SRI research firms are being forced to establish greater geographical footprints as their existing clients look beyond their home market for investment opportunities and more sophisticated institutional investors start to make environmental, social and governance (ESG) considerations a part of their investment decision.
That SRI is a big topic for investors is clear from the number of signatories to the United Nations Principles for Responsible Investment. It stands at 271 asset owners, 765 investment managers and 195 service partners, representing around $35tr of assets under management.
The SRI research market saw a wave of consolidation two to three years ago. That was in part because smaller, regional players could not compete with client demands for geographical spread, according to Andy White, associate director of the advisory services team at Sustainalytics, an SRI research firm with operations in 12 countries and 250 institutional clients globally.
“In the past there tended to be alliances between different providers,” says London-based White. “But clients needed a seamless process and harmonisation between methodologies, which led to consolidation.”
With new jurisdictions come new challenges. Investors are increasingly demanding ESG data on companies in emerging markets — something that can prove difficult, with corporate disclosure regulations in some of these jurisdictions much less robust than in more established markets.
But researchers are finding new tools to adapt to the demands.
“It’s possible to tap into third party data sources that were unavailable 10 or 20 years ago, including social networks and non-governmental organisation (NGO) observations,” says White. “We also tap into a very large number of news networks to source on-the-ground data and find if companies are engaged in poor practices.”
Oekom Research, another SRI research company, rates corporations’ ESG performance on a scale from A+ (excellent) to D- (poor). In the past, it would provide detailed research on the best performing companies from an ESG standpoint and assign an estimated rating based on publicly available information for those with a poor ESG track record. But that is changing.
“More and more clients want to have all the details on companies that are not performing so well because they want to integrate that over their whole financial management,” says Till Jung, director, business development at Oekom in Munich.
That shift in behaviour also applies to whole sectors.
FTSE4Good, part of the FTSE Group, offers a range of equity indices that only include companies that meet its SRI criteria. When it launched in 2001 it excluded five industries: weapons manufacturing, tobacco, nuclear power, uranium mining and the manufacture of infant formula.
Only tobacco and weapons manufacturers are still excluded.
“After extensive market consultation we developed criteria that looked at the last three industries and we have developed some specific criteria to allow firms to be included if they pass the requirements,” says David Harris, director of responsible investment at the FTSE Group in London.
Looking at companies by sector is never clear cut, however.
Sustainalytics does not exclude any industries and, while its clients have the power to, they do not normally want to.
“It’s more that a client might want to exclude tobacco companies but also retailers of tobacco,” says White at Sustainalytics. “Or they may allow some weapons manufacturers so long as the company only derives, say, 10% of revenues from weapon production. Others may only want to exclude those that manufacture cluster bombs or weapons of mass destruction. It’s very important for investors to get the data correct — as shown by some recent examples of prominent investors taking a public stand against an industry, only to find that their pension fund had some related assets.”
Deep data
Providers also report a shift in the type of services that investors want. Previously, most clients were content receiving a company’s overall rating. But now they are requesting the underlying data.
“Over the last couple of years investors have bought data from us and then built their own models, which they integrate into their SRI product and even their whole analysis product,” says Oekom’s Jung. “That’s especially true of the big asset managers. This is an upcoming trend. The more the topic moves into the mainstream the more this will be the usual way data is used. But for now the majority of clients want our opinion and will take that and work with it.”
Investors are also demanding bespoke solutions that can help them make SRI decisions which often have a powerful underlying economic argument, aside from the conscientious one.
BT’s pension scheme — the largest corporate pension scheme in the UK — provides a good example. It was concerned that costs associated with greenhouse gases through mechanisms such as carbon taxes could be much higher in the future than the low levels they are at now.
It asked FTSE4Good to provide a bespoke index that addressed this possibility.
“They wanted to shift some of their passive funds to take account of how that shift could affect the future profitability of companies in carbon intense industries,” says FTSE’s Harris.
