Moving Towards Investor-Friendly Ratings

22 Jul 2011 – Cécile Churet

As Rate the Raters pointed out, we are indeed witnessing a proliferation of “sustainability-related“ ratings, but these come in many different sizes and flavours, making comparison difficult. While some are directed towards consumers, others are akin to corporate reputation barometers, others are issue-specific, and still others are largely driven by ethical considerations. Only a handful seek to provide investors with a comprehensive view on a company’s performance and its ability to address long-term challenges compared to its peers, and can therefore be considered truly “mainstream” from an investor’s perspective.

The more “mainstream” sustainability ratings or indices share many of the key characteristics described in the Rate the Raters report. They seek to identify and analyze sector-specific issues and structural trends that are reshaping the competitive landscape of the industry. They focus on long-term issues and seek to understand the extent to which these issues can have a material impact on a company’s performance (and how). These can be current externalities that are progressively being internalized by companies (e.g. GHG emissions, supply chain risks) or intangible assets that need to be managed for the long-term (e.g. human capital, ecosystem services).

By analyzing how these issues are being managed, mainstream sustainability ratings help create a better understanding of the overall quality of management. In that sense, they complement and enhance traditional financial analysis because they give investors additional insights into “change management processes” that are not only critical to delivering on the corporate growth strategy but are also essential in making the company more adaptive to a changing landscape and more resilient to potential shocks.

Arguably, few sustainability indices have captured the attention of mainstream investors because too few are focusing on sector-relevant (if not company-specific) issues and on value creation (e.g. understanding the costs and benefits of investing in energy efficiency or addressing water-related risks at some manufacturing locations). In our view, this focus on material issues is a prerequisite to a wider adoption of sustainability ratings by the investor community.

Mind the gap

This is compounded by another problem, namely the large discrepancy between the nominal interest in ESG research (the backbone of any sustainability rating) – as can be inferred by the growing number of PRI signatories (now representing over USD 25 trillion) – and the true size of the Responsible Investment markets. In spite of this impressive aggregated number, the PRI indicates that the listed equity assets managed by PRI signatories which actually incorporate ESG analysis in the investment process represent only 5% of the total market size of all listed equity assets globally. Similarly, according to Lipper, there is approximately a €100bn market for Responsible Investment in Europe at present. This suggests that the amount spent on ESG research is still relatively small.

Closing the gap between the actual and the potential size of the market requires a broad acceptance and wider adoption of sustainability ratings. It is also the key to making value-adding sustainability ratings financially viable. Here, transparency regarding the underlying research process would certainly help and we would expect robust analytical frameworks to receive a growing share of Asset Managers’ research budgets. Considering that the amount spent annually on relatively homogenous sell-side research completely dwarfs the amount spent on ESG research and ratings, it is reasonable to expect that a small percentage of this research pot could be redirected towards differentiating and value-adding research.

Going beyond the headlines

Greater transparency will also enable greater integration of ESG in actively managed funds. As this field matures, investors are increasingly interested in the actual data and analysis upon which sustainability ratings are built. Whilst they will certainly continue to use ratings to help define their investable universe, to measure the ESG impacts of their portfolios or as benchmarks, investors will also increasingly use the underlying data to inform their investment decisions on a stock-by-stock basis. Therefore, it will be in the interest of all market participants to create more transparency around the building blocks of sustainability ratings in order to help grow the overall market for ESG research. This will naturally go hand-in-hand with some specialization along the value chain. As some ESG data becomes increasingly standardized and commoditized, this provides an opportunity for some players to concentrate on data collection and distribution, whilst others focus on data interpretation and analysis. Depending on their experience and their investment strategies, some investors will want more of the former or more of the latter, or indeed a customized mix of both.

Raising the bar

As ESG core data becomes more readily available, dedicated sustainability asset managers and ESG research providers will continue to strengthen their competitive advantage by focusing on under-researched long-term issues that lie at the crossroads between traditional financial performance and broader business performance. This might include a company’s ability to involve stakeholders in its innovation management process, its ability to grow local markets in emerging economies by increasing the share of locally-sourced procurement or its ability to derive more value from closed-loop business models and eco-systems services.

Even though these “next-generation” sustainability issues are rapidly emerging on the corporate radar screen, little information is available in the public domain. In this dynamic environment, it is extremely important to have strong relationships with companies to enable these conversations to take place. In the process, investors gain further insights in management’s ability to manage these new types of risks and opportunities, and management becomes more aware of the materiality of these issues.

Therefore, there is also some “engagement value” in sustainability ratings and indices that have structured and ongoing dialogues with the companies they assess and rate. For investors increasingly interested in passive investment products, this offers a powerful vehicle to exercise their stewardship responsibilities as universal owners.

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Cecile Churet is a Senior Equity Analyst at Sustainable Asset Management (SAM). Launched in 1999, the Dow Jones Sustainability Indexes (DJSI) are a family of global equity indices comprised of companies demonstrating leading sustainability performance. The DJSI is based on a collaboration between Dow Jones Indexes and Sustainable Asset Management (SAM). Using a best-in-class approach, SAM evaluates the environmental, social and governance performance of companies based on completed questionnaires, company-submitted information and public information using a proprietary methodology. The DJSI family of indexes includes indices that are global and regional in scope (e.g. North America, United States, Asia Pacific, Korea). The primary audience is investors who have over $9.5 billion in assets under management based on the DJSI (as of June 30, 2011).