Environmental, Social, and Governance (ESG) considerations are becoming more relevant globally, and companies are now being evaluated on “non-financial” criteria alongside more traditional financial metrics. Changing priorities such as climate change and gender equality have become critical issues for the global community, including the investment landscape. As ESG metrics increase in importance, asset managers are increasingly analyzing ESG data in conjunction with traditional financial measures. ESG’s position as a central element of any company’s investment case is the new normal, as several prominent shareholder groups and governance advocates have turned their focus to ESG issues and have been increasingly vocal about their expectations for transparency and reporting on these matters. For example, BlackRock announced in 2018 that it would require that all of its fund managers consider ESG factors when making investment decisions. An uptick in shareholder proposals or other informal engagement on these issues has recently become even more prominent.
In fact, c-suites and boards are already noticing steadily increasing interest from investors in ESG-related risks and value creation. Yet, while the importance of ESG is gaining recognition, this topic has traditionally not been central to the financial workings of companies. In spite of the proliferation of consultants, experts, and service providers, ESG data is non-standardized and only lightly regulated – there is no single authority, no benchmark, no industry standard.
Rather, companies are often being evaluated and rated on their ESG performance by various third-party providers of reports and ratings, such as Institutional Shareholder Services (ISS), MSCI ESG Research, and Bloomberg ESG Data Service (think of these as the Moodys and Standards and Poors for sustainability). Institutional investors, asset managers, financial institutions and other stakeholders are increasingly relying on these reports and ratings to assess and measure company ESG performance over time and as compared to peers. This assessment and measurement often forms the basis of informal and shareholder proposal-related investor engagement with companies on ESG matters. However, report and ratings methodology, scope, and coverage vary greatly among providers. How well a company understands these agencies’ methodologies and how thoughtfully a company tailors its own disclosures to these standards will be increasingly important in the coming months and years.
What is an ESG report?
Corporate ESG reports are externally generated by third parties and are based on company disclosures in the three distinct ESG categories: environmental, social, and governance. In most cases, companies are automatically rated on an annual basis, whether or not the company desires such ratings. Companies are often rated on a scale (typically alphabetical or numerical) according to their exposure to industry specific ESG risks and their ability to manage those risks relative to peers. Scores are then sold by the ratings firms to interested outlets, such as investors. Some investors will follow this recommendation, similar to the way they do for traditional proxy voting measures. However, many of the larger asset managers and going forward, bulge bracket banks, will be doing their own due diligence.
How do rating agencies develop a company’s ESG score?
Rating agencies collect public ESG information disclosed by companies (often leveraging artificial intelligence and alternative data) through corporate social responsibility (CSR) or sustainability reports, government databases, company publications including mainstream filings, publicly available company policies as well as information on a company website. Then, they rank the respective company and its practices on a variety of indicators (sometimes upwards of 150+). Various rating agencies will often invite companies to review and verify their data through routine data verification. That is why it is important for companies to engage with these agencies to improve or correct data.
What are the criteria rating agencies evaluate?
As previously mentioned, ESG scores are based on company disclosures in the three distinct ESG categories: environmental, social, and governance. For example, environmental disclosures include topics such as greenhouse gas emissions, pollution, renewable energy, water usage, and waste disposal, while social disclosures focus on diversity, labor relations, product safety, employee health and safety, and community relations. Governance indicators often discuss ethics, board diversity and composition, executive compensation, shareholder rights, and supply chain engagement. Below are a select handful of the types of questions these firms consider during the evaluation process:
- Are there any specific, salient risks that the company’s activities and business relationships pose on the environment, and if so, how are they being addressed or offset?
- Does the company disclose a climate change policy or equivalent information that specifically addresses its climate change risks, performance, and opportunities?
- What are the company’s risk management procedures regarding climate change risks; how far into the future does it monitor risk management procedures?
- Does the company have waste management and recycling programs? Does the company provide specific targets for reducing hazardous and non-hazardous waste?
- What specific salient risks does the company’s activities and business relationships pose on human rights?
- What is the scope of your company’s disclosed training or professional development programs for employees?
- Does it publicly disclose a diversity strategy or similar commitment to ensure workforce equality beyond gender at the board, senior management, or workforce levels?
- Does the company have any information on its website regarding corporate social responsibility?
- What is the company’s approach to identifying and addressing data security risks?
- How many women are on the board? What is the proportion of women on the board?
- Does the board have any mechanisms to encourage director refreshment?
- Does the company disclose a performance measure for the short-term incentive plan for executives?
- Does the company have a shareholder rights plan in effect? When was this plan implemented or renewed?
- Has your company disclosed any material weaknesses in its internal controls in the past two years?
Though several standards exist to provide a framework for how a company can disclose sustainability information to investors in mandatory filings, such as the Sustainability Accounting Standards Board, the SEC has not mandated ESG disclosure. Thus, many companies have not felt required to understand sustainability and ESG. However, as sustainability increases in significance across investors and all stakeholders, companies should be prepared to understand the implications of growing ESG transparency and the opportunities and risks that follow. Tune in next week for our discussion on best practices for ESG disclosure!
If you are looking for a team to help evaluate or develop your company’s ESG practices, contact Gilmartin today.
Audrey Gibson, Associate