In this article we introduce climate networks founded to share knowledge and drive innovation across businesses, industry, cities and regions, and we cover the major principles for responsible, sustainable business conduct and responsible investing as well as the key ESG reporting frameworks. Finally, we look in more detail at the role of ESG rating agencies and ESG data providers.

1. The principles for responsible investment

The six Principles for Responsible Investment (PRI) have become the common reference point for investors considering ESG issues. Drawn up in early 2005 by a group of the world’s largest institutional investors and supported by 70 experts from the investment industry, intergovernmental organisations and civil society, the principles were launched in April 2006 at the New York Stock Exchange. In implementing them, the now over 3,000 signatories, representing well over $45 trillion in capital, commit to developing a more sustainable global financial system.

2. The Equator Principles

The Equator Principles (EPs) constitute a risk management framework for financial institutions to determine, assess and manage environmental and social risk in projects. The EPs apply to all industry sectors worldwide and to four financial products 1) Project Finance Advisory Services 2) Project Finance 3) Project-Related Corporate Loans and 4) Bridge Loans. There are currently 105 so-called Equator Principles Financial Institutions (EPFIs) in 38 countries, covering over 70% of all international project finance debt within developed and emerging markets.

3. Eurosif

The European counterpart, Eurosif, promotes sustainability through European financial markets. The organisation works as a partnership of all Europe-based Sustainable Investment Fora with over 400 members drawn from the sustainable investment industry, totalling over €8 trillion in assets. The main activities of Eurosif are public policy, research and creating platforms for nurturing sustainable investing best practices.

4. UKSIF

The UK Sustainable Investment and Finance Association promotes responsible investment and other forms of finance in the UK that advance sustainable economic development, enhance quality of life and safeguard the environment. Founded in 1991, UKSIF has over 250 members including asset managers, pension funds, research providers, financial advisers and non-governmental organisations.

UN Global Compact

The UN Global Compact is based on 10 principles that should define a company’s value system and approach to doing business. The voluntary business initiative, which brings together 8,000 business participants and 4,000 non-business participants, provides a universal language and a framework for corporate responsibility. The organisation also offers hands-on support for businesses with assessing, defining, implementing, measuring and communicating their sustainability strategy.

1. Global Reporting Initiative

The GRI Sustainability Reporting Standards are the first and most widely adopted global standards for sustainability reporting. They were designed for use by any organisation that wants to report about its impacts and how it contributes towards sustainable development. Organised in sets, the “100 series” of the GRI Standards contains three universal standards. The “200 series” includes reporting standards related to economic topics, the “300 series” and “400 series” set out standards covering the reporting of environmental topics and social topics respectively.

2. Sustainability Accounting Standards Board

In November 2018, SASB published 77 standards, providing a complete set of globally applicable industry-specific standards, which identify the minimal set of financially material sustainability topics and their associated metrics for the typical company in an industry.

3. International Integrated Reporting Council

The IIRC’s vision is to align capital allocation and corporate behaviour to wider goals of financial stability and sustainable development. To achieve this, the council has created an International Integrated Reporting Framework, which includes principles-based guidance and content elements to govern and explain the information within an integrated report. The IIRC runs its own network, the <IR> Business Network, which engages with leading organisations around the world committed to furthering integrated thinking, strategy and reporting.

The role of ESG rating agencies and ESG data providers

The ESG rating industry has grown considerably over the past ten years and has already seen a phase of consolidation as well as a new wave of competitors entering the market – often ESG data providers extending their services to also include ratings.

According to the Global Initiative for Sustainability Rankings (GISR), there are well over 100 organisations that produce sustainability research and ratings on companies[1]. The leading ESG data companies include Bloomberg, MSCI, RepRisk, Sustainalytics and Thomson Reuters, while Vigeo Eiris, MSCI, ISS ESG, Inrate and Sustainalytics count to the top 10 ESG rating agencies.

In a bid to secure a footing in the lucrative ESG ratings markets, credit rating companies S&P Global bought RobecoSAM’s ESG ratings business, while its biggest rival, Moody’s, acquired a majority stake of Vigeo Eiris last year.

How do ESG ratings work? Based on a composite score of individual ESG indicators, ranging from 70 to 1,000 different indicators with each weighting differently, they provide an overall rating of a company’s ESG performance.

In addition to single ESG ratings, many agencies also produce ESG-themed indices, such as for example the Dow Jones Sustainability Index (DJSI) or the FTSE4Good Index, which include companies that meet certain ESG thresholds.

Contrary to credit ratings, which issuers request and where credit relevant information is collated through a number of interviews and discussions with the company before a rating is published, ESG ratings are in most cases unsolicited. ESG rating agencies typically make their evaluations based on publicly available information, on corporate sustainability reports and on information from corporate websites. Some agencies will also send questionnaires to firms and offer companies to review and comment on profiles before finalising them.

However, ESG ratings from different providers have shown to diverge significantly. This isn’t necessarily surprising, considering that ESG rating agencies adopt different definitions of ESG performance and different approaches to measure it. The issue is, that the divergence is significant: an MIT study found that in a dataset of five ESG rating agencies, correlations between scores on 823 companies were on average a fairly low 0.61. For comparison: credit ratings from Moody’s and S&P Global Ratings are correlated at 0.99[2].

Hence, ESG ratings have received very mixed reviews. Critics point out that discrepancies in measuring ESG performance make it very difficult for investors to correctly identify ESG leaders and laggards. Likewise, different rating approaches cause confusion amongst companies, which are receiving mixed signals about what good ESG performance looks like. Finally, there’s also concern that there’ll be companies that know how to tell their ESG story, without evidence of the fundamentals, and equally there will be firms that haven’t yet succeeded in showcasing their ESG credentials in an impactful manner.

To find a reliable measure of ESG performance in an unregulated market, efforts are being made to bring more transparency and standardization to the ESG ratings industry. In July 2019, the European Securities and Markets Authority (ESMA) published technical advice on sustainability considerations in the credit rating market and guidelines on the disclosure requirements applicable to credit ratings around whether ESG factors were a key driver of the credit rating action – as this will allow the users of ratings to better assess where ESG factors are affecting credit rating actions[3].

At the same time ESMA chair, Steven Maijoor, called for regulating the ESG ratings market, pointing out that “the lack of clarity on the methodologies underpinning those scoring mechanisms and their diversity does not contribute to enabling investors to effectively compare investments which are marketed as sustainable.”[4]

ESMA has now established the Coordination Network on Sustainability (CNS), which will be responsible for the development of policy in the area of sustainable investing, with a strategic view on issues related to integrating sustainability considerations into financial regulation[5].

Corporate clients who would like to discuss this topic further should contact Dr Arthur Krebbers, Head of Sustainable Finance, Corporates or, Varun Sarda, Head of ESG Advisory.

Notes

[1] Sustainable Insight Capital Management: Who are the ESG rating agencies? (PDF)

[2] MIT Sloan School of Management: Aggregate Confusion - The Divergence of ESG Ratings (PDF)

[3] ESMA advises on credit rating sustainability issues and sets disclosure requirements

[4] Reuters: EU watchdog says ESG rating firms need rules to stop 'greenwashing'

[5] ESMA appoints chair for its new Coordination Network on Sustainability