The focus that investors and analysts are placing on company ESG performance has intensified in recent years. While organisations are still trying to wrap their heads around changing sustainability codes and standards, they also being scrutinsised by raters and rankers. This is all happening against the backdrop of an inconsistent correlation between a company’s ESG scores and their market performance across global rating models.
On 28 July 2022, the ESG advisory consultancy at Trialogue, in partnership with the Institute of Directors South Africa (IoDSA), hosted a webinar that explored how companies in South Africa should engage with these issues.
The panellists included Ann Leepile, CEO of Alexforbes Investments; Marina Madale, MTN Group GM: Sustainability and Shared Value; JSE head of sustainability, Shameela Soobramoney and Farsight’s Matt Worthington-Smith. ESG consultant Lee Swan opened the webinar with a presentation providing context on the topic and Matthew Le Cordeur moderated the conversation that unfolded.
An overview of ESG raters and rankers
The increasing expectations of companies are being driven by various regulatory requirements and a greater demand on the part of investors for clearer corporate reporting on the various codes and standards. ESG performance is becoming increasingly important. Many of the large capital owners in South Africa are taking sustainability into account, and most of the large pension funds and asset managers are integrating ESG factors into their investment decisions.
There is little consensus regarding the correlation or causality between ESG scores and performance in the market. Swan pointed to emerging evidence that suggests that integrating ESG information into investment decisions is linked to higher returns by many indexes. However, there is also a growing body of research that questions the link between ESG performance and returns. A comprehensive study published this year by the Network for Studies on Pension, Aging and Retirement, found no systemic relation between ESG and worldwide stock returns over the past 20 years.
In spite of this lack of consensus, Soobramoney believes that the presence of raters and rankers has increased transparency. She asserted that the foundation of corporate sustainability in South Africa has been well established by the King Codes. She highlights the role that raters and rankers play in bolstering transparency as well as impact.
Soobramoney highlighted, that from the JSE’s point of view, once you have a tool or index that is aspirational, “it encourages companies to have better practices and disclosures without necessarily mandating ‘forty metrics’ that you need to disclose.” Because the JSE’s ratings are based on publicly disclosed information only, this increases transparency in the market and in turn creates a multiplier effect.
“Most of the ESG ratings and data providers make publicly available the overall scores assigned to companies they cover. This increased transparency undoubtedly paves the way for market participants to scrutinise their approach,” Swan said.
This is important given the significant divergence in methodologies. There is divergence in terms of scope, where different ESG factors are considered. There is measurement divergence as raters might consider varying indicators to measure ESG factors. Raters also weight aspects of ESG performance differently – Swan points out that “input data or certain topics are allocated more weight than others, reflecting diverging views on the materiality of these factors”.
Although there is a lack of alignment and divergent opinions regarding ESG raters and rankers, Swan believes they still offer immense value. “The early stage of development is an essential step to enable detailed debate and analysis of varying approaches and their outcomes,” she said.
The future of ESG ratings and rankings appears likely to become even more complex in the short-term;however, in the long term, there will be improvement because of the rigorous discourse and ‘attack and defence’ of methodologies taking place. In the meantime, it is important that companies understand the methods used by ESG raters and rankers, and appreciate that their findings will vary and should not be taken at face value.
There does, however, seem to be increasing standardisation and alignment between raters, rankers, and standards. Leepile drew attention to the McKinsey Sustainability Reporting Survey from 2019, which shows that most investors and executives would prefer a consolidation of sustainability standards to streamline issues. However, Leepile also warned that standardisation may translate to a lack of a country-specific approach, which would pose challenges for developing countries.
Raters and rankers from a multi-manager perspective
Leepile reiterated the complex nature of ESG raters and rankers. From a multi-manger perspective, “we are finding ourselves with a lack of standardisation of methodologies which makes it difficult to effectively rank the raters,” she said.
Leepile posed the question: “How does one define a credible rating, why should it add so much to the cost of investment, and how do we make it make sense in our country?”
South Africa faces a unique set of challenges that differentiates us from the Global North and with much bigger social problems. Global raters and rankers pose a difficult dynamic for South African companies. Leepile highlighted the fact that global ratings often have a ‘First World’ view or imperative. This is challenging when you are in a developing country with high rate of unemployment. “Should we be considering the impact of adverse ratings on some South African companies and what it means for potential employment levels?” she asked. This would put greater responsibility on the local raters and rankers to play a significant role in providing more contextual assessments of companies.
Alexforbes has found a way to balance the opinions of both global and local raters: they have an internal ESG rating process but also look to external ESG ratings to complement their own ESG integration into portfolios. There is value placed on asset managers engaging with companies. According to Leepile, “Exclusion should not be encouraged and does not bring about change. Engagement encourages management to listen to shareholders.” This is vital in the South African context, given the huge role that mining companies play in the economy. If these are excluded because of adverse ESG scores, this poses a significant risk to the country.
