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Just as the credit crisis increased emphasis on credit rating methodologies, coronavirus has placed ESG ratings in the spotlight. But do they focus on the correct factors?
Setting the scene
Just as the credit crisis increased emphasis on credit rating methodologies, coronavirus has placed environmental, social and governance (ESG) ratings in the spotlight. Are they emphasising the correct factors that have led some companies to respond more effectively to the pandemic? Many of the leading players in this space are starting to re-examine their approach for a post-coronavirus society.
This is critical as they are no longer marginal players. Over the last few years we have seen a significant growth in the use of these ESG ratings. These ratings – usually awarded by independent ESG rating agencies such as Sustainalytics, MSCI, ISS-ESG and Vigeo Eiris – are starting to become just as important as traditional credit ratings. This is largely the result of investor behaviour. The buy-side is increasingly expressing a preference to invest in companies with strong sustainability credentials, and as a result more corporates are actively engaging with ESG rating agencies.
Recent ESG agency statements on coronavirus are therefore important reading. Several have published research on the impacts of the pandemic on different sectors (for example, food production) and on topics such as workforce restructuring, supply chains and the rise of fake news during the pandemic. A few have also produced pandemic preparedness ratings, screens and data on offer.
In this article, we reflect on the perspectives being taken by standalone ESG rating agencies on some of the most commonly referenced post-coronavirus ESG sub-factors and share our observations on the implications of these trends.
Spotlight on S and G factors
There is a sense that ESG methodologies do address many material factors that have driven coronavirus-related corporate performance. For instance, comparing a number of MSCI1,2 indices, it is clear that those with strong ESG characteristics have proven more resilient during the recent market turmoil than those with weak or non-existent ESG characteristics. Research by AXA Investment Managers3 has also shown that, over a period of time, companies with a higher ESG score are likely to fare better. Hence, understanding how ESG rating agencies are assessing companies is becoming increasingly important as it will eventually have an impact on stock selection strategies by investors.
Of course, these agency reviews don’t take place in a vacuum. ESG agencies continuously monitor whether a company is managing business-critical risks and is aware of its broader societal reputation and impact; and hence assessing wider public views on appropriate corporate social behaviour. They have taken note of growing regulatory and stakeholder interest around topics such as employee health and well-being, flexible working and restructuring (e.g. support being offered to furloughed employees or those being made redundant), diversity and charitable giving, as well as the broader public discussion that has emerged around the ethics of excessive executive pay during the pandemic, and, in general, about the role of businesses within society.
Health and safety and employee wellbeing come into focus
An important “S” factor gaining prominence is health and safety. Given the risk of infection from the coronavirus, this is unsurprising. It is clearly essential that employers safeguard their employees (and their families), customers and other stakeholders from potential exposure to the virus, and failure to implement such safeguards could carry operational disruptions, legal and reputational ramifications.
Vigeo Eiris4 identified that amongst 65 corporate coronavirus-related ESG controversies, 36 of them were health and safety related. Given ESG rating agencies and investors monitor ESG controversies that are in the public eye and often take reporting at face value, it is important for companies to ensure they have robust health and safety policies and systems in place.
This mirrors Sustainalytics’ research, which found that companies with advanced health and safety management infrastructure, such as managerial responsibility for health and safety issues, emergency preparedness procedures and audits, are in a better position to efficiently manage the coronavirus risk.
ISS ESG emphasise international standards in this regard. For much of their rated universe, they specifically require certification to policies and alignment to standards such as OHSAS 18001 (now replaced by ISO 45001) for occupational health and safety management to obtain the best available score for this indicator. In addition, ISS ESG applies sector-specific indicators assessing for example, to what extent retailers or cruise ship operators protect employees and customers against (pandemic) health risks.
Looking ahead, we expect a higher number of ESG methodologies to actively incorporate more work-force related factors. The combination of lockdown measures and great economic uncertainty has significantly impacted employees’ mental health and physical wellbeing, particularly employees from ethnic minorities. It is therefore likely that reporting on workforce policies will get additional attention – be that factors such as flexible working, employee well-being, diversity and inclusion.
Keeping it local
Another post-coronavirus topic of interest to ESG agencies is supply chains. Whilst this is by no means novel – companies themselves are looking more into the ESG performance of their supply chain – coronavirus is likely to be a fundamental game-changer of companies’ approach to sustainable supply chains. The ESG performance of the supply chain is now an integral part of the company ESG performance.
For many supply chain managers the pandemic has required a return to the drawing board. Given the drop in international trade, companies have realised that they have to look closer to home to source materials. Likewise, ESG agencies will spend more time scrutinising a company’s supply chain resilience, its related planning, and the impact on its sustainability commitments.
Sustainalytics5 have pointed out that the adoption of localised supply chains could lead to several ESG benefits such as an increase in local jobs, higher tax revenues for the government, a reduction in carbon emissions and a better enforcement of supplier standards – which could possibly enhance product quality. Given the increased scrutiny on sustainable business models, localised supply chains may play a greater significance in ESG rating methodologies.
Turning to the “G”, we expect greater focus on information management and product governance. Concerns around how companies are dealing with misinformation have attracted further interest, especially in light of reported rises of “fake news” about the pandemic.
Social media companies in particular have been placed under greater scrutiny as to how they manage content on their platforms. Sustainalytics6 for instance found that the largest media outlets generally have weak content moderation systems and score poorly on their “Product Governance” ESG issue indicator. This indicator captures risks related to editorial guidelines, media ethics and content governance.
Sustainalytics, however, also acknowledges that, since the crisis, these companies have invested in policies to prevent the spread of misinformation, and – like their peers – will actively assess the effectiveness of these policies. Facebook, for example, has partnered with relevant bodies such as the World Health Organization (WHO) and United Nations Children’s Fund (UNICEF) to limit the spread of misinformation about coronavirus on their platform. Will such initiatives be successful? Only time will tell.
Safeguarding the interests of investors
Another G-factor is focused on investor engagement. With coronavirus restrictions in place, rating agencies are also taking an interest in how companies safeguard the interests of investors – one example being the approach companies have taken to hold their Annual General Meetings during the pandemic.
ISS ESG7, for instance provides policy application guidance for companies on benchmark proxy voting policies. They state that it’ll be positively noted when companies use webcasts, conference calls and other forms of electronic communications to engage with their shareholders and investors, even if meetings have had to be postponed. The agency further points out that it’ll also look for, and be open to, company disclosures of alternative forms of attendance and its adequacy.
Credit rating agencies also not keeping still
Traditional credit rating agencies have been understandably forceful in their response to coronavirus. They acknowledge that the shutting down of economies globally is taking a material toll on companies’ revenues and earnings. This has resulted in thousands of coronavirus-related credit rating actions globally since the beginning of the outbreak. These agencies are increasingly integrating ESG factors into their credit analysis and will be tracking the ESG and credit impacts of post-coronavirus company strategies. We intend to explore the increasing links between ESG factors and credit ratings in future articles.
As the economy recovers, hopefully many of these firms will be able to grow earnings and return to a more solid financial and credit footing. However, it will take more structural shifts for them to also continue to improve their ESG rating.
This is what makes the next months of methodological announcements crucial. In the second half of the year, ESG rating agencies will be outlining to investors and companies what tangible changes they’ve made to their methodologies. Only then can we really know: what does a high-ESG rated business look like in a post-coronavirus era?