By Cecile LAFON, Partner and Tarek BOURCHACHEN, Senior Consultant
Many investors now want to give meaning to their investment, and we can only welcome this. At the end of March 2021, nearly €11,000 billion in European assets somehow incorporated environmental, social and governance (ESG) criteria, factors and risks according to a study published in November 2021 by EFAMA, the European asset management association. And these assets have only increased, very significantly, over the last two years.
Taking ESG criteria into account in investment choices is therefore now a reality. In this respect, the impact of extra-financial analysis is increasingly integrated into the overall assessments of companies, states or other types of securities issuers (local authorities, supranational bodies, para-public organisations, etc.).
To guide their choices, investors can use their own methodology or that of extra-financial rating agencies. Who are they? How do they work? Can their analysis be enough for investors who want to use their savings for sustainable development?
Who are the extra-financial rating agencies? What is their role?
Since the early 2000s, new types of rating agencies have developed. They aim to assess the environmental, social and governance policies of issuers of listed and unlisted securities and to establish, based on this analysis, a rating to compare the ESG practices of these different issuers. This rating is used in particular by management companies to establish SRI (Socially Responsible Investment) funds.
To establish their ratings, these agencies mainly rely on:
- Information from companies themselves: reference documents, sustainable development reports, etc. ;
- Public documents such as tax returns or social balance sheets;
- Qualitative data retrieved through questionnaires sent to companies and interviews conducted with staff and management;
- The direct environment of the company: trade unions, NGOs, suppliers, customers.
Following the collection and analysis of this information, they assign a score based on their own ESG criteria weightings.
Unlike financial rating agencies, investors remunerate extra-financial rating agencies so that they assess the companies in which they wish to invest. This is referred to as an “investor-payer” model, as opposed to an “issuer-payer” model, which limits the risks of conflicts of interest, but makes the economic model of rating agencies more fragile. For some years now, there has been a strong concentration movement in this sector. The main generalist extra-financial rating agencies include Vigéo Eiris (part of Moody’s ESG Solutions since 2021), MSCI ESG Research, ISS-oekom, EcoVadis and Sustainanalytics (part of the Morningstar group).
What are the limits to extra-financial ratings?
Each rating agency applies its own assessment methodology: whether it concerns the variables used to calculate the scores, the controls performed on the data collected, the processing of missing data, the weights attributed to the various variables and components of the score or the calculation methods, the methodologies implemented by the rating agencies may be very different and thus contribute to an absence of convergence of ratings.
The choice of rating criteria and their weighting may differ for several reasons (business sectors, countries, etc.). In addition, the E, S and G criteria do not all have the same weight in the rating of certain agencies. Consequently, a company with a high social impact but a less significant environmental impact may nevertheless have a high overall rating.
Beyond the weighting, the scores assigned to companies may vary significantly depending on the data used, their approval in the calculation and their interpretation. It then becomes difficult to compare the different rating methodologies. Especially as the data collected are often themselves insufficient, heterogeneous or of poor quality, and the current regulatory framework for non-financial reporting is still largely insufficient.
The non-financial rating must therefore become more reliable and more comparable.
What levers can be used to address these limits?
More transparency to improve comparability
It is not necessarily desirable to move towards greater convergence of methodologies as this could adversely affect market efficiency, even if rating agencies insist that their rating reflects an opinion and should not in itself constitute a recommendation to buy or sell a financial security.
However, it seems absolutely necessary to move towards greater transparency on the part of rating agencies, in order to improve their credibility. This transparency concerns both:
- The sources of the data and the methods used to ensure their reliability and the improvement of their completeness;
- Rating methods, processes and remuneration methods;
- Identifying and managing conflicts of interest.
Aware of this need for transparency, some rating agencies have begun a certification process. There are currently two standards, issued on a voluntary basis, aimed at ensuring the implementation of good practices concerning, in particular, the data collected and the transparency of the methodologies used: the Deep Data Delivery Standard and Arista. This is undoubtedly an avenue to be explored to increase transparency and, therefore, the credibility of non-financial rating agencies.
Harmonised ESG reporting for greater reliability
To increase reliability, rating agencies must be able to rely on more standardised and harmonised data. However, this quality of information is not always up to date with the ESG reports currently produced by companies. The harmonisation of companies’ ESG standards and reports is therefore crucial.
With this in mind, several standardisation procedures are underway, including that of the European Union, which presented the Corporate Sustainability Reporting Directive (CSRD) in April 2021. This will soon replace the directive on non-financial reporting for companies (NFRD). The CSRD must extend the requirements of the NFRD and apply them to all companies with more than 250 employees while improving the content of non-financial reports: companies will thus have to communicate information on sustainability and climate change issues and assess the impact of their activity on the environment and society in general. The reporting process will be simplified thanks to the interoperability of ESG criteria, with homogeneous standards to be developed by the EFRAG (European Financial Reporting Advisory Group). In France, the new provisions will replace the non-financial performance declaration (DPEF) from 1 December 2022 according to the European Commission's timetable.
In the same vein, certain US private players such as the Sustainability Accounting Standards Board and The Climate Disclosure Standards Board have each put in place a framework as well as standardised tools to integrate climate change information into companies' financial reports.
It will also be necessary to rely on the IFRS foundation, which manages accounting standards internationally. It is currently working on sustainable reporting standards.
Conclusion: The growing interest in responsible investment represents a major step forward in the construction of a fair and sustainable society, which combines economic performance, respect for the environment and social responsibility.
The extra-financial rating should thus enable investors to direct their savings towards companies that are committed and act towards greater sustainability.
The recent scandal at Orpea (abuse of elderly people, failure to respect union rights for staff) highlighted the limitations of current rating models. This company had a very good rating since it was ranked 5th or 6th in its sector according to various extra-financial rating agencies.
To avoid “CSR washing” linked to the strategies of companies that master codes and use these good ratings to attract investors, it is essential to change the rating model towards a more rigorous and transparent methodology.
The credibility of rating agencies and their approach is at stake.