Board directors often ask our stewardship team: “What is the one question about environmental, social and governance (ESG) that I need to ask at the next board meeting?” Our answer: “What is our ESG score?” While many companies have no idea how to reply to that question, we believe that a company’s ESG score will ultimately become as important as their credit ratings for investment purposes. For a growing number of investors, the risks and opportunities around sustainability and ESG impact have become an integral part of their investment decision-making.
More will follow as millennials increasingly invest not only for returns but also to align with their values. This trend of “values investing” is redefining the investment landscape and driving the growth of ESG investment strategies, which now account for $22.8 trillion in AUM globally.
To create ESG investable products, portfolio managers rely on ESG scores compiled according to company-reported ESG data. Without that input from companies, ESG data providers such as MSCI, Sustainalytics, ISS- Oekom and Vigeo-Eiris come up with their own estimates. Investible ESG strategies are currently designed in ways that prioritize companies with higher ESG scores.
To show the growing power of ESG as an investment differentiator, we often cite the example of a small oil and gas company in the US that recently told us they were surprised by the number of European ESG investors that began investing in their stock after they published their first sustainability report. Their report provided enough detailed data about the company’s carbon emissions that the company’s assigned ESG score improved as a result. Yet too few board directors take the time to absorb their companies’ sustainability reports, let alone know what score has been assigned by third-party ESG specialists.
This needs to change, because corporate boards are central to overseeing whether management is taking these sustainability issues seriously and changing capital allocation decisions as a result. State Street Global Advisors has been calling on boards to incorporate material sustainability factors into a company’s long-term strategy for over a year. We also provided a framework to help boards think of the ways ESG risks might impact their businesses. However, many boards are still struggling to understand how to do this.
“a company’s ESG score will increasingly determine if trillions in global institutional and retail capital will flow toward them or away from them.”
But with that one question: “What is our ESG score?” directors can begin to focus board attention on issues such as: “What are the material ESG risks to our business? How are these risks being mitigated? How should they be incorporated into strategy? Are we giving investors the information they need to assess the effectiveness of our sustainability practices? How are we communicating the relevance of these factors to our long-term strategy?”
What board directors will quickly find is that the methodology driving the company’s ESG score is currently opaque and varies by data provider. Recent research conducted by State Street, for example, found that there was only a 0.53 correlation between the MSCI and Sustainalytics ESG scores.
As an industry, we need to do a better job at creating more consistent and higher-quality scoring. The good news is that the Sustainable Accounting Standards Board (SASB) has developed a sophisticated environmental and social reporting framework for companies, which identifies sustainability factors by GICS and sub-GICS sectors that are material for investors. Further, SASB is in the process of finalizing accounting standards for hundreds of sustainability metrics that will allow companies across an industry to measure and report on material sustainability factors in a systematic and comparable way. Over time, we believe that the SASB reporting framework will increasingly drive the ESG scores of companies. Therefore, companies should begin to report their activities in accordance with SASB’s framework.
What boards need to recognize is that ESG is no longer an ancillary topic that shows up once a year in the company’s Corporate Responsibility report. On the contrary, a company’s ESG score will increasingly determine if trillions in global institutional and retail capital will flow toward them or away from them. It is past time for boards to take notice.