How do investors assess companies for ESG

How do investors assess companies for ESG?

In Insight by James Verstringhe

With more companies than ever stating their Environmental, Social and Governance (ESG) credentials, how do institutional investors assess investee companies for ESG factors? What are they really interested in? How do they sort the material ESG initiatives from the greenwashing?

With these questions in mind, we decided to go direct to the source and invited Suresh Mistry, a veteran in the ESG investing space, to speak to the team at Tavistock.

Having helped found Alquity Investment Management more than ten years ago, Suresh has a wealth of knowledge and experience on how companies are assessed for ESG, as well as responsibility for ensuring Alquity’s own ESG credentials are beyond reproach.

After a very informative session, we’ve distilled his advice into six main points:

1. You’ve got to make it through the initial triage process

Despite the increased focus on ESG, not all investors approach the assessment of ESG factors in the same way. Some use a values-based approach which will automatically exclude specific sectors such as tobacco, gambling, armaments or fossil fuel industries, while others will consider most sectors. If your business falls into one of these ‘flagged’ areas, it’s unlikely even to make it through the initial round of selection; however, by doing the basics you can reduce the risk of being triaged unnecessarily.

2. Proactive engagement with investors and rating agencies is a requirement, not an option

Unless your business is a large corporation in the FTSE 100 or equivalent index, you should proactively engage with the rating agencies like MSCI ESG and Sustainalytics to ensure they have a thorough understanding and correct interpretation of your ESG plan. Failure to disclose the right sort of information may lead to an inaccurate or even damaging rating of your business. You may even find that non-engagement results in the agencies using information from your peer group to assess your company, which could lead to a wholly inaccurate outcome.

While being properly understood by the ratings agencies is important, their reports tend to be backward looking, relying on previously reported information to form a view. For discerning investors, ESG is also used to assess the future viability of a business, so direct engagement with the management team is extremely important to ensure they get the whole picture. Moreover, many investors view the quality of the management team as a proxy for the health and viability of the broader business and its operations. If you make the right impression and as you communicate how the business has adopted ESG, you are more likely to enhance their understanding and confidence in you.

3. Focus on material ESG factors that have a direct impact on the bottom line

Not all ESG factors are equally relevant to every business. Therefore, knowing which ones are relevant to your business and then communicating your performance in that area is critical. Don’t assume that investors naturally know which are the best or most relevant to you.

These have become known as material ESG factors, a term that is derived from the concept of material information in accounting. Material ESG factors are the ones that will have a measurable effect on an investment’s financial performance.

There is already a good body of research to show that companies that address material ESG issues significantly outperform their peers.

4. Wherever you are on your ESG journey, make sure you have a clear road map and maintain transparency as you progress

No one company is perfect but there is a requirement to show how a company is managing its ESG journey. 

Measures to limit our overall impact on the planet and to ensure the overall wellbeing of all areas of society will only become more pronounced as time moves on, so avoid the temptation to bury your head in the sand if you operate in a sector that is perceived to be beyond hope.

Even some of the renewable companies perform miserably in certain aspects of ESG. What the investor wants to understand is how you measure up against your peer group and whether your plan to improve that position is viable and ultimately investable.

No matter where you are on the ESG journey, investors will look for a well-structured road map with progress against milestones clearly communicated. This will improve their understanding and help them to assess you against your peer group, both large and small, in a similar way to your financial performance and viability.

5. Be transparent and focus on disclosure

Once you’ve created a plan, make sure you can back it up by disclosing the correct information in a format that is easily understood, not only by the analysts at the rating agencies, but also the institutional investors and the retail investors. Look at what your peers are doing, but also engage with other stakeholders, including investors, to find out what they need to know as this will make their lives substantially easier.

6. Be careful about focussing too hard on donations to charity

In a final point, be wary of using charity donations as a panacea for ESG. While donations to charity are extremely important and should form part of the process, they are not normally considered to be material ESG factors. Many investors donate money to charity already, so why should they give you money to donate on their behalf.

There are plenty of other ways to donate in a material way. For example, some companies invest in local schools and apprenticeship schemes that both improve prospects for people in the local economy while potentially providing a pool of future talent for the business.

A core part of Alquity’s ESG approach is to donate 10% of its fee income to projects aimed at transforming lives in the regions where its investee companies operate. For Alquity, this 10% is far more than just a straight donation. Each recipient is targeted on their potential to generate sustainable, long-term economic activity that will help to transform the overall standard of living in the local area by stimulating job creation and further investment.

ESG is fast becoming a main stream consideration for all investors. If you have questions about how to best communicate your ESG strategy, we’d be happy to have an informal exploratory conversation. Please get in touch.