Who will be the Moody's of ESG investing?

ESG investing needs to be quantified. The myriad benefits of doing so may surprise you.

  • By John Divine,
  • U.S. News & World Report
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The year 2020 has already seen environmental, social and governance (ESG) investing gain some high-profile converts. For context, ESG factors have been increasingly used in recent years to evaluate the responsibility and sustainability of public companies, as well as their societal impact.

In January, the head of the world’s largest investment management firm wrote an open letter to fellow CEOs. In it, BlackRock (BLK) CEO Larry Fink vowed to use his firm’s $7 trillion in assets under management – and the considerable voting power that comes with such a portfolio – to encourage sustainability and fight climate change.

It's a big moment for ESG investing.

Making the case that climate risk was investment risk, Fink said BlackRock would use its voice to push for greater company disclosures on sustainability. In fact, the letter included a not-so-veiled threat, saying it would be “increasingly disposed” to vote against management when disclosures are wanting or the business isn’t making progress on sustainability.

Derek Horstmeyer, an associate professor of finance at George Mason University, says BlackRock’s sheer size is what makes Fink’s announcement carry some heft.

“As the largest manager of money out there, especially retail money, this is an important step,” Horstmeyer says.

The necessity of ESG ratings

BlackRock isn’t the first firm to use its influence to encourage more well-rounded and thoughtful corporate behavior.

The market as a whole has been moving that way for a number of years. The number of exchange-traded funds (ETFs) that are tracking more socially responsible companies is ballooning. BlackRock itself now plans to double the number of ESG ETFs it offers to 150 in the next several years.

In another notable sign of adoption, Yahoo Finance, one of the internet’s most popular investing resources for individual investors, added a “sustainability” tab to its stock quotes pages in 2018.

That said, when there’s a $7 trillion carrot-and-stick situation, it begs an important question that Wall Street suddenly must take more seriously than ever: Who will get to judge exactly how sustainable company X is, for instance, and how will they do it?

After all, someone must decide which ESG factors matter, and decide how to objectively and quantitatively score them.

Early-inning leaders

Yahoo uses a firm called Sustainalytics to populate the metrics in its sustainability tab. Other firms jockeying to become the leading providers of ESG ratings include MSCI, Refinitiv and ISS.

“Sustainalytics is probably the premier data provider for ESG,” Horstmeyer says. A number of firms are jockeying for position in the space or hoping to carve out a niche, including each of the big three credit rating agencies: Fitch Ratings, Moody’s Corp. (MCO) and S&P.

Frankly, it’s not hard to see why so many firms are rushing to become one of the go-to providers for ESG ratings.

Moody’s alone is worth more than $50 billion. Its an empire built on the back of its credit ratings. The other two companies are private, but S&P is comparable in size to Moody’s.

Even given the fact that the ESG-ratings industry will likely be a fraction of the market for bond ratings, there are still plenty of opportunities.

So, what’s the problem?

Inconsistent ratings and a dearth of data

Erika Karp is the founder and CEO of Cornerstone Capital Group, an ESG-focused registered investment advisory that recently launched its own impact fund, CCIIX.

“If you think about credit ratings – Moody’s, S&P, Fitch – their ratings are correlated almost perfectly. But if you look at the different ESG raters, the correlations around their ratings are extremely low,” Karp says.

There's another problem, and it's one that’s been around since the dawn of the ESG, SRI and impact investing movements. There needs to be agreed-upon standards – sets of values – that investors demand from companies. What information does someone need to quantify which stocks are best-in-class names worthy of being included in a "responsible investing"-themed ETF, for instance?

To that end, Karp is a founding board member of the Sustainability Accounting Standards Board (SASB), a nonprofit organization. “The reason we founded it was to get consistent, projectable, auditable disclosures on material factors by sector,” she says.

And data like that, it turns out, is really the catalyst that most ratings firms are missing today. If every public company immediately disclosed reams of relevant, quality data, the inconsistency between ESG grades would shrink overnight.

“It’s not about more data, it’s about better data,” Karp says. “You go by industry and say, ‘What is the fundamental information we need to make a fully informed investment decision?’”

Frankly, it's curious that institutional investors didn't pounce on this back when SASB was conceived back in 2011. You'd think portfolio managers, hedge funds and other Wall Street folks would love nothing more than greater insight into company goings-on.

Karp gives examples of the kinds of disclosures SASB might require by industry: In the beverage industry, you’d want water-related disclosures. Shipping might focus on safety and carbon emissions, while human trafficking risks would be more relevant in the hotel and airline businesses.

“Fundamental ESG data is about revenues and costs and risk,” Karp says.

“When you do that work you don’t even have to talk about sustainable investing or impact investing. This is just investing,” she says. “But with more information and more insight.”

Difficulty of starting a feedback loop

So, high-quality ratings are needed to take ESG investing to the next level. But that can’t be achieved without a material increase in company disclosures. And companies aren’t likely to simply disclose more data voluntarily.

Plus, given today’s famously fractured political landscape, counting on the government to require ESG disclosures seems a fool’s errand, at least in the near term. But there’s still another option, which could actually be quicker and more efficient.

“I think it will be market-driven – the increase in disclosures. It’ll come from investors saying, ‘Tell us about ESG risks and what you’re doing on that front,’” Horstmeyer says.

Once the market has enough data, and there's a broad consensus on which ESG criteria are most important for any given industry, companies will start paying more and more attention to ESG issues as investors weigh these previously ignored areas more and more heavily.

First things first

While any company with a meaningful chunk of the ESG ratings market 10 or 20 years from now should be sitting pretty, it’s a little silly to declare a frontrunner today, when no consensus exists on how to actually best score ESG risks.

From a branding perspective, it seems companies like Sustainalytics, Refinitiv, MSCI and ISS have done the best jobs associating themselves with ESG.

Once some baseline methodologies are established and widely adopted, the race to become the Moody’s or S&P of the ESG world will really get interesting.

Vincent Manier is CFO at ENGIE Impact, a company that helps businesses, cities and governments become as sustainable as possible. Manier thinks BlackRock could play a pivotal role in the next phase of ESG's evolution if it wanted. Manier thinks BlackRock should “use its dominant market position to normalize ways of measuring and mitigating sustainability-related risks.”

“Right now, the Task Force on Climate-related Financial Disclosures reporting is voluntary, but if heavy hitters like BlackRock systematically demand it, climate-related financial disclosures will quickly become the industry norm, even before they are regulated,” Manier says.

Who tomorrow's leader in ESG ratings will be is unclear, but what's certain is that many companies have exciting opportunities in the nascent area right now. At the end of the day, it’s also exciting to consider that investing continues to be a dynamic mix between art and science – and that its evolution on both fronts is far from over.

Consumers long ago learned how to vote with their checkbooks to affect change. It’s refreshing to see Wall Street, whose moral compass has always pointed to dollar signs, finally exercise some of its enormous power to pursue something good – even if it fundamentally does so in the interest of profits.

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