ESG Ratings – Quo Vadis?

An outlook on the sustainability ratings market —

This article goes beyond the findings of a scientific study about sustainable investing and ESG ratings published in 2016 on Academia. It accounts for some significant events that took place in the ESG ratings industry more recently. 

The ESG ratings industry is in full transition. Driven by the demand from institutional investors and the awakening of the retail investment market, asset managers increasingly consider environmental, social and governance (ESG) issues an integral part of their investment approach. Gone the days when ESG considerations were confined to a laudable but small group of socially responsible investors (SRI). In today’s world, the inclusion of ESG factors as part of a fundamental assessment to gauge potential risk and seize long-term financial performance is becoming common practice among mainstream asset managers.

According to a study by the Global Sustainable Investment Association (GSIA), in early 2014 some US$21.4 trillion of financial investments were taking into account ESG issues. This figure represents 37.5% of all assets managed globally, up from 25% in 2012.The tendency today is to invest at the earliest stage of wealth accumulation attaching paramount importance to the ESG quality of the portfolio and the underlying ESG information.

As a consequence, the rising demand from the mainstream for ESG information has been adding considerable momentum to the development of the ESG ratings market. After long years of modest growth, it is now said to have a potential value of US$1 billion [source: GISR]. After the entry of MSCI, Bloomberg, Thomson Reuters into the ESG rating market in 2010 and 2009 respectively, 2016 marked the entrance of credit rating agencies, with S&P announcing the purchase of Trucost and the introduction of a proper ESG rating tool in 2017. In an effort to gain the critical mass to service the mainstream investment industry at international level, some traditional ratings providers such as Vigeo (UK) and Eiris (France) in 2015 merged into VigeoEiris. Others, like Oekom Research (Germany) have been widening their geographical coverage by opening international offices in the US and the EU. Still others invest in collaboration and integration. Recent examples are Bloomberg, who now provide ESG data from RobecoSam on the Bloomberg Terminal. Or Sustainalytics, who are the data engine behind Morningstar’s new fund rating services.

What’s your focus?

Ratings are a common aid for institutional investors, genuine socially responsible investors and conventional asset managers to better assess a company’s performance and potential risks for long-term investment decisions. However, while conventional asset managers prioritize the financial return, institutional investors and SRI managers are bound to more normative investment policies. This results in a different demand in regard to the type and focus of ESG rating information. Depending on a specific policy and focus, one group might give a greater weight to social and environmental issues than another.

Driven by rigorous due-diligence standards, institutional investors therefore usually work with several specialized ESG rating providers and a number of internal analysts to cover all material issues related to an investee. This also includes direct communication techniques as part of an active portfolio management process. Conventional and SRI asset managers, on the other hand, must increasingly protect their bottom line. They often rely on one single ESG rating provider, as they typically don’t have the resources for a complementary assessment approach.

The comfort of receiving bite-sized ESG scores from a single rating provider, however, bears the risk of dependency. It obliges the asset manager to trust in the independence of his agency, the accuracy of the ESG data, the competence of the analyst, the transparency and logic of the rating methodology, and – ultimately – the reliability of the final ESG rating score.

While SRI managers traditionally favor established providers with a values-based focus like VigeoEIRIS or Oekom Research, conventional asset managers might tend to look at renowned market players like MSCI or S&P that concentrate more on financial materiality aspects like governance and environmental issues. Due to their vigor and reputation on the financial market, these mainstream players could also offer ESG rating information as part of a package along with other services at very competitive rates. Whether the market entry of these heavyweights will lead to a gradual standardization of ESG rating techniques and scores over time remains to be seen.

So how can established ESG rating agencies stand their ground in this increasingly competitive environment? Rather than trying to woo new customers from the mainstream, traditional providers will be well advised to stay true to their unique selling proposition characterized by a strong ethical focus, independence, and high quality standards. This strategy makes them a natural partner for SRI and institutional investors, especially if services can be provided at international level and in the form of collaboration. Oekom Research, for example, supports the Climate Bonds Standards board with the certification of climate and green bonds, while VigeoEiris represents the methodological power behind the upcoming Corporate Human Rights Benchmark (CHRB).

It’s all about value

No matter whether specialized or mainstream, ultimately the value of all ESG rating providers is in the impact their services have on the outcome of a specific investment strategy. In order to ensure high quality standards and to counter the single-source issue, many ESG rating providers follow the call for more transparency and accountability by aligning themselves with ESG quality standards from ARISTA, the guidelines from the Global Initiative for Sustainability Ratings (GISR), or the new Deep Data Delivery Standardlabel. Ultimately, active engagement might become a substantial differentiator between providers and the quality of their services. This implies the training of internal researchers and analysts to enable them to engage with rated companies with the objective of complementing information that isn’t publically available in corporate sustainability reports or press releases. However, this quality approach poses a major challenge because it means higher investments costs and squeezed margins.

Due to the rising interest in ESG issues in the broader investment community, the ESG ratings market is likely to grow and consolidate further, leaving ever greater attention on the part of the financial world in its wake. While the growing demand from mainstream investors is likely to be covered by large financial players with a more profit-oriented mandate, institutional investors and SRI managers will privilege traditional values-based ESG raters to meet their specific standards. No matter the provider, at the end of the day it is all about the quality of ESG rating information and their impact on investment results. It might take some extra efforts by sustainability raters to make sure that these high expectations are being met in the long run.

This article was first published on January 17 2017 by Sustainable Brands Magazine.

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