Why more nuance is needed in ESG ratings

There is far more scrutiny on a company’s environmental, social and governance (ESG) credentials that an any time in history. Given the potential brand damage from falling short on contentious issues, regulatory censure from poorly designed policies issues and the sheer flow of money into this area, companies simply cannot afford to ignore ESG considerations. Done well it can be a win for all stakeholders. Unfortunately, it isn’t always obvious what data needs to be presented and the ESG scoring can leave much to be desired.

Many companies have long factored ESG considerations into their business models, although they may not have explicitly reported them in the depth demanded today. Indeed, some management teams told us they positively avoided going into too much detail on projects fearing it would reduce their competitive advantage or because their own customers demanded anonymity. But the growth in the power of ESG rating agencies has made it more important for companies to publicise their ESG credentials rather than hide them under a bushel.

The rise of ratings

In much the same way that credit rating agencies analyse a company’s financial reports, ESG rating agencies use data from a company’s activities to assign an ESG score to a company’s efforts.

There are a multitude of ESG data points - more than 100 in many cases - on which companies are increasingly expected to report. The key word is ‘expected’. There are no hard and fast rules on what data need to be reported and often it may be as much qualitative as quantitative. Companies are often left to ask their shareholders, advisers, and ESG ratings agencies to find out. It’s easy to omit some crucial data when there is no established template.

Providing incomplete ESG data, the wrong statistics or omitting data altogether often results in a poor ESG score. BP and Shell both publish annual sustainability reports, each exceeding 100 pages, requiring huge amounts of data and human resource to produce. In relative terms, this penalises smaller, less well-resourced companies that lack the financial muscle to employ an army of ESG specialists to collect, collate and publicise their sustainability credentials. The unintended consequence may be to concentrate sustainable investment into larger capitalised companies.

The power of engagement

One area where active investors can help companies is through engagement. This may be as simple as offering an objective viewpoint on a remuneration issue or may be more involved where we feel the pace of change at a company is slower than desirable. The second scenario may involve a series of meetings to go through the issues, aiming to establish a roadmap that is acceptable to both sides. It is important that engagement should not be perceived in a negative light.  We find that the vast majority of companies are only too happy to engage on ESG issues in a desire to improve their understanding of the landscape and to further their own transformation.

One example is Games Workshop. The company has some excellent financial attributes but scores less well on its environmental credentials. We engaged with its management on its efforts to increase the use of recycled materials in its packaging and the explicit implementation of green policies. Encouragingly the company has installed a dedicated recycling facility at its new warehouse near Nottingham, which will allow for streamlined sorting and recycling of plastic and cardboard waste. It is also conducting feasibility assessments in respect of a replicated facility at its Memphis warehouse. It has pledged to reduce its greenhouse gas emissions and has upgraded its head office and primary manufacturing sites to be powered by renewable energy and installed energy saving lighting. We firmly believe Games Workshop has excellent financial and ESG credentials - but, because it has not shouted about its initiatives, rating agencies have failed to score it accordingly.

We have similarly engaged with Rotork, a global leader in manufacturing and supplying actuators used in flow control. Half of the group’s revenues come from carbon intensive industries. We met with the company to gain greater insight into the Group’s plans to promote the energy transition to more renewable sources. We feel the company is well positioned, investing in new products with applications in non-carbon fuels such as hydrogen and carbon mitigation strategies such as carbon capture. Having said this, we feel the company can do more on its relatively high levels of waste to landfill and should look to set more aggressive carbon reduction targets for its own activities.         

Applying common sense

There is little doubt that the greater focus on a company’s ESG credentials has led to an improvement in corporate behaviour. In the last decade we have witnessed the increase in female directors on UK listed company boards, much wider realisation of the need to move to net zero carbon emission targets (and sooner) and improved labour standards. These are just three examples, but the positive impact has been widespread.

There is still room for improvement though. In the desire to score and rank companies on ESG, sometimes it would appear that common sense gets left behind. Possibly the two biggest issues of today are carbon emissions and use of water. Water is an increasingly scarce resource in many parts of the world, and companies are trying to increase the efficiency with which they extract and use it. However, the calculation of water intensity is not always straightforward.

A widespread method for measuring water intensity is a company’s use of cubic metres of water per unit of revenue. The more water a company uses per unit of revenue the higher the intensity level. The simple implication is the higher the score the worse the company is on this measure.

But why is water usage calculated relative to revenue? Take for example Severn Trent, whose primary activity is providing clean water. Severn Trent cleans and supplies two billion litres of drinking water per day to its customers. The average household is charged just £1 per day for its water, under a strictly administered regulatory regime¹ . So while Severn Trent’s water intensity is considerably higher than other companies, I do not believe it is bad thing – in fact it is a good thing.

Similarly, carbon intensity is often measured with the same calculation method as water intensity. If a company raises its prices by 10% (and assuming the price rises stick) then its carbon intensity has nominally declined by 9%. Yet the company is still producing the same absolute amount of carbon. Talk about being lulled into a false sense of security!

To track the progress being made, companies need to measure and publicise their baseline consumption and use of water and carbon emissions.  Against this, we can track improvements over time, factoring in changes to business mix. As ever, targets should be made applying a good dose of common sense.

Linking executive pay to ESG may not be the answer

A key question being debated by many stakeholders is how to increase the pace of change on environmental and social issues. An often-touted way is through executive remuneration. However, there may be a danger if we link too many variables to executive pay then these issues will be prioritised potentially to the detriment of the wider business.

A recent example comes from a FTSE 350 listed consumer goods company. An element of management’s variable remuneration focused on increasing market share in core markets. However, market share gains in small and marginally profitable core markets carried the same weight as improving market share in much larger and more profitable markets. By prioritising share gains in smaller markets, management earned a full bonus allocation in this category, despite losing overall share and seeing profits decline. Clearly, increasing the number of targets does not always translate into better corporate behaviour or improved performance. 

In a refreshing antidote it was good to read a remuneration committee favouring simplicity over complexity when implementing management’s variable pay scheme.

“The committee noted that our remuneration policy differs from that in many other companies within the FTSE. This is a reflection of our belief that, culturally, our managers and colleagues want to deliver a high level of performance and the use of complex and formulaic incentive programmes might have unintended consequences and do more harm than good.”

Well said!

The increased scrutiny on ESG by investors is having tangible benefits, especially in improving the environmental sustainability of listed companies. Corporates are measuring their output of carbon and putting in place schemes to reduce their environmental footprints over time. This is undoubtedly good news. However, investors need to dig into the numbers rather than take them at face value. A company’s ESG score, whether good or bad, should be the starting point for further analysis and if need be, engagement. The fund management community has a big role to play in shaping future ESG policy. To that end, we need to ensure our analysis and methodology are fit for purpose.