the carbon intensity goals, they have to pay penalties. If a car manufacturer develops an electric car, this comes with positive ramifications for its rating, because the revenues generated contribute positively to sustainability. A so-called reality check also enters the rating: the rating agency closely monitors whether a company keeps its promises, i.e. whether it has caused controversies in recent years.
Environmental, Social, Governance
Historically speaking, governance (G) has always been regarded as the most important pillar of the ESG rating. In fact, corporate governance has played a particularly important role in portfolio management, more specifically, in the qualitative assessment of a company. Research, on the other hand, put its focus on the environment and social aspects quite early on. Given topics with a lot of societal currency such as climate change, the focus of the investment sector has also moved to the environment in recent years.
Remarkably, some rating agencies will put an even stronger focus on governance in the coming years. This is due to corporate governance playing an increasingly significant part in company valuation. Corporate governance is concerned, among other things, with the structure of the Board, with the salary structure of the company, and with corporate ethics.
The demands placed on companies have changed substantially in the past 20 years. The rating agencies require more data and information. Over the years, many companies have also realised that more data can lead to a better rating. The willingness to provide the agencies with data voluntarily has increased enormously in recent years as companies have tried to stay competitive. Given that many companies like to present themselves in a better light on paper than they possibly really are, agencies also resort to alternative sources such as state-run institutions, non-profit organisations, and alternative data providers. There is, for example, a way to find out how often a company has been hacked, and – if the hack was successful – how much data was stolen; this, of course, may have a negative impact on the rating.
Rating agencies follow their own approach in evaluating companies. Whereas in the early days they had to contend with a clear lack of transparency, nowadays rating agencies have more and more access to a vast array of different sources of information, which facilitates an ongoing development of the rating models. The rising interest in ESG has also led to a rising demand for ESG ratings. It is therefore important to understand how they were derived and what sustainability really means in this context.
Prognoses are no reliable indicator for future performance.