Lowering Your Cost of Capital Through Effective ESG Disclosure – Part III

Part III:  Understanding investors’ ESG information requirements, the ratings firms who serve them, and sustainability indexes

As we covered in the first and second sections of this blog, ESG investment strategies are rapidly becoming common. Another clear indicator of this trend’s strength is the CFA Institute’s development of standards for investment managers to report the ESG performance of their portfolios. Outside of governance factors, much of investors’ ESG analysis focuses on a company’s impact on the environment and communities. More specifically, it takes into account the magnitude of impact and associated risks, although positive impacts are also taken into consideration. Examples of related risks include reputational harm to a brand, the loss of a license to operate in a country, or an insurance company’s exposure to future damages arising from climate change.

Within this context, many of today’s investors seek to understand how sustainable a company’s financial performance is, as this is considered directly related to its impact on society and the natural environment, such as air, water and climate. When gauging related risks, investors seek to measure how ESG performance is improving over time and at what rate. To conduct their analysis, they rely on detailed ESG metrics that are publicly disclosed by companies, just as they rely on financial statements to forecast earnings. Examples of these metrics include energy sources and consumption levels, carbon emissions (Scope 1 to 3), water usage, and waste generation.

The strong influence of third-party ESG ratings firms and ESG Indices

Some investors pay third parties for ESG assessments of companies they are researching as potential investments, or which already comprise their portfolios.  These assessments take the form of ratings in much the same way that credit rating agencies, such as S&P Global and Moody’s, assign ratings to bonds. For example, MSCI has an ESG ratings scale of AAA to CCC. Other firms that rate and/or write research about companies’ ESG performance include leaders CDP and RobecoSAM, which was recently acquired by S&P, as well as Bloomberg, FTSE-Russell, ISS, Refinitiv, formerly Thomson-Reuters, Moody’s, which holds a majority stake in Vigeo Eiris, a leading ESG research firm in Europe, and Sustainalytics. The powerful ESG ratings of these firms are used as screens by asset managers and/or integrated into traditional investment analysis. These ratings are increasingly used by other key stakeholders as well, such as corporations and governments that need to assess the ESG performance of current and prospective suppliers.

According to the MSCI study that we referenced in Part I of this series, “….high ESG-rated companies experienced lower levels of beta [a measure of risk] and therefore – in the context of the CAPM [model] – lower costs of capital.” This provides some insight into why investors purchase the research and ratings of the aforementioned firms. The study’s authors also note that, “high ESG-rated companies are typically more transparent, in particular with respect to their risk exposures and their risk management and governance standards.” In other words, they can meet investors’ information requirements through effective ESG reporting.

Index providers, such as FTSE, MSCI and S&P also conduct ESG analysis to determine which companies around the world should be components of their respective sustainability indices. In 2019, index funds, in the aggregate, surpassed the $10 trillion mark, led by BlackRock, State Street and Vanguard. As more investors continue to allocate their capital to passive funds and hence ESG-related ones, the implications here too are very significant.  The market valuations of companies that become part of such indices benefit from demand coming from funds based on ESG indices like the Dow Jones Sustainability, FTSE4Good and the MSCI ESG indices, the former being among the most well-known and widely used by investors and other stakeholders.

The InspIR Group can help you learn more about ESG reporting.  Call or email us if you would like to set up a workshop for management or discuss customized projects to initiate your journey to develop best practices in ESG reporting.

Monique Skruzny, New York – monique@inspirgroup.com, +1 212.661.2243