October 1, 2020
Corporate boards and executives, institutional asset managers and investors are all increasingly focused on environment, social and governance (ESG) issues. A host of factors are driving this attention, including:
- The outperformance of ESG-themed investment funds in 2020
- Resulting increased asset flows — $54.6 billion in the second quarter per Morningstar Inc. data, more than double 2019’s record $20.6 billion haul
- Shareholder activity — there were more than 400-ESG themed shareholder resolutions filed during 2020 proxy season
Even beyond intense investor interest, however, many companies are increasingly attuned to ESG for one simple reason: better corporate performance. How companies approach ESG issues can have a significant impact on their success or failure, especially during ESG ratings to guide investors and companies looking to assess ESG achievements.
But as ESG interest has grown, so too have efforts to measure it. More than a dozen third-party entities — including MSCI CDP, Sustainalytics, S&P Global, Moody’s, Arabesque S-Ray, ISS, CSRHub, and others — offer ESG ratings to guide investors and companies looking to assess ESG achievements. Data sources, ratings methodologies and update frequencies vary, but all seek to condense a company’s approach to ESG issues into a score or grade.
For companies looking to advance their ESG practices, it can be tempting to rely on ratings alone: working to improve a particular provider’s score or measuring its success or failure based on peers’ scores. But the variances in methodology and ongoing evolution of ESG mean that managing ESG initiatives to match scoring systems can be difficult at best.
“Not all ESG efforts can be quantified into a dashboard of key performance indicators,” says Meredith Jones, partner and global ESG practice lead at Aon. “Ratings can certainly be a useful tool. But to make genuine progress in this space, a company should be willing to look beyond scores and make a holistic ESG plan that focuses on material issues while also engaging key shareholders. In other words: Do the homework and the grades will follow.”
A solid ESG approach can offer a business a wealth of benefits including stronger connections to shareholders, employees and customers; reduced costs; and improved productivity, talent attraction and retention. Comprehensive ESG tactics may also help avoid public relations disasters, product boycotts and shareholder activism.
A myopic focus on achieving high ratings means a company could miss out on building a comprehensive approach to mitigating ESG risks, as well as fail to identify the opportunities created in a changing global landscape. This is due to three key shortcomings with ESG ratings: they try to quantify the unquantifiable, they don’t always capture ESG’s “moving target” and they aren’t comprehensive.
RATINGS TRY TO QUANTIFY THE UNQUANTIFIABLE
“Certainly there are some metrics in ESG that are easily quantifiable, like board or executive diversity, carbon emissions or voluntary turnover,” says Jones. “But how do you assign a value to the depth of a supply chain or to cyber security efforts?”
And for companies that are new to the ESG game, quantifying intent before there are measurable outcomes is highly discretionary and can lead to misleading results, Jones says.
For example: Two companies state they have diversity, equity and inclusion (DEI) policies. Both get credit in their scores. However, one policy is more comprehensive and includes mandatory unconscious bias training and other factors that will ultimately make it more successful. “The scores likely won’t reflect the disparity in quality and corporate commitment until there are outcome metrics available, giving companies a temporary false sense of security that a deeper dive could have uncovered immediately,” Jones says.
In addition, as different rating agencies apply proprietary methods to measuring unquantifiable factors, results can vary significantly. That variability suggests ratings should be a starting point, and that companies should not take too much comfort in a single good rating, says Jones.
Another consideration: “Investors use a variety of ESG data sources and compile their own analysis. Managing ESG initiatives, metrics and disclosures to multiple regimes can therefore be incredibly time consuming and still may not lead to desired results,” Jones says.
THE ESG ‘MOVING TARGET’
An additional challenge: ESG can evolve quickly.
“ESG isn’t a static set of principles; it’s something that evolves as the environment changes,” says Laura Wanlass, partner and global head of Corporate Governance at Aon. “That’s why we’ve seen a shift in investors’ focus on what matters for particular companies and industries in terms of the E, the S, or the G. The challenges or materiality of the focus are company- and industry-specific.”
During the COVID-19 crisis, for example, the hospitality, consumer goods and professional services industries all face different material ESG risks. The changing nature of ESG risks and variance in exposures by industry makes it necessary to have strong internal controls for evaluating and managing ESG risks in real time, says Wanlass.
“COVID-19 brought to light a lot of social factors that had not been in investors’ crosshairs before,” says Jones. “In fact, prior to 2020, with the exception of DEI initiatives, the social pillar of ESG was often an afterthought. But with new issues around workforce safety, pay-cut proportionality and even more attention on diversity and inclusion, the calculus of ESG has changed dramatically in just a six-month period. So, if you measure yourself based on the 2019 metrics, you may find your 2020 scores fall short.”
RATINGS AREN’T ALWAYS COMPREHENSIVE
Ratings can’t reflect what’s not publicly known. Some companies’ ESG ratings might fall short simply because a company hasn’t done a thorough job of disclosing its ESG efforts.
“You may have to disclose this information through multiple channels to ensure it reaches investors, potential investors and ratings agencies,” says Jones.
In some cases, organizations might be hesitant to highlight ESG efforts because of a perceived lack of progress, says Jones.
“Sometimes companies focus on their intentions and not on their outcomes because, up until recently, intention has been sufficient,” she says. “Now that the ESG mentality is more established, investors and other stakeholders expect to see outcomes. That’s where we see a little more pushback from companies about reporting.”
Often what investors are looking for is the company’s direction of travel, says Jones. “They want to see that you’re making improvements. They don’t expect you to be able to fix your supply chain, lower your greenhouse gases or increase your diversity participation at executive levels overnight,” she says. “Those things take time — but they do want to see progress.”
THE RIGHT APPROACH TO ESG STRATEGY
As they shape ESG strategies, businesses should recognize that ESG ratings have value — not as the road map itself, but as guideposts along the way.
The right approach is thoughtful about ESG risks and opportunities, and the outcomes a company is trying to achieve, rather than simply focusing on trying to achieve a numerical score, Wanlass says. For best results, an ESG approach should engage stakeholders, evaluate current and emerging best practice for a company’s size and industry to determine short-, medium- and long-term ESG goals, and determine how best to demonstrate progress.
Put simply: “An ESG strategy is about determining what issues are material for your own company and industry, identifying gaps, taking action to address those gaps, and then disclosing your strategy and actions to get credit externally,” says Wanlass.
Who should lead these efforts? In larger firms, there may be a dedicated ESG or corporate social responsibility role to lead strategy efforts, working with leaders across the business to understand how ESG factors affect operations. In small to midsized companies, ESG efforts may fall to human resources or investor relations personnel. Regardless of who champions ESG strategy and disclosure within a firm, governance of the process is key.
Increasingly, firms are enlisting the support of their boards to help shape their ESG strategies, as well as efforts to tie ESG metrics to executive compensation to provide additional incentive to manage these important risks, Wanlass says.
Ultimately, the hunt is on for ESG information, and investors are willing to engage with companies to get it, says Wanlass. Communicating details of ESG efforts and progress will help demonstrate that the organization is really embracing ESG in a way that a rating metric alone cannot.
“A resilient company takes a holistic approach to ESG strategy: It continually seeks to understand its ESG risks, mitigate them and create opportunities from ESG where it can,” says Jones. “When ratings become just one input of many in your strategy, you’re making progress.”
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