A recent study on environmental, social, and governance ratings found that not all ESG ratings are created equal. This could be a confusing terrain for individuals and money managers alike to navigate. Fortunately, being aware of where the differences lie is a solid step toward understanding key ESG risks corporations face.
Tara Patock, portfolio specialist for William Blair’s U.S. growth and core equity strategies, said in a recent report (ESG Integration Across the Cap Spectrum) that there is a bias toward large-cap companies earning higher ESG ratings due to their broader disclosure of sustainability (or ESG) information.
“As investors have increased their attention on ESG factors, so too have corporations,” she noted. “We have observed a marked increase in the quantity of data that is available to us as investors. This is most evident among large caps, with 90 percent of corporations included in the S&P 500 Index issuing sustainability reports in 2019, an increase from 20 percent in 2011.”
While reporting is high among the S&P 500 companies, there’s still a lot of fragmentation when it comes to the type and ways ESG information is disclosed. Patock said the most common reporting framework in 2019 was the Global Reporting Initiative (GRI) disclosure standards. About half of the S&P 500 names used the GRI, according to the Governance & Accountability Institute. Other sustainability standards included CDP, Sustainability Accounting Standards Board (SASB), and Task Force on Climate-related Financial Disclosures (TCFD).
“With a lack of unified reporting standards, large-cap companies have been disclosing enormous amounts of information, but much of it is not useful in making investment decisions,” said Patock.
Another finding was that while large-cap companies had the financial means and resources to disclose various ESG data via websites, SEC filings, and sustainability reports, smaller-cap firms lagged in that area.
“Expanding beyond the S&P 500 Index to roughly the next largest 500 companies—as measured by the bottom half of the Russell 1000 Index, which can be described as mid-cap companies—only 39 percent of companies issued sustainability reports in 2019,” she noted.
This is because smaller-cap companies tend to be earlier in the process of incorporating sustainability factors into their strategy, and they also lack the required resources for detailed reporting.
She pointed out that because of this lack of ESG disclosure in the smaller-cap space, a different approach is necessary for money managers. This would include direct discussions with company management about ESG issues and solutions – things that otherwise would not be disclosed on their website or via a sustainability report.
In addition, because rating agencies more readily find ESG information from large-cap firms, their ratings tend to be more positively biased toward those larger companies. Also, because of different methodologies, ESG ratings from the agencies provide inconsistent results when evaluating a firm on its ESG risks.
The four rating agencies that were compared in the study were Sustainalytics, MSCI, RobecoSAM, and Bloomberg.
“Analysis from Empirical Research Partners comparing four ESG ratings providers against one another suggests the average correlation of ESG ratings is only 60 percent,” she pointed out. “This implies that using two different ESG ratings vendors to assess the ESG quality of an individual company, or a portfolio of companies, could lead to very different conclusions.”
The solution to better understand smaller firms’ ESG engagement, according to Patock, is to hold meaningful and constructive dialogues about these issues with their management. Also, when money managers hold large and long-term stakes in these companies for their clients, they have more say regarding ESG risks and initiatives of these firms.
By comparison, since stock holdings in larger firms are more diluted, money managers have less sway. However, by coming together in a collaborative shareholder engagement they can still make a significant impact regarding ESG issues facing large-cap corporations.