Ed. note: Today’s article is from Huub Savelkouls. Huub held several senior leadership positions in his 26 years at global tobacco giant Philip Morris (PMI) until he left in 2020. From 2016 – 2020, Huub was Vice President Value Chain and Sustainability, Vice President of Social & Economic Affairs, and Chief Sustainability Officer (CSO), leading the company’s transition to its current position as an ESG leader. He was a member of the SASB Standards Advisory Group and a Liaison Delegate to the World Business Council for Sustainable Development (WBCSD). He is currently a visiting lecturer at Franklin University Switzerland. I had the great pleasure of meeting Huub several years ago and discussing meaty ESG issues – which he does not back away from as this piece shows. This is part 1 of 2.
More than a third of financial assets traded in the world’s biggest markets, representing $35.3 trillion, are now marketed as sustainable investments. This rapidly growing investment style has in turn increased the demand for environmental, social and governance (ESG) related information, including so-called ESG ratings. These ratings purport to assess and summarize the overall ESG performance of publicly traded companies into a single number or ranking, based on proprietary systems developed and commercialized by specialized agencies such as Sustainalytics, MSCI, Refinitiv and ISS (among others).
ESG ratings are often mocked for their contradictory and divergent assessments. In their study Aggregate Confusion, MIT’s Florian Berg and co-authors calculate a correlation coefficient of 0.54 for ESG ratings provided by 6 major rating agencies. In other words, these ratings are halfway between fully consistent with each other (1.00) and completely uncorrelated (0.00). This finding is no outlier. A recent article in a Swiss financial newspaper[1] compared ESG ratings provided by Sustainalytics and Refinitiv for companies listed on the Swiss stock exchange. Even though the ratings were often aligned, they displayed very contrasting views on a number of companies. For example Credit Suisse ranked as a top ESG performer by Refinitiv yet was a laggard by Sustainalytics, and vice versa for Swatch Group.
This pattern is consistent with my own experience. A couple of years ago, when I was Chief Sustainability Officer at Philip Morris International (PMI), I compared the ESG ratings assigned to the four major international tobacco companies according to four different rating agencies. The result? PMI came out as best, second best, third and last of the group, depending on the ESG rating agency. Aggregate confusion, indeed!
These findings prompt the question why agencies arrive at such different results and whether it is worthwhile to pay attention to these ratings, given their inconclusive results. I have also been asked how it is possible that tobacco companies tend to achieve high ESG scores. I will discuss these and other questions below.
Why do ESG rating agencies arrive at such different conclusions?
Without a single, authoritative definition of sustainability, what “good” looks like tends to be subjective and subject to change over time. The list of potential environmental, social and governance topics that a company could be measured on is long and there is no harmonized view on the materiality of each topic, in terms of their impact on a company or impact on society. As a result, the scope of topics included as well as each topic’s relative weight in calculating an overall company score can differ significantly between one rating agency and another. This is an important reason why the same company can be rated so differently by different agencies.
Ideally, rating agencies should disclose the scope and weighting of ESG topics used for assessing individual companies. Such transparency would allow stakeholders (including investors) to assess whether their view on materiality matches with the rating agency’s perspective and act accordingly, i.e. accepting or ignoring the rating agencies assessment of a company. Transparency would also enable constructive feedback to the rating agency, which in turn should improve the robustness of their ratings. The emergence of sector specific sustainability standards, such as those developed by SASB and GRI, should also influence the scope of topics that rating agencies include in their assessment and thus promote a convergence of rating outcomes. Having said that: I do think it is healthy and normal that differences of opinion exist when it comes to assessing ESG materiality. Just like sell-side financial analysts come to different conclusions with regard to a company stock price targets, we should expect different conclusions as to how sustainable a company is deemed to be.
A second reason for variability in ESG ratings is the choice of information sources and the quality assurance applied when analyzing this information. Some rating agencies work on the basis of questionnaires which ask companies to provide a long list of ESG related information. Not answering these questionnaires can trigger a low ESG score, even if a company’s actual ESG practices are good.
