Expert
Lesson 11
7 min

What is an ESG rating and why is it important for investors?

Despite the increasing importance of non-financial factors in investing decisions, environmental, social and governance (ESG) topics are not captured and analysed in a standardised manner yet.

  • Traditionally, investments were mainly rated according to economic criteria such as profitability, liquidity and risk of an asset;

  • Investors and other stakeholders are increasingly considering social and environmental impact and other non-financial information before making investment decisions;

  • The letters “ESG” stand for environment, social standards and governance and reporting obligations that apply are increasingly becoming standardised to ensure transparency and comparability between companies.

In this lesson, we are going to explain what ESG ratings are and why they are important for investors.

What is sustainable investing?

It is not only innovation, adaptation and learning that play a decisive role in the development of new products and services. In an optimal scenario, a company also has to identify new opportunities, create social value and ensure economically sustainable development with its offering to be considered “successful”.  

Imagine the following scenario: a company is rated as very sustainable by one analyst firm and unsustainable by another simultaneously. What is behind such different results? 

One of the reasons is that there are large discrepancies between the approaches of European and American companies regarding the assessment of sustainability as the definition of sustainability is not standardised. 

This leaves investors in a bind, as ideally all three criteria - environment, sustainability and corporate management (governance) should be included in an assessment based on standardised definitions, on top of other factors such as dividends. There are many moving parts that slow down the standardisation process, such as companies’ fear that their competitive positioning may be negatively affected or in conflict with stakeholder interests on different levels. 

Nonetheless, putting solid ESG strategies into place is of the essence for companies, as their conduct increasingly influences how they are being viewed and assessed by investors, and ultimately, society at large. 

The conduct of companies influences how they are being viewed by investors, and ultimately, society at large. 

Where did ESG investing originate?

First attempts towards adding non-financial factors into the cost benefit analysis of companies dates back almost 50 years. The profit or loss generated by a company is referred to as what is “beneath the bottom line” in business accounting. 

In 1994, the writer John Elkington came up with the term “triple bottom line” - “profit, people and the planet” -  also referred to as TBL or RBL, to include social and ecological impact along with financial impact in assessing a company’s performance. Since this concept has evolved into ESG as the foundation of sustainable and responsible investing (SRI). 

What are some examples of sustainable corporate governance?

Let’s take a look at a few examples of responsible and sustainable conduct of a company or the reverse that may catch the attention of investors. 

Environmental factors

Imagine you read in the media that a publicly-listed clothing manufacturer requires excessive amounts of water in producing their goods, causing water scarcity that affects the entire community next to their main production plant. You know that you are invested in an index via an ETF that includes this company. How do you feel about being invested? Would this influence your decision to invest in this company’s stock?

Widely underestimated until just recently, social aspects into the spotlight and the eye of potential investors. 

Another company is highly reliant on palm oil in the production of its products, driving deforestation of the rainforests, and consequently responsible for pushing animal species to the brink of extinction as well as driving the climate crisis. This company announces that it has put an extensive reforestation programme into place to safeguard biodiversity in the rainforests. How would this influence this company’s ESG rating?

Social factors

Widely underestimated until just recently, social aspects are moving into the spotlight and the eye of potential investors and are gaining importance in decision-making processes in personal finance. Societal issues such as diversity and gender equality representation are increasingly under public scrutiny. However, social factors also include a company’s efforts to provide efficient and effective customer services to ensure customer satisfaction as well as top-notch data protection and privacy measures involving their users’ data. 

Another example is a manufacturer conducting human rights due diligence throughout the entire supply chain of their product to ensure that there is no forced labour or child labour involved in manufacturing. A social issue is also that employee rights are respected and protected and a company ensures fair working conditions are adhered to. Corporations may work on driving employee engagement to a new level or a company may set new standards in community relations by regularly hosting events or campaigns. Thanks to digitalisation and connectivity, both negative and positive news stories spread like wildfire, influencing public opinion, and ultimately share prices and ratings, within seconds. 

Europe is working towards becoming the first climate-neutral continent in the world in the scope of the European Green Deal.

(Corporate) governance factors 

Corporate governance involves defining expectations, responsibilities and rights between different stakeholders in how a company (or also a government) is managed and directed. Governance issues may involve the abuse of users’ data by a corporation, spreading fake news to influence public opinion or disguising flawed exhaust emission readings to customers in the automotive industry. Shareholders expect companies to set and to adhere to appropriate governance practices, just like they do concerning environmental policies and societal conduct, both of which may overlap with governance factors in many cases. 

 

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What is underway in terms of standardising ESG?

In order to ensure that companies, investors and policymakers can access appropriate definitions for which activities are environmentally sustainable, the EU taxonomy was put into place as a classification system. (Taxonomy is the practice of categorisation.) Europe is working on becoming the first climate-neutral continent in the world in the scope of the European Green Deal and the EU taxonomy is to support this process. 

Several EU directives (legal acts setting a target to be achieved by all EU countries) are underway to promote ESG reporting (non-financial reporting) in the financial union and to ensure comparability and greater transparency between companies.

Important EU directives

The Non-Financial Reporting Directive (NFRD) was the first directive that required large companies to disclose and to publish information on matters of the environment, social matters and treatment of employees, respect for human rights, anti-corruption and bribery and diversity on corporate boards (in terms of gender, educational and professional background).

The Corporate Sustainability Reporting Directive (CSRD) amends reporting requirements of the NFRD and is to be implemented in Austrian national law by December 2022. To comply with CSRD, in addition to complying with NFRD, companies are required to record the effect of sustainability aspects on the economic situation of the company as well as the impact of their operations on sustainability aspects.

Reporting will need to include information on a company’s sustainability goals, the role of the management board and supervisory board they are met, the company's most significant adverse impacts, and on intangible resources not yet recognized in the balance sheet.

The Sustainable Finance Disclosure Regulation (SFDR) went into effect in 2021 and contains stipulations discouraging “greenwashing” (misleading information on environmentally friendly conduct) while ensuring that participants in financial markets are able to finance long-term growth in a sustainable manner. The roadmap of the SFDR includes “reorienting capital flows towards sustainable investment and away from sectors contributing to global warming (i.e. fossil fuels), managing financial risks arising from climate change and fostering greater transparency and long-termism in financial and economic activity, to achieve sustainable and inclusive growth”. 

The directive contains requirements at both a company and product level. In addition, participants in financial markets have to indicate whether they are in compliance with so-called Principle Adverse Impacts (PAIs) and if not, why. PAIs include 66 actionable items to be adhered to.  

In summary, EU law has the objective to ensure that all interested parties, including investors, have access to the social and environmental impact and other non-financial information on large companies to incentivise them to take a responsible approach towards the way they conduct business. However, these directives are just the beginning of reporting obligations that companies are required to comply with in the future. 

FURTHER READING

BOOKS

  • Brown, Debra L. and David, A.H.  - ESG Matters: How to Save the Planet, Empower People, and Outperform the Competition

  • Matos, Pedro - ESG and Responsible Institutional Investing Around the World: A Critical Review

Why ESG ratings matter and why companies use them

Can we finally standardize ESG standards?

Why ESG is here to stay

ESG investing and analysis

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