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The ESG rating under the microscope. Is "Sustainable Investing" Profitable?
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The ESG rating under the microscope. Is "Sustainable Investing" Profitable?

created Alice NowakJuly 2 2020

The financial crisis in 2008 significantly undermined investor confidence in companies focused only on maximizing profits and financial results. It was then the trend of the so-called Sustainable investing, also known as responsible investing, has started to gain momentum. Today, this approach is becoming increasingly popular and even more relevant. Sustainable investing takes into account not only financial results but also non-financial results in assessing the potential and stability of a given enterprise. One of the methods for assessing companies is the ESG rating. Below we look at how such a rating is created and what exactly is hidden under the mysterious marks "AAA" or "CCC".

ESG Rating - Environmental, Social , Governance

ESG is an abbreviation of three main, non-financial, factors affecting the assessment of the ability for sustainable, balanced development of an enterprise or industry. The abbreviation is made of English words Environmental (Environmental), Social (Social) and Governance (Corporate).

Institutions creating the ESG rating take into account emerging opportunities and threats in these areas for the surveyed entities. It is an approach assuming a long-term (5 years or more) time horizon.

Research shows that companies that use good ESG practices are as profitable in times of prosperity as their competitors who do not implement responsible business principles, but are much more resistant to crises.

A growing trend among institutional investors

At the end of 2016, according to a CollerCapital study "Global Private Equity Barometer. Winter 2016-17 " over 30% of the surveyed institutional investors from Europe, Asia and the Pacific confirmed that they make investment decisions based largely on ESG factors. At the same time, in North America only 20% of respondents made such a declaration.

The growing interest in ESG rating and sustainable investing is also evidenced by the creation of the WIG-ESG index on the Warsaw Stock Exchange in 2019. The WIG-ESG index consists of companies listed in the WIG20 and mWIG40 indices, which have implemented areas of responsibility defined by the ESG abbreviation.

E - Environmental, or environmental issues

Perhaps many will be surprised to consider environmental factors when choosing investment goals. Global trends, such as climate change or shrinking of natural resources, affect the opportunities and threats for any business, especially those operating in industries related to natural resources. The extent to which companies take into account these trends and introduce measures aimed at protecting the natural environment and operating in conditions of limited resources and increasingly stringent climate policy can give us a picture of how stable and crisis-proof their development will be in the coming years.

Climate change

In terms of climate change, the rating agency is investigating how companies use and attempt to reduce carbon dioxide emissions, how much their industry and business are vulnerable to climate change, and whether products that create a large carbon footprint. That is, whether it is necessary to emit a large amount of exhaust gas to produce them.

Natural resources

In this category, water consumption and business / industry vulnerability to a deepening fresh water deficit, impact on biodiversity and the use of natural resources are assessed.

Pollution and waste

Emission of toxic waste, the use of materials for packaging products, the generation of electro-waste - these are issues taken into account when assigning the rating.

Exploiting environmental opportunities

New niches to be developed due to climate change. To what extent does the company use the opportunities associated with creating clean technologies, ecological, sustainable construction and renewable energy sources.

S - Social, or social issues

Sustainable business not only cares about maximizing its profits while respecting and protecting the natural environment. Social issues are another area of ​​responsibility. Not only investors, but also end customers are taking care of such issues as buying products "Fair trade", that is, those that do not violate the rights of people working in their creation. On social issues, the rating agency draws attention to the following aspects.

Human capital

How does the company manage its employees? Is the work environment she creates safe and healthy? Does the company focus on the development and training of its employees? Over time, the so-called inclusiveness, i.e. putting emphasis on including both sexes and people of different nationalities in all company positions.

Product liability

Are the offered products safe, tested and do not adversely affect health? Do they emit toxic chemicals? If the company processes personal data, are they adequately protected? Since the financial crisis in 2008, the financial security of the offered financial products is also taken into account - if this is the company's business profile.

Social responsibility

Does the company have any contracts with foreign companies that violate people's rights (e.g. on cocoa plantations or in factories assembling components for products).

The issue of respecting animal rights is also becoming an increasingly important issue. In the case of cosmetics companies, it boils down to not using substances of animal origin or giving up testing of products on animals.

