As interest in sustainable investing has grown, so too have the number of companies that now receive environmental, social and governance (ESG) ratings. Sustainalytics, a Morningstar company and a globally recognized provider of ESG research, ratings and data, has been continually focused on expanding its research, with coverage that’s climbed to over 12,000 companies today.

When it comes to ESG investing, ratings are key, as they help investors and advisors decide on what businesses and funds to potentially add to their portfolios. With 141 Canadian-made ESG mutual funds and exchange-traded funds (ETFs) available for purchase as of December 2020 – there were 102 funds at the end of 2019, according to Morningstar Direct1 – investors want to know that the companies they’re holding are meeting high ESG standards.

That’s especially true today, with the pandemic putting a greater focus on the interconnectedness of sustainability and financial costs.

“The past year has really underscored this conviction that strong ESG performance can be indicative of resiliency, especially during a downturn,” says Trevor David, associate director at Sustainalytics.

Measuring key metrics

The ESG ratings industry has exploded over the last few years, with several companies now scrutinizing and reviewing company reports, business decisions and exposure to controversies, in such areas as human rights and business ethics.

A growing number of fund companies are also collaborating with these firms to create ESG funds that align with specific sustainability themes and values. For instance, three new ESG-focused ETFs at TD Asset Management Inc. (TDAM), follow indexes created by and licensed from Morningstar, which incorporate the research Sustainalytics conducts.

Firms look at a wide range of metrics that relate to how a business mitigates ESG risks. Sustainalytics, for instance, assesses companies based on exposure to 20 material ESG issues, including the environmental and social impact of products and services, human rights, data privacy, business ethics, corruption, community relations and greenhouse gas emissions, among others.

“Corporate governance is important, for instance, because it’s considered a material issue for all companies,” says David, adding a company’s corporate governance practices could detract from or add to their business strategies.

Another important factor is the degree to which an ESG risk can be managed by the company and what portion of it is unmanageable.

“For certain issues, like cybersecurity, we consider a portion of risk exposure to be unmanageable,” says David. “Despite a company having strong data privacy and security programs in place, there remains a degree of inherent risk of a data breach.”

Company-specific factors could also influence a rating – certain products or services may influence their exposure to certain ESG risks – while other things like lost time due to injuries or a company’s involvement in an oil spill or pipeline protest could serve as “important data points to inform our view of how companies are exposed to and managing risk for a given issue,” says David.

Settling on a score

When all is said and done, a company receives an overall ESG risk score, and is based on a 0 to 100 scale. The higher the score, the more ESG risk a company is exposed to and the higher the chances it could experience a material financial impact. A score between 0 and 10 is rated negligible, 10 to 20 is low, 20 to 30 medium, 30 to 40 is categorized high and anything above 40 is regarded as severe ESG risk exposure.

These ratings are critical, because not all companies that say they care about ESG actually do. Many businesses extol the virtues of racial and gender equality on social media, for instance, while their own workforce is anything but diverse. Others might say they care about the environment, but don’t take any meaningful steps toward, say, reducing their carbon footprint.

“Our approach to getting past this disconnect is to apply a robust and consistent methodology to evaluate ESG risks for issues that are most material for the company,” says David.

In other words, when assessing automotive companies, for instance, Sustainalytics is less focused on recycling efforts at head office, compared to identifying if structures are in place to address material issues like fleet emissions, eco-design, product safety and human capital. Evaluating the strength of key policies and programs alongside quantitative performance is “critical in understanding if commitments are meaningful and how company performance is changing year over year and relative to its peers,” says David.

Investing in ESG

While a company like TDAM has a number of analysts that review companies – and TDAM has been incorporating various ESG factors into its funds for years – it helps to work with a firm that’s dedicated to assessing these kinds of risk factors.

When building its ETFs, David Roode, vice president and director of ETF Product Strategy at TDAM, says that it starts with “our ability to trust the ratings that Sustainalytics puts together, and then an investor’s ability to trust that the composition of the portfolio reflects values investors want to invest in.”  He adds that “we’re confident when we create a product that has Sustainalytics’s ESG rating that it’s achieving those particular aims for the individual investor.”

Roode, who helped design the three new ESG funds at TDAM – the TD Morningstar ESG International Equity Index ETF (TMEI), the TD Morningstar ESG Canada Equity Index ETF (TMEC) and the TD Morningstar ESG U.S. Equity Index ETF (TMEU) – and the team at Morningstar and Sustainalytics are measuring the ESG performance of the securities in the underlying index. Indeed, every quarter they review the sustainability scores of the businesses in these funds and takes out names that are no longer on the right side of the ESG spectrum.

“It’s not just a question of looking at what the companies say, it’s a question of evaluating what they do and how they react,” he says.

While sustainability has become a hot topic, most investors are relying on their advisors to help them navigate the ever-expanding world of ESG. And they have their work cut out for them: In the future, with regulators and investors continuing to press companies for greater transparency, more companies will adopt ESG policies. Disclosures will also improve, which will give rating firms more information to evaluate a businesses’ ESG characteristics and their impact on financial performance. “We believe that over time you’ll see those companies with high ESG scores will outperform,” says Roode. “This is a trend we expect to continue well into the future.”

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1 - Source: Morningstar Direct.