Other agencies work exclusively on the basis of publicly available information, such as company reports and media articles, which are then processed by analysts or artificial intelligence (AI) algorithms. In my experience, this regularly led to incorrect information, especially when interpreting media articles as a source for so called “controversy reports”.
These reports cover incidents in which a company is involved, often rated according to an incident’s severity, influencing the overall company ESG score. Several times per year, I was confronted with alleged incidents that upon further investigation turned out to be completely unrelated to our company. My own experience therefore aligns well with the findings of the ERM report “Rate the Raters” that “Investors interviewed expressed strong critiques of ratings, from inaccuracies and use of old or backwards-looking data…”.
Should companies pay attention to ESG ratings?
From a company perspective, it can be tempting to ignore ESG rating agencies and their scores. Not all investors pay attention to ESG, there is much skepticism towards ESG ratings as I explained above. Furthermore, it takes time and resources to fill in ESG questionnaires and answer rating agency queries. Finally, many investors have developed their own internal ratings frameworks independent of the commercial ones (this is discussed more in Part 2).
My advice is that the time a company spends on ESG ratings should be inversely proportionate to the maturity of a company’s sustainability strategy and programs. Completing an ESG questionnaire functions as a checklist helps identify blind spots in a company’s environmental, social and governance policies and programs. ESG ratings can enable a company to benchmark their ESG practices with peer companies and identify areas for improvement (keeping in mind the potential for meaningful variability of course). A low ESG score can be the result of an incorrect understanding of a company’s practices and performance by the rating organization. Here, companies should use the opportunity to engage with and educate the rating agency as well as consider ways to improve their ESG reporting and communication. In short, ESG ratings can truly help to improve a company’s policies, programs and reporting practices.
Some companies have actually taken the step to sue an ESG rating agency. Last year in Germany, Isra Vision successfully sued Institutional Shareholder Services (ISS) for assigning the lowest rating to the company after it failed to participate in an ISS sustainability survey. This development may be an indication that ESG ratings are at least perceived as having a business impact, for instance by influencing investor decisions and thus affecting a company’s cost of capital.
Another suggestion is not to change company practices just to please ESG raters, but always be led by a company’s own materiality analysis and resulting prioritization of issues. If this costs points in an ESG score, then so be it.
Companies should engage with ESG agencies to explain their rationale for prioritizing some issues over others. Companies should not, in my opinion, allocate resources on topics that the company (its sustainability team, senior management and board of directors) believes to be less material based on their assessment of their specific situation.
Finally, companies should be selective when it comes to answering ESG questionnaires and engaging with rating agencies. Find out which rating agencies are considered most relevant for your stakeholders. Use this information to make a shortlist of ESG raters that will get full attention, while only monitoring others.
Why do tobacco companies achieve high ESG scores?
Tobacco companies tend to rank among the better ESG performers, with for instance Sustainalytics rating each of the four major international tobacco companies within the top quartile in a set of 598 companies. This good performance is, in my opinion, enabled by three factors that tend to play a role for all tobacco companies:
- their business models are traditionally not very complex;
- their profitability is robust, enabling them to pay suppliers fair prices and invest in people and technology; and
- the harsh public scrutiny to which they are accustomed results in a general drive towards excellence
With regard to the “low complexity” point, big changes are underway as the sector is transforming away from cigarettes towards reduced risk products. This transformation involves new scientific research capabilities, an increasingly complex supply chain which now includes electronics manufacturing, new manufacturing processes and new ways of interacting with consumers. These new dimensions require enhanced ESG practices, from recycling of electronic devices to increased standards for responsible business practices. Not all companies are transforming at the same speed and not all of them will be able to equally master these new ESG challenges; therefore I expect the “spread” in tobacco company ESG scores to increase.
Finally, let’s keep an important caveat in mind when considering ESG ratings: they tend to focus on assessing a company’s operating practices rather than the impact of a company’s products on consumers. The fact that cigarettes are very harmful to the health of consumers thus hardly weighs into an ESG rating, making it possible for tobacco companies to achieve a good ESG score.
In Part 2, Huub will look at investor demand for ESG ratings and how ratings can be improved.
[1] Handelszeitung, October 21, 2021
