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Tracking the ESG trajectory

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Pivotal players in capital markets through their credit ratings, rating agencies are responding to investors’ increasing focus on environmental, social and governance (ESG) factors by providing ESG ratings too. But how do the two products differ and is there room for both, given ESG’s growing influence on credit risk? Experts from Moody’s ESG Solutions explain their approach.

Unlike traditional credit ratings, ESG ratings have not yet evolved to the point where they offer an instantly recognisable scale on the model of triple-A and below. Moody’s ESG Solutions acknowledges appetite for standardisation. 

“We are hearing a call for greater clarity across ESG data and scores, especially as they are often used for benchmarking. Market participants want to understand what different scores mean and how to interpret them,” says Angela Brown, senior vice-president — product strategy at Moody’s ESG Solutions. “It’s early days but we are seeing quite a dramatic shift both by investors and companies wanting to understand the comparability of ESG scores with expectations that a standard will emerge.”

“As these scores become increasingly used in decision-making, we expect that a more engaged and forward-looking assessment process for sustainability performance will emerge,” she adds.

The firm argues that the value of its ESG ratings lies less in standard scales than in what goes into its assessments. This includes forward-looking views of companies’ ability to adapt to future ESG risks. 

“The focus on the final ESG score today is less important than the opinion and narrative that underpins it. In our analysis, we emphasise the key ESG drivers for a particular organisation — both now and in the future — and what that company is doing to ensure that it addresses stakeholder needs and remains resilient to material sustainability challenges,” says Rahul Ghosh, managing director for ESG outreach and research at Moody’s ESG Solutions. 

“A Sustainability Rating ultimately looks at whether a company or an entity can manage the ESG risks and opportunities that it faces now and in the future,” Brown notes. 

She sees scope for recognised scales in future. “But for now, it’s really getting from data and data analysis to issuer-centric opinion and insight.”

Moody’s ESG Solutions emphasises a so-called ‘dual materiality’ approach. This looks both at the impact of ESG factors on companies’ financial operations and operational performance, but also on the impact of each company on its stakeholders. This perspective is gaining increasing traction with the standardisation of disclosure frameworks and reporting requirements, particularly in Europe. 

“We think that that’s an important distinction that is valued and appreciated by investors,” says Brown. 

This systematic perspective is accompanied by the concept of ‘trajectory’. “It is important that companies are able to demonstrate where they are on their sustainability journey, and make sure that they are progressing and developing strategic KPIs and performance metrics that will help continue to advance that performance,” she adds, noting how this is reflected in the targets embedded in sustainability-linked bonds (SLBs) and even remuneration policies. 

“It’s that continued improvement in metrics over time that moves us towards sustainability.”

In addition, ESG ratings seek to capture the sustainability context in which organisations operate. Crucially, this includes future developments. “We look at material factors today but also topics or considerations that are likely to emerge in the future, and whether a company is positioned to respond to them effectively,” as Brown puts it. 

 

Broad needs

Though much of their use is for portfolio construction, monitoring and maintenance, Moody’s ESG Solutions emphasises that its ESG ratings are intended as input to a broad range of investor activities. “ESG issues can be material for risk analysis; they can also be material for stewardship and engagement activities; or opportunity determination,” notes Ghosh, citing the spectrum of ESG investment strategies from pure exclusion through to impact investing.

“There are broad market needs for ESG, which is reflected in different types of tools. We have to be clear on what those tools are there to deliver.”

This raises the question of the rating industry’s multiplicity of approaches. “There are already a diverse range of approaches to measuring sustainability — different methodologies, different strengths and different insights,” says Ghosh. 

However, he views the resulting diversity of conclusions as positive. “In 10 years’ time, some of the factors that we look at and ultimately the data that we use will be materially different to what it is today. We need to encourage good debate around the question of measuring sustainability and that we are innovative, perhaps even disruptive, in our approaches.” 

 

‘Engaged’ ratings

This relates to the key ESG concept of ‘engagement’, Brown points out. “Both on the investor side and on the issuer side, what we’re seeing is an increased desire for pro-active engagement on the topic of sustainability.” 

“Investor engagement has gone from ‘we want you to disclose specific information or data’ to ‘we want to talk to you about your strategy and how you’re going to manage risk and capitalise on opportunity going forward,” she adds. “That’s where the idea of an engaged Sustainability Rating is really important.

“A sector specification of a methodology may not capture the nuance of an individual company. An assessment based on engagement and interaction with senior leaders within an entity provides a much more powerful tool for investors to leverage, whether shareholders or any type of bond investor”

“ESG ratings are becoming much more relevant for the market,” agrees Cristina Lacaci, head of ESG structuring for global capital markets at Morgan Stanley. “Many investors will have their own ESG scoring systems but will use the information in the ESG rating reports as inputs for their own models. 

“So it is increasingly important for issuers to ensure that the information in these reports is correct, and properly reflects their strategy.” 

A good ESG rating report also helps to limit the potential number of requests for ESG information from investors or lenders, Lacaci notes.   GC

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