Ed. note: Today’s article is a continuation of yesterday’s piece 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. Part 1 is here.
Will investor demand for ESG ratings increase?
I see two trends with opposite effects on the demand for ESG ratings:
- There is strong growth in sustainability focused exchange traded funds (ETFs). UBS, the world’s largest wealth manager, recently noted that all their net ETF fund inflows were for sustainable ETFs, with a net outflow for other ETFs. The selection and weighting of shares for these ETFs is often based on a set of exclusion criteria (e.g. no coal, no tobacco) in combination with an under- or overweighting of company shares based on their ESG ratings in relation to their sector. Sustainable investing continues to grow and ETFs are gaining importance within that segment, which raises the importance and demand for ESG ratings as well as indices based on such ratings.
- At the same time there is a trend in the opposite direction. According to the earlier mentioned ERM research, investors “often use the data but explicitly not the scores” when it comes to information they buy from ESG ratings agencies. In other words, investors use ESG rating agencies as providers and aggregators of non-financial information, which they use to analyze and evaluate companies. This is an area where I see a declining role for ESG rating agencies because of the increasing standardization of sustainability related information published by corporations, thanks to good work by organizations such as GRI and SASB. We can expect that ESG information will become more standardized thanks to the recently formed International Sustainability Standards Board (ISSB) and regulatory developments in the European Union.
How could ESG ratings be improved?
Apart from the attention to be paid to strengthen information accuracy, which I referred to earlier, I see two areas where ESG ratings could make a step change improvement.
As mentioned earlier, ESG ratings tend focus on environmental and social issues that affect the supply chain and the way a company operates. The ratings agencies thus played an important role in encouraging companies to improve their programs and reporting on major cross-sectoral topics, such as climate change, diversity and inclusion and human rights. These areas are now becoming part of accepted standards and regulations, such as the TCFD or the Modern Slavery Act. In other words: for these cross-sectoral sustainability topics, ESG ratings provide less added value today compared to 5-10 years ago.
I recommend rating agencies to now focus on better incorporating the impact of a company’s products on consumers. In other words, the ESG score should not only assess “how” a company operates but also “what” a company produces. Some of the SASB standards already go in this direction, for instance by mandating tobacco companies to separately report on combustible versus non-combustible tobacco products. As far as I know, this does not yet exist for other FMCG sectors. One could for instance incorporate the Nutri-Score nutritional rating system, which is officially recommended by health authorities in a number of European countries, into the ESG ratings of FMCG companies, based on their product portfolio. Another possibility is to leverage on the Yuka app scores, which independently rate the health impact of food and cosmetic products.
Another possible improvement for ESG ratings is to go beyond assessing company “risk” and start incorporating “impact”. As an example, if an energy company divests its coal plants, it will see an improvement in its ESG rating. The “impact” question is: will this transaction help to reduce global greenhouse gas emissions? The current “risk” perspective taken by ESG ratings qualifies a divestment of activities as an improvement in the risk profile of the company, without considering whether it has a positive impact on society. Assessing impact will not be an easy exercise, but this is where ESG rating agencies can develop new areas of expertise and value added.
In sum, I encourage ESG rating agencies to integrate both “product” and “impact” dimensions of companies into their ESG scores.