“So we built a bespoke index taking into account those concerns. For utilities, say, it over-weighted those utilities using renewables and gas relative to coal powered generators which are more carbon intense. The concept is that they are hedging climate risk, future proofing it, to be prepared ahead of when market anticipation of carbon costs kick in.”
These bespoke services are also popular in the US, particularly for municipalities’ project bonds, says Darragh Gallant, managing director for the US at Sustainalytics.
“We have the capability to rate local municipalities’ project bonds,” he says. “But we can’t offer a standard universe — we have to define a custom universe to support clients’ individual challenges.”
The importance of interaction
The other service providers EuroWeek spoke to interact with institutions in a broadly similar fashion. Following initial research, their findings are discussed with the institutions to ensure nothing has been missed or misunderstood. Stakeholders — such as trade unions or NGOs — are also consulted.
But they often encounter different reactions from institutions.
“Some make a lot of information available through their own channels, such as their websites, and by responding to the bespoke questionnaire we send,” says Lindsay Smart, UK business development manager at specialist SRI rating agency Vigeo in London. “We assess a company first, and then send them a specific set of questions based on the information we are still looking for. It’s quite interesting how many companies struggle to make their activities transparent. I’ve even heard some companies say, ‘We’re global, we have thousands of employees and a vast number of procedures, so it’s impossible for us to keep track or aggregate all our ESG credentials.’ It’s concerning for stakeholders if they’re too complicated to explain themselves. It reduces investor confidence that they have a grip on their operations.”
Willingness to comply also varies across jurisdiction.
“We’ve traditionally seen higher engagement and response rates from European companies,” says Gallant at Sustainalytics. “ESG compliance is much more widely accepted in Europe compared with the US. But that’s changing — we’re seeing so much momentum both from investors and issuers here. But there’s more transparency and reporting in Europe still.”
Making a difference
There are nascent signs that this research is having an effect on corporations’ behaviour. For instance, companies have to meet a particular set of criteria to be included in FTSE4Good’s headline ESG indices, with the entry standards for each sector toughened over time.
Independent research has suggested that this technique makes a difference.
“A study by Edinburgh University compared those companies that FTSE had been in communication with regarding the need to meet higher standards to retain index inclusion with a control group that weren’t contacted,” says FTSE’s Harris. “The rate of ESG improvement among those FTSE was in communication with was twice that of the control group.”
Oekom found a similar result in an internal impact study released in May. It asked 700 companies how Oekom’s rating had affected their practices. One-third of respondents said the rating had had an impact on their general policy or strategy, while two-thirds said it had had a clear impact on their sustainability management and measurement.
“That’s only a first finding but it’s already a quite strong signal,” says Oekom’s Jung.
Vigeo’s Smart believes institutions that do not shape up could fall behind.
“It’s time-consuming for a company to understand all their ESG challenges, and to develop a strategy to respond,” she says. “But our process pulls apart the committed players from the ones who offer lip service. The future for the market is in those committed players being rewarded, by attracting those long term investors who also value their sustainable approach.”
Bond developments
Investors are also requesting more ESG research on bond issuers, say providers. Aviva, for instance, has traditionally focused its ESG efforts on equities but also plans to integrate the criteria across all asset classes and regions.
“We’ll definitely look at sourcing the best research possible and we’ll consider commissioning bespoke research too,” says Aviva’s head of corporate responsibility Stephanie Maier.
But fixed income ESG research has room for improvement, say investors.
“Corporate bonds are one area that is not as developed as equities,” says Mike Appleby, a London-based SRI analyst at Alliance Trust, which has around £1.4bn of assets in its sustainable future fund range. “Much of that is because some firms don’t have the same disclosure requirements as public listed entities. But we are seeing some progress in that area.”
Research companies believe they can step up to the task.
“Our country risk monitor can be used for sovereign debt,” says White at Sustainalytics. “As the level of interest grows it will be quite easy to tailor what we offer now to the fixed income markets.”
