Navigating ESG Ratings Agencies
BY DAN MCDERMOTT
As ESG matters have grown in importance to investors, so has the influence of ESG ratings agencies. Issuers often struggle to navigate which ESG issues to disclose, the best practices for disclosure, and which surveys distributed by ESG ratings agencies require the most attention. As a result, the ESG performance metrics gleaned through these surveys are inconsistent, posing challenges for investors looking to make informed investment decisions, and issuers trying to figure out which surveys investors are most relying on.
There has been a significant increase in the firms that provide sustainability ratings; more than 100 organizations currently provide sustainability ratings for companies. These organizations include a mix of media enterprises (Bloomberg, Newsweek, CRO Magazine, etc.) and independent ratings agencies (ISS, MSCI, Sustainalytics, etc.). Some rate companies across a full spectrum of ESG issues, while others focus exclusively on environmental factors.
The fragmentation of the sustainability ratings universe can make it difficult for issuers to understand what sustainability data to report. Responding to ESG ratings questionnaires/surveys can significantly drain a company’s resources. GE responds to over 640 ESG questionnaires, a process involving more than 75 employees, over the span of several months. It’s not just GE that devotes copious time and resources to complete ESG surveys. In fact, according to a 2016 Institute of Management Accountants survey, 7.5% of respondents reported completing more than 250 ESG surveys per year.
Mid-cap and small-cap companies rarely have the luxury to dedicate significant resources to ESG reporting. Unlike GE, mid-cap and small-cap companies may have one position dedicated to managing ESG reporting, or none at all. In many cases, ESG reporting falls under the responsibility of investor relations, the CFO, or a combination of the two. Answering lengthy ESG questionnaires can distract these employees from their day-to-day roles.
ESG questionnaires must also be performed carefully, as the process carries some regulatory risk. Regulation FD (“Reg FD”) requires an issuer to publicly disclose any material, nonpublic information provided to certain individuals or entities. In other words, it is critical that issuers provide consistent and uniform information across all ratings agencies platforms to limit the risk of regulatory scrutiny.
Despite these challenges, many companies elect to participate in ESG surveys because there are consequences to a non-response. Top ESG ratings agency CDP (Carbon Disclosure Project) issues F ratings to all companies that do not fill out their questionnaires, regardless of their actual ESG weaknesses.
The resources required to complete these surveys often results in incomplete or inconsistent information that varies between companies and industries and makes comparing and evaluating issuers based on ESG factors difficult for investors. This problem is compounded because each ESG ratings agency has its own criteria, requires its own data set in a unique format, and can score a company differently based on its proprietary scoring system. As a result, different ratings systems will often score a single company at opposite ends of the spectrum.
Increased demand for sustainability data creates challenges for issuers not only through tracking relevant ESG data, but also through employee resource limitations. ICR advises its clients to achieve the maximum impact with investors in the least invasive manner possible. Despite the ‘overload’ of ESG disclosure information, ICR recommends following four simple steps for the best results:
1. Analyze what is “material” for the issuer’s investor base. Review the ESG policies and voting history of the company’s shareholder base. Review the leading frameworks for ESG reporting such as SASB (“Sustainable Accounting Standards Board”), GRI (“Global Reporting Initiative”) and FCLTGlobal to inform decision-useful disclosures.
2. Highlight current accomplishments. Many companies have several ESG initiatives in-place but fail to receive credit for their efforts because of incomplete disclosures. Take credit for what you are already doing. Identify the ‘low hanging fruit’ (e.g. the ESG initiatives already in-place) and properly communicate the information to investors.
3. Be consistent. Report the uniform ESG data across all platforms including public filings (10-K, proxy), ratings agencies questionnaires, Sustainability Reports and company websites. Consistent disclosure negates Reg FD risk.
4. Tell a story. In addition to providing easily accessible, decision-useful information, ESG disclosures provide companies the opportunity to construct a narrative to its investors and other stakeholders that expresses their commitment to long-term value creation.
ESG Ratings Agencies may consolidate in the years ahead, but until a few, market-leadings entities emerge, companies must be proactive about reporting their ESG initiatives to investors and must identify gaps for future disclosure. Though, at first, ESG reporting may appear to be a daunting task, following ICR’s 4-Step approach provides a great opportunity to build an overall narrative of long-term value creation.
Dan McDermott is a Senior Vice President in ICR’s Special Situations Group and is a former Senior ISS Analyst.
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