Focusing Corporate Sustainability Ratings on What Matters

Investors need strong signals on sustainability performance--signals that cut through the noise. Toward this end, corporate sustainability ratings must focus on what really matters, not just quantity of corporate ESG disclosure, but quality and materiality.
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Co-authored by Allen White

In the mid-1990s, corporate sustainability ratings, ranking and indexes began to appear with the goal of helping investors "do well while doing good." The trend has accelerated over the past 15 years, and today there are more than 100 organizations offering more than 400 corporate sustainability ratings products that assess some 50,000 companies on more than 8,000 metrics of environmental, social and governance (ESG) performance.

Corporate ESG rating is a growing field, rife with innovation, competition, and promise. These ratings have the potential to help guide markets toward sustainable outcomes in which high ESG performing companies receive recognition and reward. However, with the large and growing number of ratings products currently available and a deluge of sustainability disclosure from corporations, investors face substantial challenges in discerning which ratings and factors are most relevant to their needs.

Investors need strong signals on sustainability performance--signals that cut through the noise. Toward this end, corporate sustainability ratings must focus on what really matters, not just quantity of corporate ESG disclosure, but quality and materiality.

Within ESG investing, the volume of corporate disclosure through sustainability reports and questionnaires has sometimes been used a proxy for performance. This assumption is not entirely without merit. Companies that are serious about transparency, it could be argued, are those most likely to effectively manage risks of both acute events like a major airborne chemical release or pipeline rupture, or chronic conditions such as human rights violations or supply chain mismanagement.

However, investors, raters, and companies alike have come to recognize the serious flaw in equating volume of disclosures with quality of performance. When disclosures fail to focus on data that is germane to long-term company performance, the signal to investors is blurred and misleading, regardless of the volume of disclosures.

To achieve improved risk-adjusted returns, ESG ratings, rankings, and indexes must rate companies on material factors, and be transparent about what those factors are. Factors likely to be material differ at the industry level. What matters to a forest products firm may have little relevance to an IT hardware enterprise. The determination of whether a particular issue is material requires discretion on the part of the both the rater and the investor, and it should not preclude the universal indicators, such as fair wages, carbon emissions, or occupational health and safety. Rater discretion is indispensable to avoiding indiscriminate use of all possible issues and indicators while controlling the tendency toward data overload.

Research shows that materiality matters. In a recently issued Harvard Business School working paper, "Corporate Sustainability: First Evidence on Materiality", authors Mozaffar Khan, George Serafeim and Aaron Yoon analyzed a dataset that illuminated the value implications of sustainability investments using the materiality framework developed by the Sustainability Accounting Standards Board (SASB). Based on a time-series analysis of 2,300 companies, the authors found that companies with good performance on material sustainability issues significantly outperform firms with poor performance on these issues."

Since the Harvard research shows that only 20 percent of what companies currently disclose is material to investors, a clear opportunity exists to refine investor-focused reporting to focus on what truly matters. This should significantly reduce the costs of corporate data reporting, data collection, and index construction and maintenance, as well as enhancing the signal to noise ratio in sustainability reporting.

Our respective organizations, the Sustainability Accounting Standards Board (SASB) and the Global Initiative for Sustainability Ratings (GISR), are working to position materiality at the core of ratings, rankings and indexes, thereby creating the conditions for directing capital to both individual firms and indexes that are likely to outperform, respectively, their peers and the overall market. With the increased rigor and transparency that GISR brings to ratings, coupled with the comparable, decision-relevant data from SASB standards, companies and investors alike can reap the rewards of materiality-driven analytics.

As independent, non-profit organizations, SASB and GISR are in the business of advancing responsible business and responsible investing worldwide. Neither organization grades raters. Instead, our business is to facilitate the exchange of decision-useful, material information to the capital markets. Transparent comparable and material factors will drive continuous improvement across the three critical players in the ESG landscape: rated companies, rating agencies, and ratings users.

Enriching this tripartite relationship promises to vastly expand the global ESG-based assets under management, as well as the market for ESG products that truly enhance the quality of ESG investments.

Dr. Jean Rogers is Founder and CEO of the Sustainability Accounting Standards Board Dr. Allen White is Founder and Co-Chair of the Global Initiative for Sustainability Ratings and Co-Founder of the Global Reporting Initiative

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