Green bonds
Along with the demand for ESG research on fixed income, a market for analysing specific bond issues is starting to develop. The proceeds from these products — dubbed green bonds or responsible bonds — are earmarked for socially or environmentally responsible projects.
Air Liquide, the French industrial gases group, sold a €500m nine year bond in October 2012 that was marketed as having some of these credentials.
The bond did not get a rating but received a rubberstamp from Vigeo.
“When a company shows interest in issuing a responsible bond, we highlight a series of requirements to how that bond should, in our opinion, be structured,” says Vigeo’s Smart. “Vigeo has four key criteria, one of which is that the bond itself has to target a project that is dedicated to social and environmental issues.”
Investors, public bodies and corporations are interested in the green bond product, says Smart — although that doesn’t always transpire into deals.
“Responsible bonds offer new access to responsible investors — it can be a great opportunity, however, the path of issuing a responsible bond is not easy or possible for all corporations,” says Smart.
“It’s often easier for local authorities, than for corporations, to identify large enough projects that can attract both institutional responsible investors and meet the criteria Vigeo has outlined for responsible bond issuance. There’s potential in the long term but for it to remain credible and genuine, there has to be recognition that issuing a responsible bond is not something every corporation is currently in a position to do.”
Independence matters
Some SRI research companies are considering rating green bonds. However, others are unsure about the move as it could mean they receive payment from the issuer of the bond, something at odds with the standard SRI ratings business model of relying on investor payments.
Oekom’s Jung believes independence from the institutions being rated is crucial to providing an accurate reflection of an institution’s SRI credentials.
“One of the major requirements for ESG rating quality is the independence of the rating agency or research house — there should be no link to the issuers being rated,” he says.
“That’s neither in terms of the people that own the company nor in terms of providing consulting services to these companies. In financial credit ratings it’s very common for companies to pay for a rating but in ESG it’s very uncommon. We rate issuers on behalf of clients. We have clear independence from the companies.”
A shift towards an issuer payment model also worries investors.
“We want independent research that’s robust and not influenced by other factors,” says Aviva’s Maier. “Obviously a direct revenue stream from the company being rated would raise concerns.”
There could be a solution, however. Oekom can analyse a division of a company and decide whether it warrants a different rating from the parent, a rating that would also apply to any bonds the division issues.
But specific ratings for bonds may be a moot point anyway, according to Alliance’s Appleby.
“If the bond prospectus said money was earmarked for a specific project I’d be very surprised if it wasn’t the case,” he says. “That’s not to say we take everything at face value but I’m not sure there’s a massive need for policing that.”
Others see further arguments against rating specific bonds.
“The potential danger of having a requirement for third party certification is that it might lead to a bottleneck that could restrict the growth of the market,” says Navindu Katugampola, vice president in SSA origination at Morgan Stanley in London. “To help the market develop, you need something that is available to all but is also a rigorous standard. We need to promote accessibility for issuers, but should be careful not to sacrifice rigour and diligence in doing this.”
Suzanne Buchta, managing director, green DCM Americas at Bank of America Merrill Lynch in New York, agrees more standards are required.
“We would encourage NGOs, research centres and not-for-profits to create standards on the use of proceeds that can be followed for green bonds,” she says.
“Those standards should be public, timely and scalable and continue to evolve as the market evolves. That’s something we encourage in particular to maintain the integrity of the market as it grows over time. We don’t want something that prohibits the market from growing at all [and] we don’t want to force entities looking to come to market to jump through a hoop that doesn’t even exist yet.”
Supranationals have provided a good benchmark for such standards, according to Julia Hoggett, responsible for EMEA green DCM at Bank of America Merrill Lynch in London.
“The multinationals benefit from having had a socially responsible ethos baked into their DNA for some time,” she says. “When you move into the corporate and the financial institution space, the onus shifts to demonstrating how the money has been spent and the verification of that spending.”