Do employees have access to medical care or is the communication inside the company transparent and transparent? Are career and promotion paths clearly defined and clear to team members?

G - Governance, i.e. management (corporate governance)

What is the structure of the company's management board? In recent years, more and more attention has been paid to the balance between the CEO's and management's influence on the company's decisions. Other issues taken into account are management fees, tax transparency, vulnerability to corruption and instability of funding.

EGS rating and its structure

As a result of the analysis of all these spheres, the rating agency gives each of the spheres a score from 0 to 10, which determines how well the company is doing in a given area. A note for a given segment is extracted from this (Environment, Society, Management). Then from these three values ​​a weighted average is taken, taking into account the susceptibility of a given industry to a given sphere (not all companies are equally exposed to environmental and social opportunities and threats). From this we have a final note from 0 to 10, which corresponds to the rating from CCC to AAA.

The exact process of creating the final note is presented in the chart below taken from the report MSCI ESG Ratings Methodology.

esg rating chart

What is the "AAA" grade for a given company? For ESG ratings prepared by MSCI, the following scores correspond to the ranges of points earned.

Rating Final note adapted to the industry
AAA 8.6 – 10
AA 7.1 – 8.6
A 5.7 – 7.1
BBB 4.3 – 5.7
BB 2.9 – 4.3
B 1.4 – 2.9
CCC 0.0 – 1.4

AAA and AA

The company operates in its industry, managing and responding to all key threats and opportunities in ESG areas.

A, BBB and BB

The company is able to address most or part of the key ESG opportunities and threats for its industry.

B and CCC

The company lags behind its competitors, being vulnerable and not taking steps to deal with them.

Is the ESG approach profitable?

Despite all ethical issues and a desire to contribute to sustainable development on our planet, it should not be forgotten that investors put profit first. Investments are to bring the highest possible rates of return while limiting the risk. Will investing in companies devoting so much time and resources to these non-financial spheres weaken financial results?

Analysis made by Oxford University "From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance" shows that quite the opposite. The study involved analyzing 200 different scientific sources and studies on the profitability of a sustainable development approach in ESG terms. The results of this analysis indicate that sustainable development means lower operating costs and higher profits. The results of the study indicate that companies addressing issues of social and environmental impact and caring for good business management practices show higher profits in the medium and long term compared to their competitors not using good practices in the ESG sphere.

esg rating for oxford research results

The above graphic presents the results of this study in numbers. 90% of the analyzed studies indicate that the application of ESG sustainable development standards reduces the cost of credit and raising capital in companies. This indicates that companies that care for ESG standards are more restrained in taking loans, and thus more resistant to financial and non-financial crises. 88% of the 200 studies analyzed indicate lower operating costs for companies using ESG standards. 80% of sources have shown that companies focusing on sustainable and responsible development record higher profits than their competitors. You can read the full report in PDF format and the list of studies taken into account when preparing this report pod tym linkiem.

How to check the ESG rating?

If you are interested in the subject of ESG approach in the analysis and forecasting of sustainable and stable development of enterprises and entire industries, you can check the ESG rating.

Projects

On page msci.com we can see the rating for all companies listed on the American Stock Exchange and many companies from other stock exchanges in the world (including Poland). For example CD Projekt received BBB rating from MSCI.

cd project esg

From the page we will find out what is the rating for a given company and in which areas it excels and which ones it does not manage or does on average. The CD Projekt given in the example above according to the MSCI agency, on average, deals with privacy and data protection as well as emissions. However, it excels in its industry in terms of organization structure and the use of human capital.

esg categories cdp

ETFs

ESG analysis covers not only individual companies, but also entire indices and ETFs. On page etf.com each ETF has its own page with the technical details described, including the MSCI ESG rating (if it is developed for it). Enter the name of the ETF you are interested in and check if it has the ESG rating described in the tab "Overview".

etf rating esg

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About the Author
Alice Nowak
An active trader on an individual Forex account since 2014, keenly interested in the subject of economy, business and capital markets. For over 10 years closely associated with the world of IT and new technologies, programmer, internet marketing enthusiast. Enthusiast of spending time outdoors surrounded by nature and greenery or practicing yoga.