Leepile concluded by saying, “Ratings need to offer an understanding of the actual challenges faced by investors to show actual impact. Let’s understand the purpose of ESG beyond a checklist. In our mind, that purpose is to leave a sustainable world for those that come after us – growth, employment, diversity, and inclusion, and most importantly a responsible green transition.”
Where should you start as a company?
Madale provided insights from MTN’s management of ESG raters and rankers. She asserted that “the heart of MTN’s sustainability approach is about driving impact and sharing value…we as an organisation recognise the importance of raters and rankers as they help us to quantify the impact that we are having”. They provide a useful ‘dipstick’ of where the company is in terms of ESG.
Madale pointed to the benefit of undergoing a process of prioritising and ranking assessments based on “influence, reputation and linkages”. There is a lot of alignment across rankers and raters and it is pragmatic to address common elements.
Madale says at MTN they focus on four pillars: engaging rankers and raters, working with them to make corrections, improving transparency and disclosures at MTN and driving change of practices at MTN.
In response to the challenge of ratings that are not contextualised to their operating environment, Madale highlighted the importance of engagement with raters and rankers: “As a corporate, we continue to engage and to encourage to make sure that ratings are adapted to the realities of the kind of markets that we operate in.”
Engaging with raters and rankers can help strengthen a company’s ESG scores, as it helps to stay abreast of changes or improvements in methodology, but also allows companies to query assessments. ”In instances where information is incorrectly captured by raters and rankers, what we find is that, when we engage them, they are willing to make corrections. It just comes down to the company taking the time to sit and review and then give the feedback within the assessment cycles so that these corrections can be addressed,” Madale said.
To improve ratings, Madale suggests focussing on disclosures: “There are certain things that as an organisation need to improve our transparency and disclosure on. That’s why, even in the work we do with Trialogue on our transparency and disclosures, every year we continuously look at what else can we add and disclose more information on …The key to the kingdom of the ESG raters and rankers’ world is really disclosure. So, if you are more transparent, it goes a long way,” she said.
She added that it is important to look at where management can improve and what needs to be done differently in terms of practice. Once this is addressed, companies can then look to how to disclose these actions.
Going back to first principles
Soobramoney suggested that good governance lies at the heart of sustainability: “If you don’t have that good governance at play, the chances that your company is going to take these things into consideration at a serious level start reducing,” she said.
What is important is returning to first principles: “If you want resilience for the long term, it is your business model that you need to question. You need to use ratings in a way that are helpful to that, but it does not absolve you of your responsibility to understand fundamentally what your value creation process is and to know that story very well,” she asserted.
Madale summed up her perspective by saying: “At the end of the day, we have to go back to the North Star. The very reason why we do sustainability is really to drive impact. So ESG is really just how to measure that impact. If you see it that way, and in that light, you then start to understand the role that ESG raters and rankers play. They help you to see where you are this on journey; it is a story of continuous improvement.”
Leepile corroborated this by saying that, in order to drive change, we need to move beyond checklists and move to truly grappling with problems facing our own markets and countries. “We need to seek innovative solutions to our problems. Dealing with these issues cannot be outsourced to checklists or ratings or rankers,” she said.
Moving into the future with Farsight
Farsight is a ranking service that provides a qualitative next-generation methodology that looks to address the complexities highlighted by the other speakers. Farsight rates companies for their leadership quality by assessing response to Governance, Ethics, Labour, Societal, Customer and Environmental (GELSCE) issues using publicly available reporting information that is weighted based on the material issues to the individual company.
Worthington-Smith highlighted that according to Farsight’s model, well-led businesses build value for owners and society through solving societal concerns with innovative solutions; they mitigate risks mediated through regulation and build long-term value for asset owners.
As shown in the graph below, the top quintile of South African companies assessed by Farsight is shown to far outperform those in the bottom quintile of companies assessed by Farsight, and outperform the market. This not only highlights the importance of good governance but also shows the strength of Farsight’s qualitative model.
Outcomes from poll questions during webinar
Watch a recording of the webinar here:
Read the presentation here
- Findings from the McKinsey Sustainability Reporting Survey can be found within this report by McKinsey & Company called ‘More than values: The value-based sustainability reporting that investors want’
- Find the study conducted by the Network for Studies on Pension, Aging and Retirement here: https://www.netspar.nl/en/news/drawing-up-the-bill-does-sustainable-investing-affect-stock-returns-around-the-world/ .
- JSE Sustainability Disclosure Guidance and JSE Climate Disclosure Guidance:https://www.jse.co.za/our-business/sustainability/jses-sustainability-and-climate-disclosure-guidance .
- For more information on Farsight: https://farsightfirms.com/about-us/